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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.

The Worldwide Equity Risk Premium

What is the state of the equity risk premium across global markets? In the October 2011 version of their paper entitled “Equity Premia Around the World”, Elroy Dimson, Paul Marsh, and Mike Staunton update their estimates of equity risk premiums for 19 country markets and a worldwide aggregate relative to both short-term government bills and long-term government bonds over a period of 111 years. They report local currency and dollar-based real returns and the historical equity premium for each country, and they decompose the premium into dividends, dividend growth, multiple expansion and change in real exchange rate. All aggregates are value-weighted. Using stock, bond, bill, inflation and currency returns for the period 1900 through 2010, they find that: Keep Reading

Equity Risk Premium Book Learning

What do leading textbooks have to say about the excess return you got, should expect, should require or should infer from the market for taking the risk of owning stocks? In the July 2011 version of his paper entitled “The Equity Premium in 150 Textbooks”, Pablo Fernandez reviews definitions and values of the equity risk premium offered in 150 finance and valuation textbooks published from 1979 to 2009. Based on this review, he finds that: Keep Reading

Technical Boost to Fundamental Stock Market Forecasting?

Do technical indicators add value to fundamental indicators in assessing broad stock market valuation? In their March 2011 paper entitled “Forecasting the Equity Risk Premium: The Role of Technical Indicators”, Christopher Neely, David Rapach, Jun Tu and Guofu Zhou examine the powers of technical and fundamental indicators to predict stock market returns. They consider 12 variations of three stock market index technical indicators: (1) relative values of two moving averages (1 month versus 3, 6, 9 and 12 months); (2) return momentum (past 3, 6, 9 and 12 months); and, (3) relative values of two on-balance volume moving averages (1 month versus 3, 6, 9 and 12 months). They consider 14 fundamental indicators ranging from stock market valuation ratios to Treasury yields, yield spreads and the default spread. They compare mean squared equity risk premium forecast errors for technical and fundamental indicators to that for the historical average premium. They also compare the average utility gain for a mean-variance investor who allocates monthly between stocks and Treasury bills based on either technical or fundamental market forecasts to that for an investor who uses the historical average premium. Finally, they generate equity risk premium forecasts based on a rolling principal component analysis that encapsulates the predictive powers of the 26 technical and fundamental indicators into three or four variables. Using monthly price and volume data for the dividend-adjusted S&P 500 Index and monthly readings of the 14 U.S. fundamental indicators as available over the period 1927 through 2008 (1926-1959 for in-sample optimization and 1960–2008 for out-of-sample testing), along with NBER business expansion and contraction dates, they find that: Keep Reading

A Generation of Disappointed U.S. Equity Investors?

How have S&P 500 firms performed over the past two decades, in aggregate and individually, relative to reasonable investor expectations? In their February 2011 brief entitled “Shareholder Value Creators in the S&P 500: 1991-2010”, Pablo Fernandez, Javier Aguirreamalloa and Luis Corres tabulate the creation of value by major U.S. firms for long-term shareholders relative to a rationally constructed required rate of return for an equity investment. Using stock prices and capital flows for 644 firms assigned to the S&P 500 Index in 2004 or 2010, along with 10-year Treasury note (T-note) yields and equity risk premium estimates over the period 1991 through 2010, they find that: Keep Reading

An Era of Unstable Risk Premiums?

How stable are risk premiums? How should investors respond to instabilities? In his August 2010 paper entitled “A New ‘Risky’ World Order: Unstable Risk Premiums: Implications for Practice”, Aswath Damodaran presents approaches for estimating equity, bond and real asset risk premiums that are imprecise, unstable and linked across markets. He also explores the implications of dynamic, linked premiums for asset allocation, market timing and asset valuation. Using long-run data for all three asset classes, he concludes that: Keep Reading

All the Equity Risk Premiums?

What would the distribution of equity risk premium estimates from a broad sample of studies look like? What factors explain the dispersion of estimates? In their August 2010 paper entitled “A Meta-Analysis of the Equity Premium”, Casper van Ewijk, Henri L.F. de Groota and Coos Santing collect and analyze equity risk premium estimates derived from a broad range of sample periods, markets and methods. Using a base of 24 studies including 535 distinct measurements of the equity risk premium, they find that: Keep Reading

The Equity Risk Premium Through 2008

How has stock market behavior during the 2000s affected estimates of the U.S. equity risk premium? In the February 2009 version of their paper entitled “The Equity Premium Revisited”, Bradford Cornell, Robert Arnott and Max Moroz update estimates of the equity risk premium to incorporate the generally weak U.S. stock market performance through 2008. They consider three models to estimate the premium relative to an annualized real commercial paper yield: (1) dividend yield plus capital gains; (2) dividend yield plus dividend growth rate; and, (3) dividend yield plus earnings growth rate. Using historical data for dividends, earnings, stock market returns (for the S&P 500 and antecedents) and six-month commercial paper yields spanning 1872-2008 (with focus on 1951-2008), they conclude that: Keep Reading

Trading Frictions Over the Long Run

Careful assessment of the exploitability of premiums or anomalies derived from long-run series such as stock indexes requires consideration of contemporaneous trading frictions. How have frictions changed over time? In the May 2002 version of his paper entitled “A Century of Stock Market Liquidity and Trading Costs”, Charles Jones assembles annual long-run series of three components of aggregate liquidity: (1) proportional bid-ask spreads for large-capitalization NYSE stocks (1900-2000); (2) proportional commissions for NYSE stocks (1925-2000); and, (3) turnover for NYSE stocks (1900-2000). He applies these series to explore the relationship between stock market returns and aggregate liquidity over time. Using a range of sources to calculate bid-ask spreads for the Dow Jones/DJIA stocks and commission, volume and return data for a broader sample of NYSE stocks, he finds that: Keep Reading

Fear of Disasters?

Is fear of rare stock market plunges a major factor in the pricing of equities? In the March 2010 version of their paper entitled “Tails, Fears and Risk Premia”, Tim Bollerslev and Viktor Todorov apply highly empirical methods to examine the distribution of large rare events and the effects of these events on the equity risk premium and the volatility risk premium. Specifically, they define and measure an Investors Fears index driven by: (1) slow variation in investment opportunities (for example, due to economic and demographic influences); and, (2) large rare events (for example, due to economic and political crises). Using high-frequency (five-minute) prices for S&P 500 Index futures prices during 1990-2008 and prices for near-to-expiration out-of-the-money S&P 500 Index options during 1996-2008, they conclude that: Keep Reading

The 2008 Equity Risk Premium from Academia

What is the current academic estimate of the annual premium over the risk-free rate demanded by equity investors. How has that estimate changed over the past year and since 2000? In his February 2009 paper entitled “Market Risk Premium Used in 2008: A Survey of More Than a 1,000 Professors”, Pablo Fernández summarizes the results of an early 2009 email survey soliciting the risk premium “that we, professors, use to calculate the required return to equity” in 2008 and in previous years. Based on 1,161 responses to the survey from finance and economic professors around the world, he finds that: Keep Reading

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