Equity risk premium provides financial markets insight

This article was originally published in Arab Times

Capital may loathe uncertainty, but in the wake of the sovereign debt crises in the United States and Europe, it is equities that have borne the brunt of the selling pressure compared to heavily indebted countries’ government bonds, which in some cases have even gained in value. This is all the more true for the GCC capital markets which is devoid of any reasonable long-term bond benchmark. Combined with the relatively short history of equity markets in this region makes it even more difficult to compute an equity risk premium for GCC with some authority. Following an earlier article in the Financial Times (FTfm supplement) Jason Voss, Content Director of Fixed Income, Behavioral Finance, Quantitative Methods and Corporate Finance at CFA Institute and Mandagolathur Raghu, President of CFA Kuwait analyse the equity risk premium, a metric that helps explain this paradox—and that also provides important clues about the relative riskiness of stocks versus bonds in different market environments.

What is the equity risk premium?

The equity risk premium quantifies the additional rate of return that investors require to compensate them for the risk of holding stocks as compared to holding a “risk free” asset.  Equity investors require this additional return because equities come at the end of a business’s cash claimant line.

How is the equity risk premium calculated?

There is no universally agreed upon method to calculate the equity risk premium, but one simple way is to compare a given equity market’s earnings yield, defined as the inverse of the market’s price-to-earnings ratio, to a sufficiently long-dated government bond. In the United States, the equity risk premium can be computed as follows:

ERP = Earnings Yield of S&P 500 – Yield on 10-year U.S. Treasury Note

Why is the equity risk premium important now?

The sovereign debt crises unfolding on multiple continents highlight the intimate relationship between an investment’s returns and its risks which the equity risk premium helps to describe.  When Standard & Poor’s downgraded the sovereign credit rating of the U.S. last summer, for instance, U.S. Treasury prices rose while stocks fell precipitously. Since U.S. stocks are inherently riskier than Treasuries, any increase in the riskiness of government bonds means that riskier assets, such as stocks, should also reflect these increased risks.  In fact, the equity risk premium expanded just after the downgrade.

How did recent market events in GCC affect its equity risk premium?

Global events and the sharp run down seen across GCC stock markets will have affected the equity risk premium in recent times in two ways. Firstly, with GCC capital market predominantly dominated by retail investors who trade using bank funding, the absence of available liquidity avenues will have also increased the equity risk premium demanded by investors. Secondly, the political upheaval in some GCC countries will also be an issue for foreign investors, who in spite of vast foreign reserves in the GCC will demand higher risk premium.

How has the equity risk premium varied historically?

Based on S&P 500 data compiled by Yale University economist, Robert Shiller, the equity risk premium has averaged 2.45% from January 1881 through September 2011. Over that period of time, the equity risk premium has been as high as 15.84% (in December 1920) and as low as -4.38% (in January 2000).

 Can the equity risk premium be negative?

Logically, it may seem that the equity risk premium should never be negative. After all, in that scenario, investors could simply sell their equity investments and buy “risk free” sovereign bonds that would pay a higher return. Yet over the 130 years of equity risk premium data it has actually been negative roughly 25% of the time. One explanation for periods of negativity is that equity investors expect rapid earnings growth for the entire stock market to compensate them for the additional risk of holding equities. This would result in the bidding up of share prices and a consequent decline in the equity risk premium.

What other insights can the equity risk premium provide?

A negative equity risk premium seems to be an indication of when stocks are relatively overvalued. In fact, in the equity risk premium history considered, it turned negative for the first time in the exact three months that preceded the Great Crash of 1929.  Immediately thereafter the equity risk premium was again positive for many decades until September 1965 amidst the ‘Nifty Fifty’ period when it again turned negative.  From this moment forward the equity risk premium was negative for 75% of the time until December 2007.

Interestingly, transitions between positive and negative equity risk premium seem to be correlated with turning points in economic history.  Examples include transitions during each recession of the last 46 years and the 1973 OPEC oil embargo.

At the individual stock level, a negative equity risk premium is a quick method of assessing valuation.  The more negative the equity risk premium, the higher the growth of future earnings must be to properly compensate an investor for the additional risks assumed.

What does today’s equity risk premium level suggest about the future direction of the U.S. stock market?

Since January 2008, the equity risk premium has been positive for the longest period of time since the mid-1970s, suggesting that recent stock market performance—considered by many to be disappointing—is not unusual, but rather consistent with the historical record.  Further, it implies that the paradox of a negative equity risk premium, persistent for much of the last 40 years, has reversed itself.  As of September 2011 the equity risk premium was 2.99%, strongly in line with the historical norm and suggestive of fairly valued equities where excess returns may be unlikely.