Rethinking the Equity Risk Premium Bre> Hammond Q Group October 2012 ©2011. All rights reserved. msci.com msci.com The answer is… 4 ©2011. All rights reserved. msci.com 2 But what is the quesJon? §  Historical excess return HER2001−2010 = Re − RTIPS = −3% / yr
§  Expected equity premium ERP = E ( Re ) − E ( R f )
©2011. All rights reserved. msci.com 3 ERP esJmates circa turn of the century Source
Arnott & Bernstein
Campbell & Shiller
McGratten & Prescott
Ross, Goetzmann & Brown
Reichenstein
Phillips
Siegel
Bansal & Lundblad
Shoven
Asness
Graham & Harvey
Ibbotson & Chen
Goyal & Welch
Fama & French
Cornell
Welch
Average
Range
Year
2002
2001
2001
1995
2001
2003
2002
2002
2001
2000
2001
2003
2002
2002
1999
2000
ERP Estimate %
0.0
0.0
0.0
low
1.3
1.0-3.0
2.0
2.5
3.0
4.0
4.0
4.0
3.0-5.0
4.3
5.0
6.0-7.0
2.5
0.0-7.0
Note: ERP estimates are expected long-term geometric return of
equities in excess of the risk-free rate.
©2011. All rights reserved. msci.com 4 Since the turn of the century §  Extreme market condiJons §  Low risk-­‐free rate §  Low equity returns §  High volaJlity §  High correlaJon §  Does these condiJons affect the ERP circa 2012? ©2011. All rights reserved. msci.com 5 Views on the ERP 3 Dimensional array of views on the ERP ©2011. All rights reserved. msci.com 6 2011 Seminar: Rethinking the Equity Risk Premium 10th Anniversary seminar and book (Hammond, Leibowitz and Siegel, CFA InsJtute: 2011): Bre> Hammond and Marty Leibowitz Roger Ibbotson Cliff Asness Elroy Dimson, Paul Marsh and Mike Staunton Richard Grinold, Ken Kroner and Larry Siegel Rob Arno> AnJi Ilmanen Peng Chen Andrew Ang and Xiaoyan Zhang Jeremy Siegel Rajnish Mehra ©2011. All rights reserved. msci.com 7 Ibbotson §  Users §  Investors: expected returns §  CorporaJons: cost of capital §  Analysts: discount rate for future cash flow esJmates §  Other premia §  Investment horizon – tacJcal v. strategic view of ERP §  Company size §  Value §  Momentum §  Default risk §  InflaJon risk §  liquidity ©2011. All rights reserved. msci.com 8 Asness §  High P/Es are not an accurate forecast for high future earnings growth rate §  To the contrary, high P/Es imply low future earnings growth and equity returns §  Current E(g) and Shiller P/E imply 4% equity returns. ©2011. All rights reserved. msci.com 9 Dimson, Marsh, Staunton §  From 1900 to 2011, excess equity returns varied considerably across countries. §  For their world index, §  annual geometric mean real return was 5.5% §  Excess return relaJve to UST bills was 4.5% §  Excess return relaJve to long-­‐term bonds was 3.8%. §  Dividend-­‐driven esJmate of ERP is 3-­‐3.5%. §  Mean reversion is a weak force. §  UncertainJe (e.g, future mean returns and ERP) predominate. ©2011. All rights reserved. msci.com 10 Grinold, Kroner, Siegel D
R − ΔS + (i + g ) + ΔPE
P
Income ⇒
©2011. All rights reserved. Earnings Growth Repricing ERP = 4% msci.com 11 Arno> §  ERP is cyclical, dynamic, and relaJvely small. §  Bonds have outperformed stocks over a significant period. §  Realized return has ooen been lower than ERP. §  Net stock buy-­‐backs are ooen lower than assumed. §  Lower earnings yields ⇒
lower future returns. §  Real earnings and prices grow with per-­‐capita GDP. §  D/P is lower now than ever before. §  ERP = negaJve to slightly posiJve ©2011. All rights reserved. msci.com 12 Ilmanen §  Term structure effects are more visible on the bond side of the premium. §  Abnormally high or low valuaJons have large mean-­‐reversion implicaJons for short to medium term ERP. §  However, even if equity returns for the next decade are “low,” we don’t know how to forecast valuaJons for starJng periods longer than that. §  This implies that long-­‐term ERP must be close to “uncondiJonal” forecast. §  Indicators besides valuaJon measures (e.g., regression and other econometric techniques) can be used to forecast returns. §  Therefore, it is possible to esJmate a full term structure of expected returns. ©2011. All rights reserved. msci.com 13 Chen §  Could bonds outperform stocks in the future as they have in the recent past? §  Recent outperformance based largely on declining yields. §  Current yields are not sustainable in the long run so expected capital gains are low to negaJve. §  Stock returns depend