The Incredible Shrinking “Realized” Equity Risk PremiumVW Staff
I call BS but here you decide……………….
The realized “trend” equity risk premium has consistently declined since 1925. Given naïve extrapolation of the past, the trend equity risk premium could be 0% by 2050. The lower the trend equity risk premium, the greater the probability that a “safe” asset will outperform stocks. A decades-long decline in the equity share of the “global market portfolio” might be a reaction to the declining trend equity risk premium. A “fundamental” reason for the declining trend equity risk premium could plausibly have been a decline in the stock-“safe” asset “yield spread”, the difference between the “CAPE earnings yield” and a “safe” asset’s yield. More informally, stocks might have been too expensive for too long relative to “safe” assets. Until something reverses the close to 90 year trend equity risk premium decline, active or passive fixed income products with a sufficiently attractive yield could possibly eliminate the equity risk premium problem.
Declining Performance of Stocks Relative To “Safe” Assets
Note: Ibbotson and Bloomberg data. The Ibbotson stock, bond and T-bill data start December 1925. For some a U.S. Treasury bill may be a safe asset.
For Campbell And Viceira inflation linked debt is a safe asset. A safe asset can also be viewed as anything that one views as safe, even if others do not agree.
• The “realized” equity risk premium is the return difference between stocks and a “safe” asset
• There is no single “safe” asset, rather a “safe” asset is an arbitrary point of reference
• Since 1925, the “realized” equity risk premium seems to have declined
Declining Trend Performance of Stocks Relative To “Safe” Assets
Note: Ibbotson and Bloomberg data. The Ibbotson stock, bond and T-bill data start December 1925. Using Dimson’s “global” data does not change
this observation. Roger G. Ibbotson and Rex A. Sinquefield – Stocks, Bonds, Bills, and Inflation: Year-by-Year Historical Returns (1926-1974)
• There is a limited amount of historical data on long-term asset returns
• If the past is prologue, it would be nice to have more historical data than exists
• However, the data that exists suggests the realized equity risk premium has declined
• The “safer” the safe asset, the higher the realized equity risk premium
Increasing Probability That The “Safe” Asset Will Outperform Stocks
• A constant equity risk premium, and mean reversion, leads to the view that
– The probability rises over time that stocks outperform “safe” assets
• A declining equity risk premium, and mean reversion, leads to the view that
– The probability rises over time that “safe” assets outperform stocks
• A conflict between “stocks for the long run” and “bonds for the long
Equity Risk Premium Views
• There are at least three views as to how the trend equity risk premium should behave
– The trend equity risk premium should rise over time
– The trend equity risk premium should be constant over time
– The trend equity risk premium should decline over time
• Of course, the historical trend equity risk premium decline since 1925 may be an “anomaly”
• Unfortunately, or fortunately, the potential “anomaly” is the only evidence that exists
• Historical experience creates a challenging dilemma for equity investors
– “Those who cannot remember the past are condemned to repeat it”
– “If past history was all there is to the game, the richest people would be librarians”
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