Equity Risk Premium Drill Down Indicates Bizarre Investor Behavior
Posted by Jason Apollo Voss on Aug 11, 2011 in Best of the Blog, Blog | 4 comments
Earlier this week in my post entitled, “Adjusting the Scale of the Selloff to Demonstrate Its Absurdity,” I spent quite a lot of time talking about this thing called the “equity risk premium” and some of the interesting data I had calculated based on this measure. Today I wanted to drill down into that equity risk premium data because it indicates some bizarre investor behavior over the last 46 years.
So what is the equity risk premium? It is based on the understandable theory that investing in the stock market is riskier than investing in the bond market. Why would this be so?
Because bond holders have the legal right to the cash flows from a cash paying entity (e.g. a government, business, or individual). Further, in the event of bankruptcy bond holders are ahead of equity holders in terms of asset disposition. In other words, they get first dibs on the assets of the bankrupt entity that issued the debt. Think: car repossession or house repossession on the part of a bank. They have first dibs compared to the car owner if the owner doesn’t pay the bill.
To take on these additional and certain risks equity holders require a higher rate of return than bond holders. Does this make sense? That higher rate of return required by equity holders is known as the equity risk premium.
One technical note before proceeding, the typical calculation of the equity risk premium is as follows:
equity risk premium = earnings yield of the stock market – yield on 10-year U.S. Treasury Note
The 10-year U.S. Treasury Note is usually used because stock market investing is generally considered to be a long-term activity. Here the assumption is that it will be for 10 years; that’s why you compare the earnings yield of the stock market to a 10-year U.S. Treasury Note and not a 5-year bond. Apples to apples, not oranges. Does this make sense?
The reason that the earnings yield of the stock market is compared to a piece of U.S. Treasury debt is that for decades U.S. government debt has been considered to be the most riskless investment in the world.
Now back to our regularly scheduled program…
So the first logical conclusion that we could all make is that the equity risk premium should absolutely never be negative. If the equity risk premium were negative an investor could sell her or his equity investment (i.e. stock investment) and buy a bond that would pay her or him a higher rate of return and be less risky.
Yet, in the 130 years of monthly data regarding the S&P 500, dating back to January of 1881 the equity risk premium has been negative for 25.1% of the time (source: What My Intuition Tells Me Now blog). Specifically, the equity risk premium has been negative for an entire month 393 times of 1568 possible months.
Frankly, this result is very surprising and is very likely a strong indication of irrationality on the part of equity investors.
But an alternative explanation might be that equity investors are, in fact, hyper-rational. Maybe the reason that they are willing to earn less on risky stocks than on a riskless bond is that they feel that the bond is actually riskier than popularly believed.
The current debt crisis in the United States might be this kind of situation. That is, a period when people actually feel investing in a business, any business, is less risky than investing in the debt of the United States.
To see whether or not this kind of rationality can explain the fact that the equity risk premium has been negative 25.1% of the time you would have to look at the historical context when the equity risk premium has turned negative. Then you can better assess the smarts of the investment community.
From January 1881 to August 2011 there have been a total of 28 turns in the equity risk premium. That is, times when it switches from positive to negative, or from negative to positive. Let’s look at each of those:
Month ERP Turns? After Run of Length What’s Going On Market History-Wise
Jan 1881 Positive 582 months
Jul 1929 Negative 3 months lead up to the great crash of 1929
Oct 1929 Positive 431 months the great crash of 1929
Sep 1965 Negative 12 months Nifty Fifty era of growth stocks
Sep 1966 Positive 2 months Nearly 20% correction of the S&P 500
Nov 1966 Negative 1 month
Dec 1966 Positive 5 months
May 1967 Negative 46 months ~12% rise in the S&P 500, Israel’s Six Day War
Mar 1971 Positive 1 month
Apr 1971 Negative 6 months Gold Standard
Oct 1971 Positive 3 months
Jan 1972 Negative 22 months
Nov 1973 Positive 75 months Yom Kippur War and Subsequent Oil Embargo
Feb 1980 Negative 2 months Runaway inflation and a recession
Apr 1980 Positive 4 months Runaway inflation and a recession
Aug 1980 Negative 19 months Recession ends
Mar 1982 Positive 1 month Recession
Apr 1982 Negative 1 month Recession
May 1982 Positive 1 month Recession
May 1983 Negative 12 months End of the recession
Apr 1986 Positive 35 months Chernobyl nuclear disaster
May 1986 Negative 1 month End of Chernobyl fears
Jul 1986 Positive 2 months
Sep 1986 Negative 1 month
Oct 1986 Positive 1 month
Nov 1986 Negative 1 month Beginning of IT/dot.com bubble, balanced budget under Clinton
Sep 2002 Positive 190 months End of dot.com bubble, September 11, Enron scandal, etc.
