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The Risk Premium Debate

By: Frank Armstrong

By: Frank Armstrong, CFP, AIF

Is It Time To Reassess Our Expected Return Assumptions?

Estimation of future returns is a critical issue for both advisors and investors. Traditionally, we have relied on 75 years of data supplied by Ibbotson and Associates, and for want of anything better, assumed that these were close to the mark as an approximation of future returns. The enormous incremental return of stocks over bonds (risk premium) led us to recommend hefty holdings in equities. Rewards from stock investing were so generous that long term investors were foolish not to take the incremental risk.

The generally agreed upon equity risk premium hovered around 8%, or more than double the risk free return (Stock Market Return 11% – T-Bill rate 3% = Equity Premium 8%). Books like Stocks for the Long Run by Jeremy J. Siegel and Peter L. Bernstein have reinforced our belief that stocks will reliably outperform bonds over any reasonable period. With a high risk premium, investors with a long-term time horizon could rationally choose to hold a portfolio dominated by equities. To date that’s been a profitable strategy.

But, today many economists believe that the historical risk premium is grossly inflated and unsustainable. Prices relative to intrinsic value models are so high that future returns in stocks may be a great deal less than we are used to, and perhaps even less than bonds.

The financial arguments follow these lines:

Observed risk premiums are too high to be sustainable. Stock prices have advanced far in excess of company earnings. These stock price increases have been driven by an increase in price/earnings (P/E) ratios to the point where the link between intrinsic values and stock prices is suspect.

At today’s high P/E ratios, investors have no rational expectation for continued returns similar to past returns. Both economic theory and past experience indicate that high P/E ratios are associated with low forward returns.

P/E ratios are so high today relative to historical averages, that the market would have to “correct” by 50% or more to regress to the mean.

To put it mildly, this is not good news. Lower future returns imply that:

  • We will have to save more to reach our objectives.
  • We will have to have more capital at retirement to generate our required income.
  • We may have to put off retirement.
  • We may have to reduce our lifestyle.

Failing some combination of the above, we may die broke!

Of course, I would love to think that they are dead wrong. I’m having such a good time that I want the party to roll on. But, there is this little nagging doubt in the back of my head that just won’t go away. Meanwhile, the arguments from academia are harder and harder to ignore or refute. While the academics come at the problem from different directions, they draw the same dreary, disconcerting almost frightening conclusions.

Stock prices (in relation to earnings) remain in uncharted territory. For instance, based on today’s actual earnings, the price/earnings ratio (P/E) of the S&P 500 is over 60. The historical norm has been 8 to 18 with an average of around 14. We can imagine several possible scenarios for earnings in that market to return to historical valuations:

  • A gut wrenching correction of somewhat over 50%.
  • No growth in values for the next 15 years while earnings catch up.
  • Some combination of the above.

Note: We often hear lower P/E ratios quoted in the financial press. These are invariably based on next year’s forecast earnings divided by today’s price. But, next year’s forecast is just a guess backed by wishful thinking, certainly not a fact to bet the farm on.

As investment advisors, we are required to estimate future returns. We use those estimates as the basis for asset allocation decisions. Lower future returns for equities tilts the risk / reward tradeoff more in favor of bonds. If we can’t expect higher returns from stocks, who would want to take the additional risk?

Our first duty is to preserve our clients’ capital while hopefully making it grow. In light of this research, each investor should reflect on whether they wish to increase their bond holdings. If so, they will be decreasing their expected returns (based on past market data) but at the same time, drastically reducing the risk that something awful might happen to their portfolio over the mid term. In making the analysis consider both the opportunity cost and the downside potential. Most of our clients are well off. If the markets were to double their fortunes in the next five years, they would no doubt be pleased, but not ecstatic. On the other hand, if their net worth were to be cut in half, most would be quite upset indeed. Having more makes you happy, but not proportionally as sad as having less makes you!

Lessons from the past

I certainly am not making a forecast of dire conditions. But, it would be irresponsible to pretend that bad markets could never return, or that past performance is a guarantee of future performance. Our recent experience has been so positive that many of us have forgotten that risk happens:

When I started my career in 1974 we were in the midst of a bear market that reduced the S&P by almost half in two years. Contrary to our recent market “corrections” it took a very long time indeed to recover. It wasn’t pretty.

