At the beginning of 2014, the expectation was that government bond rates that had been kept low, at least according to the market mythology, by central banks and quantitative easing, would rise and that this would put downward pressure on stocks, which were already richly priced. Perhaps to spite the forecasters, stocks continued to rise in 2014, delivering handsome returns to investors, and government bond rates continued to fall in the US and Europe, notwithstanding the slowing down of quantitative easing. Commodity prices dropped dramatically, with oil plunging by almost 50%, Europe remained the global economic weak link, scaling up growth became more difficult for China and the US economy showed signs of perking up. Now, the sages are back, telling us what is going to happen to markets in 2015 and we continue to give them megaphones, notwithstanding their forecasting history. Rather than do a standard recap, I decided to use my favored device for assessing overall markets, the equity risk premium (ERP), to take a quick trip down memory lane and set up for the year to come.
The ERP: Setting the stage
The ERP is what investors demand over and above the risk free rate for investing in equities. as an asset class. At the risk of sounding over-the-top, if there is one number that captures investors’ hopes, fears and expectations it is this number, and I have not only posted multiple times on it in the last few years but also updated it every month on my website. In making these updates, I have had to confront a key question of how best to measure the ERP. Many practitioners use a historical risk premium, estimated by looking at how much investors have earned on stocks, relative to the returns on something riskfree ( usually defined as government bills & bonds)). Due to the volatility in stock returns, you need very long time periods of data to estimate these premiums, with “long time period” defined as 50, 75 or even 100 years of data. At the start of each year, I estimate the historical risk premiums for the United States and my January 1, 2015 update is below:
|Stocks: S&P 500; T.Bills: 3-mth Bills; T.Bonds: US 10-year
Geometric average is based on compounded returns
Based on this table, the historical equity risk premium for the US is between 2.73% to 8%, depending on the time period, risk free rate and averaging approach used. I will also cheerfully admit that I don’t trust or use any of these numbers in my valuations, for three reasons. First, using a historical risk premium requires a belief in mean reversion, i.e., that things will always go back to the way they used to be, that I no longer have. Second, all of these estimates of risk premiums carry large standard errors, ranging from 8.65% for the 2005-2014 estimate (effectively making it pure noise) to 2.32% for the 86-year estimate. Third, it is a static number that changes little as the world changes around you, which you may view as a sign of stability, but I see as denial.
In pursuit of a forward-looking, less noisy and dynamic equity risk premium, I drew on a standard metric in the bond market, the yield to maturity:
In the equity market analogue, the bond price is replaced with stock index level, the bond coupons with expected cashflows from stocks, with the twist that the cash flows can continue in perpetuity:
There are both estimation questions (Are cashflows on stocks just dividends, inclusive of buybacks or a broader measure of residual free cashflows to equity?) and challenges (Do you use last year’s cash flow or a normalized value? How do you estimate future growth? How do you deal with a perpetuity?), but they are not insurmountable. In my monthly estimates for the ERP for the S&P 500, here are my default assumptions:
This estimate is forward-looking, because it is based on expected future cashflows, dynamic, because it changes as stock prices, expected cash flows and interest rates change, and it is surprisingly robust to alternative assumptions about cash flows and growth. The spreadsheet that I use allows you to replace my default assumptions with yours and check the effects in the ERP.
The ERP in 2014
Using the framework described in the last section, I estimated an equity risk premium of 4.96% for the S&P 500 on January 1, 2014:
During 2014, the S&P 500 climbed 11.39% during the year but also allowing for changes in cash flows, growth and the risk free rate, my update from January 1, 2015, yields an implied equity risk premium of 5.78%:
At the start of each month in 2014, I posted my estimate of the ERP for the S&P 500 on my website. The figure below graphs out the paths followed by the S&P 500 and the ERP through 2014:
The ERP moved within a fairly narrow band for most of the year, ranging from just under 5% to about 5.5%, with the jump to 5.78% at the end of the year, reflecting the updating of the growth rate.
The Drivers of ERP in 2014
To understand the meandering of the ERP during 2014, note that it is determined by four variables: the level of the index, the base year cash flow, the expected growth and the government bond rate, and is a reflection of the risk that investors perceive in equities. In the figure below, I chronicle the changes in these variables during 2014, at least in my ERP estimates.
A confession is in order. While I update the index levels and government bond rates in real time, I update cashflows once every quarter and the growth rates materially only once a year (at the start of each year). One reason for the precipitous jump in the ERP in the January 1, 2015, update is the updating of the long term growth rate to 5.58% on that date. Updating the cashflow and growth estimates more frequently will smooth out the ERP but not change the starting and ending points.
Perspective: Against history and other markets
When I stated earlier in the post that the ERP was the one number that encapsulated investor hopes and fears, I was not exaggerating, since every statement about the overall market can be restated in terms of the ERP. Thus, if you believe that the ERP at the start of 2015 is around 5.78% (my estimate but you can replace with yours), your market views can be laid bare by how you answer the following question: Given what you perceive as risk in the market, do you think that 5.78% is a fair premium? If your answer is that it (5.78%) is too low (high), you are telling me