Equity Premium

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.

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Bench the Market Benchmark?

Is the capitalization-weighted market portfolio a lame benchmark? In his August 2014 paper entitled “It’s Easy to Beat the Market”, Moshe Levy tests the perception that it is hard to beat a capitalization-weighted portfolio and therefore that an index so weighted is a challenging benchmark. Specifically, he compares the gross risk-adjusted performance of a capitalization-weighted buy-and-hold portfolio to those of 1,000 random-weighted (normalized to 100%) buy-and-hold portfolios of the same stocks.To ensure liquidity, he restricts the portfolios to the 500 U.S. stocks with the largest market capitalizations at the beginning of 1998. If a stock is delisted during the sample period due to merger/acquisition or bankruptcy, he sets its weight to zero at that point and renormalizes residual portfolios to 100% [per an email exchange with the author]. He focuses on Sharpe ratio and terminal value of an initial investment as key performance metrics. He ignores trading frictions, arguing that no trading is involved other than initial purchases at portfolio formation and reinvestment of dividends. Using daily total (dividend-reinvested) returns for the specified stocks and the contemporaneous 30-day U.S. Treasury bill yield as the risk-free rate during January 1998 through December 2012, he finds that: Keep Reading

The 2014-2023 Equity Risk Premium

What is the best estimate of the Equity Risk Premium (ERP), the return in excess of the risk-free rate required as compensation for the risk of holding equity? In his August 2014 paper entitled “A History of the Equity Risk Premium and its Estimation”, Basil Copeland summarizes recent ERP estimates and explains how the historical equity return can overstate ERP in terms of unanticipated (anomalous) capital gains. He further describes the behavior of historical and expected ERP during 1872 through 2013 and estimates ERP for 2014 through 2023. He discusses ERP estimation issues such as geometric mean versus arithmetic mean and top-down versus bottom-up forecasts. Using data from Shiller for 1871-1959 and from Damodaran for 1960-2013, he finds that: Keep Reading

Preponderance of Evidence Bad for U.S. Stocks?

Is the U.S. stock market in a Federal Reserve-driven bubble that is about to burst? In his August 2014 paper entitled “Fed by the Fed: A New Bubble Grows on Wall St.”, Oliver Dettmann examines how shifts away from quantitative easing by central banks, and the introduction of rising interest rates, may affect current valuation levels of the U.S. stock market. He focuses on a discounted real earnings model, employing a range of optimistic, moderate and pessimistic scenarios. Based on estimates of S&P 500 real earnings growth and an implied earnings discount rate derived from a sample period of January 1974 through June 2014, he finds that: Keep Reading

Composite Stock Market Valuation Model

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

2014 Country Equity Risk Premiums from Academia and Practitioners

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

Emerging Stock Markets Research Stream

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

Basic Equity Return Statistics

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

Equity Premiums Overgrazed?

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

Long-term Equity Risk Premium Erosion?

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

CFOs Project the Equity Risk 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

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