Aug 2003 Negative 11 months Beginning of Real Estate Bubble
Jan 2008 Positive 53 months Real Estate Bubble POPS!
Present Still positive 44 months The Great Recession and post-Great Recession
Source: What My Intuition Tells Me Now blog and Jason Apollo Voss
Forgive the very long enumeration above. However, what’s very interesting is to note the moments when switches between positive and negative happen. Almost all of the switches happen when there is major global or economic news.
Particularly interesting is to see that when the equity risk premium goes negative the typical environment is not one of disaster, where a government’s debt might be called into question. No, instead the negative equity risk premium is strongly associated with stock market bubbles.
Interestingly enough the bubble that led to the October 1929 crash was preceded by the first negative equity risk premium in history – 3 consecutive months worth. October 1929 was the first of 431 months of positive equity risk premium. Put another way, between January 1881 and August 1965, or 1,016 months, only 3 of them saw a negative equity risk premium. That’s a paltry 0.3% of the months over 84 years, 8 months!
Then the equity risk premium turned negative again in 1965 as the “Nifty Fifty” stock market bubble started to take off. There was only a minor correction in 1966 and then much more negative equity risk premium until 1971. Again, there was a small correction, and then more negative equity risk premium until the recession and massive correction precipitated by the 1973 oil embargo.
While there were small bursts of stock market lift-off, that 1973 stock market decline seemed to correct investors of their bizarre behavior until about 1983 and the end of the double-dip recession. Then until about 2002, or 19 years (!), there was near continuous negative equity risk premium. Remember, it only took 3 months of this in 1929 to trigger a massive sell off of equities.
In fact, overwhelmingly, the negative equity risk premium years have happened since 1965 with 390 of the 393 months being logged since that turn in September 1965. Furthermore, since that fateful month the stock market has traded with a negative equity risk premium for 70.7% of the time through August 2011. This is stunning in comparison to the 0.3% of the time up until September 1965.
What I am trying to highlight here is that the sort of bizarre behavior that led to the stock market crash of 1929 has been replicated at a 130x magnitude since September 1965! What has propelled this gigantic, truly massive stock market bubble? There are myriad answers, but here is a sampling:
- Social Security created in the 1930s instills a belief in the public mind that retirement is an important goal
- Baby boomers came of investing age as they exited high school starting in the early 1960s and exiting college in the late 1960s
- Starting in the early 1960s academic research demonstrated the disproportionate wealth created by investing in stocks vs. other asset classes
- Wall Street begins marketing stocks to Baby Boomers as the natural vehicle for funding retirement
- Federal Reserve policies of injecting money into the economy post the October 1987 stock market crash and post September 2001 to allay investor fears leads to massive amounts of nearly free money
- Sophisticated Wall Street products allow for mortgages to be bundled together into securities and then bought and sold as assets. Effectively, this turns the hard, illiquid asset that is real-estate, into cash
To summarize it all: a negative equity risk premium is evidence of irrational, euphoric, bubble behavior. While a positive equity risk premium is associated with a rational investment community.
Put another way, negative equity risk premium is strongly associated with a very overvalued stock market. Whereas a positive equity risk premium is evidence of a more rationally minded investment community.
Most importantly, where are we now? Have the two generations of folks, myself included, who grew up with a relentless stock market march upward returned to their old wayward ways? Is the equity risk premium negative again post the real estate bubble popping?
