Blog - Investing Notes

July 21, 2008 - Update: CFOs Project the Equity Risk Premium

How do the corporate experts most responsible for assessing the cost of equity currently feel about future stock returns? In their July 2008 paper entitled "The Equity Risk Premium in January 2008: Evidence from the Global CFO Outlook Survey", John Graham and Campbell Harvey provide an updated report on the views of U.S. Chief Financial Officers (CFOs) on the prospective equity risk premium relative to the yield on 10-year U.S. Treasury notes (T-notes), assuming a 10-year investment horizon. After analyzing 388 responses to the 32nd quarterly survey on this topic, they find that:

• CFOs on average currently expect an annual return of 7.58% for the S&P 500 index over the coming decade. This expectation implies an equity risk premium of 3.80%, higher than the overall series average of 3.46% and the highest since March 2004.
• The standard deviation of individual responses in the most recent survey is 2.97%, the second highest level of disagreement across the series.
• Associated personal interviews indicate that CFOs follow the stock market closely. They interpret the equity risk premium as the long-term return above the T-note yield of buying and holding equities, so their average estimate indicates a geometric rather than arithmetic mean return.
• Informal statistical analyses indicate that the survey-based prospective equity risk premium relates (1) somewhat negatively to the real interest rate and (2) strongly positively to the implied volatility of the S&P 100 index option (VIX). (See the chart below for the latter relationship.)
• There seems to be no correlation between the survey-based prospective equity risk premium and past stock returns. There may be some relationship between the estimated premium and the aggregate stock price-earning ratio when the ratio is either relatively low or relatively high.

The following chart, taken from the paper, shows the contemporaneous relationship between the survey-based prospective equity risk premium and the VIX across all 32 quarterly surveys. The correlation between the the two series is a notable 0.64. Both series appear to be rebounding from an extreme low in 2006.

In summary, a current survey of U.S. CFOs indicates a prospective equity risk premium that is fairly small but on a two-year uptrend (to 3.80%).

For other research on the equity risk premium, see Blog Synthesis: The Equity Risk Premium.