on earnings growth and the change in the P/E raJo as well as their yield. §  If expected earnings growth and yields for stocks remain close to historical averages (5% and 2% respecJvely), then it is hard to see how bonds will outperform bonds. ©2011. All rights reserved. msci.com 14 Ang and Zhang §  Movements in P/E reflect changes in discount rates (which contain the ERP) AND growth opportuniJes (expected earnings and cash flow growth). §  Therefore, P/Es can be low (high), either because growth opportuniJes are high (low) or because expected returns are low (high). §  Historical data shows that the ERP is mean reverJng and fairly stable. §  And changes in growth opportuniJes explain 95% of variaJon in P/E. ©2011. All rights reserved. msci.com 15 Siegel §  Li>le reason to think that the long-­‐term ERP has changed. §  Underperformance of real equity returns from 2000 – 2010, rela%ve to the historical average of 7%, was offset by outperformance from 1990 – 2000. §  The average historical P/Es and earnings yields have changed very li>le over the past decade. ©2011. All rights reserved. msci.com 16 Mehra §  Is a low ERP sJll warranted (per Mehra and Presco> 1985)? YES §  Risk-­‐free investment should not be T-­‐bills but rather TIPS or mortgage bonds ⇒ lower ERP. §  Households typically borrow more than they lend ⇒
lower ERP. §  Younger investors have a higher demand for equiJes but face borrowing constraints ⇒
lower ERP. §  However, it is possible as baby boomers reJre, that ERP will be higher in the future. ©2011. All rights reserved. msci.com 17 “ObjecJve” drivers of the ERP Real Interest
Risk-Free Asset
Examples:
Equity Class
Inflation
Other Macro
Earnings
Rate Trend Expectations Assumptions Expectations
Dividend
ERP
Trend
Variations
Treasury Bills
U.S. Equities
High
High
Macroeconomy
High
Rising
vol
Treasury Notes
Inflation-Linked
Bonds
Global Equities
Medium
Medium
Demographics
Medium
Falling
vol of vol
Large-Cap
Low
Low
Globalization
Low
Other:
Size
Value
Geography
Sector
©2011. All rights reserved. msci.com 18 “CircumstanJal” drivers of the ERP Investment
Liquidity
Rebalancing
Valuation
Horizon
Biased
Long
Liquidity
Rebalance
Sensitive
Short
Illiquidity
Hold
Insensitive
Ability to
Risk
Trade
Tolerance
Orientation
High
Constant
Buyer
Low
Variable
Seller
Requirement Sensitivity Evaluate Mkt
Range Bound
©2011. All rights reserved. msci.com 19 “CircumstanJal” investor types Investor
Type
Horizon
Liquidity
Stance
Rebalance Valuation
Requirement Sensitive
Risk
Tolerance
LSB
Long Horizon
Sensitive
Buyer
Discretionary buyer looking for low premium
LSS
Long Horizon
Sensitive
Seller
Discretionary seller looking for extra premium
LLB
Long Horizon
Liquidity Bias
Buyer
Buyer at nearly any price
LLS
Long Horizon
Liquidity Bias
Seller
Seller at nearly any price
LRB or LRS
Long Horizon
Buyer
Must rebalance when market moves
LCB or LCS
Long Horizon
High
Constant
Constant risk tolerance but evaluates and
acts on changing market opportunities
LVB or LVS
Long Horizon
High
Variable
Risk tolerance depends on market conditions
or changing personal circumstances
LRB or LRS
Long Horizon
SSB or SSS
SLB or SLS
Short Horizon
Short Horizon
Rebalance
Range
Bound
Sensitive
Liquidity Bias
©2011. All rights reserved. Buyer or Example
Seller
Constant risk tolerance, except in extreme
market move
Daily, weekly, monthly, quarterly performance
evaluation
Must remain liquid
msci.com 20 Real interest rate regimes and the ERP Factor
Equity risk premium
Probability of occurrence
Financial/economic environment
Inflation expectations
Discount rate/cost of capital
Real growth rate
Regime persistence
Sustainability of current earnings
New investment profitability
"Franchise" value (FV)
"Ongoing" or "tangible" value (TV)
Theoretical P/E (FV + TV)
Low Rates
0-1%
Sweet Spot
2-3%
High Rates
6+%
High (6%)
Low
Dismal
Low (1-2%)
Medium (7%)
Very low (2.5%)
Hopefully brief
Fair (0.4)
Good when available (6%)
Low (4.8)
Fair (5.7)
Low (10.5)
Low (4 or less%)
High
Balanced
Low/Medium (2-3%)
Medium (7%)
Good (4%)
Sustainable
Fair (0.4)
Good (6%)
High (11.4)
Fair (5.7)
Peak (17.1)
High (5%)
Low
Overheated
High (4%+)
High (11%)
Too high (7%)
Almost surely brief
Good (0.7)
Squeezed (2%)
Low (3.2)
Fair (6.4)
Low (9.6)
Source: Leibowitz and Bova [2007].