We have now had 44 consecutive months of a positive equity risk premium and as of Wednesday the equity risk premium stood at exactly 3.0%. This compares to a historic average equity risk premium of 2.4%.
The interpretation would be that investors currently need more return on stocks to induce them to take on their greater risk. Another interpretation would be that investors have behaved rationally for almost four years and to me this is a very, very good thing.
Jason
So wait, wouldn’t that mean when it went to negative was the time to buy, as a bubble is forming? I’m not sure I get this.
Hi Saduria,
Thanks for the comment – feel free to comment at any time.
In answer to your question…I guess it depends on your relationship to risk and return. Given the persistence of the negative risk premium since September 1965 you could be forgiven for thinking that the next time the equity risk premium goes negative that it was the beginning of another bubble. The trick would be to track the equity risk premium month to month, or day to day and to see where it goes. As the equity risk premium shrinks and approaches zero you would know that euphoria was taking over. Yet, in terms of a solid, reliable predictor I would encourage you to take a look at that series of changes in the equity risk premium in the late 60s and early 80s to see that there could be a lot of volatility around that buy decision of yours.
Also, if the equity risk premium goes negative know that eventually it reverses as is completely born out by the data. So again, this all depends on your risk disposition. Sounds like you are more comfortable with it than most. Good luck and good skill in your application!
Jason
Jason,
Thanks for discussing an insightful tool. I note, that your hypothetically rational investors would be making decisions that unfold in the future; thus, they would have to devise some kind of computation to extrapolate equity returns 10 years ahead. At this point, the rational people go home and the irrational people come out to play, since no one has enough information to correctly calculate the markets 10 years into the future.
As such, we might label a negative equity risk premium as *market optimism* and a positive equity risk premium as *market pessimism*. They ultimately reflect the irrational sentiments of empathic human beings whose individual decisions are often highly correlated.
Let’s get back to the rational part of this discussion. I think it would be interesting to look at return periods other than 10 years. Provided the necessary data is available, the equities data could be binned by the duration the shares were held, and the average returns in each bin could be compared to the average returns for treasury holdings of similar duration.
What do you think we’d see?
Hello Stephen,
As always, thanks for the comment.
Believe it or not, many investment pros do project equity returns in their fundamental analysis models. I usually projected one market cycle out. That typically was 5-7 years into the future. Because of the time value of money the discounted cash flows in the latter years of any projection hardly affect the valuation of a business.
Also, strangely, longer term projections are typically more accurate than shorter term estimates. Why? It’s an issue of scale. Think about plotting a graph with every single movement of the S&P 500 for the past ten years. If you looked at it at the scale of the microscopic you would see only volatility. Now increase your scale to the macroscopic and you only see two data points, the first point and the last point. So you see a straight line. In other words, the long-term model only needs to get the direction (up and down) and the rough magnitude of movements. Shorter term predictions are counter-intuitively harder. In fact, the trading activity this week for the major U.S. stock indices demonstrates this pretty aptly.
What I like about the comments so far regarding this post is that people are using the tool in a way that is in accord with how they perceive the market. The commentator before you saw a negative equity risk premium as a buy sign because she/he wanted to ride the inflation of a bubble. On the other hand, you see “market optimism” and “market pessimism.” Investing is like basketball (or football, or hockey, or whatever sport) in that what makes for a great player is skills and techniques mastered to accentuate and take advantage of talent. The game of basketball is the same for Kobe Bryant and for Shaquille O’Neal, but how they go about their greatness is very different. What matters is identifying your talent and demeanor and then developing tools that support that talent.
I like your idea of using the 5-year Treasury. Because the spreads between 5 and 10 year treasuries are typically less than 100 basis points (i.e. 1%) I don’t think it would affect the results much. [Insert: pregnant pause as Jason manipulates the numbers in his spreadsheet.] I just ran some new numbers. The average positive ERP is 3.8%. This figure would more than cover the spread between a 10-year and 5-year Treasury. The average negative ERP is -1.6%. Again, it more than covers a typical spread between the debt maturities.
Jason