Governments are largely insulated from market forces. Companies are not. Investments in stocks therefore carry substantial risk in comparison with holdings of government bonds, notes or bills. The marketplace presumably rewards risk with extra return. How much of a return premium should investors in equities expect? These blog entries examine the equity risk premium as a return benchmark for equity investors.
July 23, 2014 - Equity Premium
Is there some better predictor of long-term stock market return than the widely cited cyclically adjusted price-earnings ratio (P/E10 or CAPE)? In the July 2014 version of his paper entitled “Forecasting Equity Returns: An Analysis of Macro vs. Micro Earnings and an Introduction of a Composite Valuation Model”, Stephen Jones compares how well several fundamental and economic factors predict real long-term (10-year) equity market total return, with focus on Market Value/Gross Domestic Product (MV/GDP). He compares the predictive power of MV/GDP to those of P/E10 and Tobin’s q. He then constructs a multi-variable forecasting model that includes MV/GDP, a demographic metric and personal income-related variables. Using U.S. data since 1954 for different input variables, he finds that: Keep Reading
July 7, 2014 - Equity Premium
What are the current academic and practitioner estimates of annual premiums over the risk-free rate demanded in each country by equity investors? In their June 2014 paper entitled “Market Risk Premium Used in 88 Countries in 2014: A Survey with 8,228 Answers”, Pablo Fernandez, Pablo Linares and Isabel Fernandez Acin summarize the results of a May-June 2014 email survey “about the Market Risk Premium (MRP or Equity Premium) that companies, analysts and professors use to calculate the required return on equity in different countries.” Based on 2,022/1,278/1,803/1,968 specific responses to the question from professors/analysts/financial companies/non-financial companies, respectively, around the world, they find that: Keep Reading
June 24, 2014 - Equity Premium
What are the main investment behaviors of emerging markets and component stocks? In their January 2014 paper entitled “Studies of Equity Returns in Emerging Markets: A Literature Review”, Yigit Atilgan, Ozgur Demirtas and Koray Simsek survey the stream of research on emerging markets equity return predictability and volatility. This survey covers articles in the top four finance journals (Journal of Finance, Journal of Financial Economics, Journal of Financial and Quantitative Analysis and Review of Financial Studies) and the three finance journals that focus on emerging markets (Emerging Markets Finance & Trade, Emerging Markets Review and Journal of International Money and Finance). Based on detailed reviews of 54 articles published in these journals over the past three decades, they conclude that: Keep Reading
June 3, 2014 - Big Ideas, Equity Premium
What do the basic statistics of stock market returns tell us about risk and predictability? Basic statistics are the measures of the moments of the return distribution: mean (average), standard deviation, skewness and kurtosis. Are these stock market return statistics (and the risk-reward environment they describe) stable over time? Do they reliably relate to future returns? To make the investigation tractable, we calculate these four statistics month-by-month based on daily returns. Using daily closes of the Dow Jones Industrial Average (DJIA) for January 1930 through April 2014 (1012 months) and the S&P 500 index for January 1950 through April 2014 (772 months), we find that: Keep Reading
May 23, 2014 - Equity Premium, Momentum Investing, Size Effect, Value Premium
Are investors exhausting the potential of stocks? In his May 2014 presentation packages entitled “Has The Stock Market Been ‘Overgrazed’?” and “Momentum Has Not Been ‘Overgrazed’”, Claude Erb investigates the proposition that sanguine research and ever easier access to investments are exhausting U.S. stock market investment opportunities. In the first package, he focuses on trends in the overall equity risk premium, the size effect and the value premium. In the second, he focuses on momentum investing. Using U.S. stock market and equity factor premium returns and contemporaneous U.S. Treasury bill yields during 1926 through 2013, he concludes that: Keep Reading
May 1, 2014 - Bonds, Equity Premium
Does the reward for taking the risk of holding stocks exhibit any long-term trend? In his April 2014 presentation package entitled “The Incredible Shrinking ‘Realized’ Equity Risk Premium”, Claude Erb examines the trend in the realized U.S. equity risk premium (ERP) since 1925. He defines this ERP as the retrospective difference in 10-year yield between the broad U.S. stock market and the 10-year yield on safe assets such as U.S. Treasury bills or intermediate-term U.S. Treasury notes. Using 10-year returns for U.S. stocks and various alternative safe assets (bills, notes and bonds) during 1925 through 2013, he finds that: Keep Reading