In the past there have been occasional long periods where stocks under performed bonds. For instance, from 1965 through 1981, a 17 year period, the S&P 500 total performance was 6.3%, while 1 month T-Bills returned 6.7%! How many of us would have wanted to wait 17 years for the return of an equity premium? In fact, that 17 year period inspired the famous Business Week cover page article “The Death of Equities”!

The Japanese market, once considered invincible, is worth a tiny fraction of its value a generation ago. Only in retrospect did investors realize that it was overvalued, and that the economy had serious structural defects. No one was making that argument in 1989!

The Academic Debate

First, let’s admit that the argument is hardly settled. We are trapped between conflicting points of view. On one hand there is Dow 36,000 by James K. Glassman, and Kevin A. Hassett which argues that stock market returns are so certain in the new millennium that investors will happily push prices up to where there is almost no risk premium over Treasury Bills. It is possible that the market will remain at these P/E levels. Investors may have re-rated the stock market risk. Given the lessons of the last two years, that conclusion seems strained.

But, check out the debate between two noted authorities, Roger Ibbotson and Robert Arnott, in the Journal of Financial Planning April 2002 edition: Is the Equity Risk Premium Still Thriving, or a Thing of the Past?

There is no debate for Robert J Shiller. In Irrational Exuberance by Robert J. Shiller, he argues that today’s prices may be a bubble in search of a pin. High prices are associated with future low return expectations. Professor Shiller is not the only noted economist to take that view.

Amongst many others, Fama/French argue from another direction in their paper The Equity Premium. I reviewed this line of argument in a previous article, “Please Don’t Shoot the Messenger!”

Cliff Asness argues we are mired in the middle of Bubble Logic, and that The Bubble Has Not Popped,

Robert D. Arnott and Peter L. Bernstein ask: What Risk Premium is ‘Normal’? , published on the Social Science Research Network.

As you can see, it almost looks like a food fight among academics. This argument is not a market timing, or where are we in the economic cycle type question. Rather, it’s one of basic financial economics.

What to do now?

If we concede that the market is severely overpriced now, it still begs the question of when it might correct. I would have said that the market was overpriced every year between 1995 and 2000. But, it kept going up anyway. The market might continue along its merry way for many more years before it returns to a more rational pricing. If so, any investor that lightens up now on his equity exposure will endure a painful underperformance. But, while further profits are possible, clearly the risk is rising each time prices ratchet up.

Most of this discussion has been based on the performance and price levels of the S&P 500 Index, which is only one portion of a well-diversified portfolio. Other areas of the world’s markets may not be so overpriced, and thus may have higher expected returns. In particular, the Fama-French three-factor model predicts additional incremental returns for exposure to small and value stocks. A portfolio with over weightings in these areas might still reasonably hope for better long-term performance than the market as a whole. However, because the three factors are cumulative, at best, we can expect these to be reduced by the same amount as the reduction in the market as a whole. In other words, it may help some ” no guarantees ” but it won’t entirely save us. The Investor Solutions equity portfolio model is already heavily weighted in the value and small company dimensions, so further tilting is probably inappropriate.

A lower risk premium implies that the future tradeoff between stocks and bonds may not be as favorable as previous experience would indicate. Stocks may offer lower upside and perhaps even greater downside over the intermediate term (loosely the next 10-20 years) . If so, investors may wish to reduce their risk exposure by increasing the portion of their portfolio allocated to bonds. The prospect of lower future profits must be weighed against smaller potential serious losses.

Whatever your individual decision, if a lower return environment comes to pass, it will be even more important to control costs, reduce risks, and reduce exposure to taxes. Capturing as much as possible of the global equity market returns will assume added importance with slimmer margins for error. For almost twenty years the rising market lifted all boats – even leaky ones. But, the days when even an irrational, dysfunctional, self destructive investor could expect fat returns may be gone forever.

I believe the arguments for lower equity returns going forward are credible and consistent with the best economic theory available. All of us must give the matter serious consideration. Read the referenced papers, then contact us to discuss. We will be happy to review your current asset allocation and discuss appropriate changes that fit your individual needs.