The equity risk premium, the excess return that investing in the stock market provides over a risk-free rate such as US Treasury bonds, is an important part of financial theory. The majority of economists and analysts agree that the concept of an equity risk premium is valid as over the long-term the market will compensate investors for taking on the greater risk of investing in stocks.
Calculating the equity risk premium requires two key data inputs, the estimated expected return on stocks and the estimated expected return on safe bonds. Unfortunately, in today’s world of ultra-low interest rates and easy money policies that are pushing money into equities, inflating valuations and pushing down long-term expected returns, the equity risk premium has been crushed to such a level that is now debatable if equity investment is worth the extra risk.
Indeed, equity investment is no less risky today than it has been for 100 years. Granted, dovish central bank policies are pushing money into equities and an extent this is limiting downside. However, over the past 12 months on two occasions the S&P 500 has recorded declines of 10% or more in just a few weeks proving that investors are as still as jumpy as ever.
Analysts at BCA Research calculate that between 1871 and 2016, the equity risk premium on US stocks is 5.5%. Today, BCA’s research shows that the equity risk premium stands at just 4.7%, which is arguably too low to compensate investors for the risk they are taking on by buying equities. If you consider the fact profit margins are acts structural highs, the debt supercycle is fizzing out, and most central banks have used up all useful monetary policy ammunition, and equity risk premium below the long-term average doesn’t make much sense.
Another 200 points of upside for the S&P 500?
Analysts at Deutsche Bank have a different view. According to analysts Dominic Konstam and team, over the past 30 years the equity risk premium is around 2% and today, the premium is still some 2% higher than this historical average. Deutsche Bank’s analysts go on to estimate that the S&P 500 could rise another 200 points from current levels to make up this difference. But this optimistic forecast comes with a more ominous undertone.
Deutsche Bank’s research shows that the current stock market rally (2012 to 2016) is almost entirely a result of the contracting equity risk premium. 90% of the recent rally can be traced to a collapse in the equity risk premium. As Konstam explains:
“The current cycle stands out in that earnings have played almost no role in the SPX rally. In fact, earnings were a slight drag on equities and were only offset by an aggressive multiple expansion. More than 90 percent of the rally was attributed to a collapse in equity risk premium … In sharp contrast, the equity gains in the 1980s and 2000s were all about earnings growth, and in 1990s earnings still accounted for more than half of the rally.” — Deutsche Bank
It’s hard to reach a conclusion as to what these two opposing views mean for investors. Although it’s clear that a bull market is driven almost entirely by a shrinking equity risk premium is nowhere near as sustainable as a rally driven by earnings growth.