April 21, 2014 - Equity Premium
How do the corporate experts most responsible for assessing the cost of equity currently feel about future U.S stock market returns? In their April 2014 paper entitled “The Equity Risk Premium in 2014″, John Graham and Campbell Harvey update their report on the views of U.S. Chief Financial Officers (CFOs) and equivalent corporate officers on the prospective U.S. equity risk premium (ERP) relative to the 10-year U.S. Treasury note (T-note) yield, assuming a 10-year investment horizon. Based on 56 quarterly surveys over the period June 2000 through March 2014 (an average 349 responses per survey), they find that: Keep Reading
April 17, 2014 - Equity Premium, Technical Trading
Does the utilities sector exhibit a useful lead-lag relationship with the broad stock market? In their January 2014 paper entitled “An Intermarket Approach to Beta Rotation: The Strategy, Signal and Power of Utilities”, Charles Bilello and Michael Gayed test a simple strategy that holds either the U.S. utilities sector or the broad U.S. stock market based on their past relative strength. Specifically, when utilities are relatively stronger (weaker) than the market based on total return over the last four weeks, hold utilities (the market) the following week. They call this strategy the Beta Rotation Strategy (BRS) because it seeks to rotate into utilities (the market) when the investing environment favors low-beta (high-beta) stocks. They perform both an ideal (frictionless) long-term test and a short-term net performance test using exchange-traded funds (ETF). Using weekly total returns for the Fama-French utilities sector and broad market since July 1926 and for the Utilities Select Sector SPDR (XLU) and Vanguard Total Stock Market (VTI) since July 2001, all through July 2013, they find that: Keep Reading
April 10, 2014 - Equity Premium
How big is the return premium associated with stock illiquidity? In his March 2014 paper entitled “The Pricing of the Illiquidity Factor’s Systematic Risk”, Yakov Amihud specifies and measures an illiquidity premium. He defines illiquidity as the average daily ratio of absolute return to dollar volume over the past three months. He specifies the illiquidity premium as the average four-factor (market, size, book-to-market, momentum) alpha on a set of hedge portfolios that are long (short) the stocks that are most (least) illiquid. Specifically, each month he:
- Sorts stocks on illiquidity and deletes the 1% with highest illiquidities as unreliable.
- Ranks surviving stocks on standard deviation of daily returns (volatility) over the last three months into three segments (terciles).
- To avoid confounding volatility and illiquidity, ranks stocks within each volatility tercile into illiquidity quintiles (creating 15 volatility-illiquidity portfolios). This step effectively controls for size, which relates negatively to volatility.
- Skips two months (avoiding reversal/momentum effects) and calculates value-weighted returns for the 15 portfolios during the third month after formation based on market capitalizations at the end of the prior month.
- Calculates the monthly illiquidity return as the average difference in returns between highest and lowest illiquidity portfolios across the three volatility groups.
- Calculates illiquidity alpha by controlling monthly illiquidity returns for market, size, book-to-market and momentum factors over the past 36 months.
Using daily and monthly data for all NYSE and AMEX common stocks and monthly factor returns during 1950 through 2012, he finds that: Keep Reading
February 3, 2014 - Equity Premium
What is the consensus of the different approaches to modeling the U.S. equity risk premium (ERP)? In their October 2013 paper entitled “The Equity Risk Premium: A Consensus of Models”, Fernando Duarte and Carlo Rosa estimate the ERP by combining outputs of 20 models prominently used by practitioners and featured in the academic literature. They define the ERP as the compensation investors require to make them indifferent between holding the equity market portfolio (proxied by the S&P 500 Index) and a risk-free bond (proxied by nominal or real U.S. Treasury instruments). They categorize the 20 ERP models into five groups: (1) historical mean returns, (2) discounted dividends, (3) cross-sectional regressions, (4) time-series regressions and (5) surveys. They measure the success of each model as the R-squared statistic for a regression of realized excess returns on ERP model outputs. They calculate the consensus of all models in real time via a single principal component. This approach reduces noise but puts some weight on non-optimal models. Using monthly data as available from widely used academic and government sources during January 1960 through July 2013, they find that: Keep Reading