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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.

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

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

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

Utilities Sector as Stock Market Tell

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

Measuring the Stock Illiquidity 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

Practically Beating a Market-weighted Stock Index?

Is there a simple compromise between easy-to-implement market weights and more diversified equal sector and equal stock weights? In their December 2013 paper entitled “A Simple Diversified Portfolio Strategy”, Bernd Hanke and Garrett Quigley present a stock portfolio construction approach that blends market weights, equal stock weights and equal sector weights. The objectives of the approach (relative to market weights) are: (1) higher returns (by capturing more of the diversification premium); (2) lower risk (via increased diversification); and, (3) competitive capacity and rebalancing frictions (by limiting the tilt toward small, illiquid stocks). In testing this approach, they form and rebalance annually regional (U.S., European and Japanese) portfolios of relatively liquid stocks. They ignore rebalancing frictions. They define sectors via the broadest Global Industry Classification Standard level (ten sectors). Using total (dividend-reinvested) returns, market capitalizations and sector memberships for a broad sample of relatively liquid stocks during January 1992 through March 2013, they find that: Keep Reading

Emerging Markets Developed Yet?

Do emerging markets still deserve their reputation as a portfolio-diversifying asset class? In the October 2013 version of their paper entitled “Emerging Equity Markets in a Globalizing World”, Geert Bekaert and Campbell Harvey examine whether, given the dramatic globalization of the past 20 years, it still make sense to classify country equity markets as “developed” or “emerging.” Using monthly returns as available for developed and emerging equity markets mostly during January 1988 through August 2013, they conclude that: Keep Reading

Optimal Allocation to Equities Versus Investment Horizon

Are stocks so attractive over the long run that they crowd bonds and cash out of the optimal portfolio? In their September 2013 paper entitled “Optimal Portfolios for the Long Run”, David Blanchett, Michael Finke and Wade Pfau relate optimal portfolio equity allocation to investment horizon worldwide to determine whether stocks universally exhibit time diversification (whereby mean reversion of returns causes equity risk to decrease as investment horizon lengthens). In calculating optimal equity allocation, they employ a utility function to model how investors feel about the risk of good and bad outcomes (not volatility as measured by standard deviation of returns). They consider different levels of investor risk aversion on a scale of 1 to 20, with 20 extremely risk averse. They measure returns for both overlapping and independent investment intervals of 1 to 20 years. They constrain portfolios to long-only positions in three assets: government bills (cash), government bonds and stock indexes. Using annual real returns to local investors in bills, bonds and stock indexes for 20 countries during 1900 through 2012, they find that: Keep Reading

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