Note: Specific functional values have no empirical validity. They are illustrative of relative values that
might be associated with P/E and other valuation components corresponding to the three growth regimes.
©2011. All rights reserved. msci.com 21 P/E raJos versus real rates: 1978-­‐2011Rates: 1978-­‐2011 18.00
16.00
14.00
12.00
P/E
Ratio
10.00
8.00
6.00
4.00
2.00
0.00
less than
0%
Source: Morgan Stanley Research ©2011. All rights reserved. 0-1%
1-2%
2-3%
3-4%
4-5%
5-6%
above
6%
Real 10-Year Treasury Rate
msci.com 2
2 Real rate condiJons and the risk premium smilemile Equity
Dis count
Rate
Bond
Nominal
Yield
Bond
Nominal
Rate
Yield
Equity
Discount
Rate
Real
Equity
Prem
Real
Equity
Prem
Real
Equity
Prem
Infl
Real
Rate
Equity
Discount
Real
Rate
Real
Rate
Bond
Nominal
Yield
Infl
Infl
Real
Rate
Real
Rate
Real
Rate
Environment
Dismal
Balanced
Buoyant
Source: Morgan Stanley Research ©2011. All rights reserved. msci.com 2
3 NoJce and Disclaimer §
This document and all of the informaJon contained in it, including without limitaJon all text, data, graphs, charts (collecJvely, the “InformaJon”) is the property of MSCl Inc. or its subsidiaries (collecJvely, “MSCI”), or MSCI’s licensors, direct or indirect suppliers or any third party involved in making or compiling any InformaJon (collecJvely, with MSCI, the “InformaJon Providers”) and is provided for informaJonal purposes only. The InformaJon may not be reproduced or redisseminated in whole or in part without prior wri>en permission from MSCI. §
The InformaJon may not be used to create derivaJve works or to verify or correct other data or informaJon. For example (but without limitaJon), the InformaJon may not be used to create indices, databases, risk models, analyJcs, sooware, or in connecJon with the issuing, offering, sponsoring, managing or markeJng of any securiJes, poruolios, financial products or other investment vehicles uJlizing or based on, linked to, tracking or otherwise derived from the InformaJon or any other MSCI data, informaJon, products or services. §
The user of the InformaJon assumes the enJre risk of any use it may make or permit to be made of the InformaJon. NONE OF THE INFORMATION PROVIDERS MAKES ANY EXPRESS OR IMPLIED WARRANTIES OR REPRESENTATIONS WITH RESPECT TO THE INFORMATION (OR THE RESULTS TO BE OBTAINED BY THE USE THEREOF), AND TO THE MAXIMUM EXTENT PERMITTED BY APPLICABLE LAW, EACH INFORMATION PROVIDER EXPRESSLY DISCLAIMS ALL IMPLIED WARRANTIES (INCLUDING, WITHOUT LIMITATION, ANY IMPLIED WARRANTIES OF ORIGINALITY, ACCURACY, TIMELINESS, NON-­‐INFRINGEMENT, COMPLETENESS, MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE) WITH RESPECT TO ANY OF THE INFORMATION. §
Without limiJng any of the foregoing and to the maximum extent permi>ed by applicable law, in no event shall any InformaJon Provider have any liability regarding any of the InformaJon for any direct, indirect, special, puniJve, consequenJal (including lost profits) or any other damages even if noJfied of the possibility of such damages. The foregoing shall not exclude or limit any liability that may not by applicable law be excluded or limited, including without limitaJon (as applicable), any liability for death or personal injury to the extent that such injury results from the negligence or wilful default of itself, its servants, agents or sub-­‐contractors. §
InformaJon containing any historical informaJon, data or analysis should not be taken as an indicaJon or guarantee of any future performance, analysis, forecast or predicJon. Past performance does not guarantee future results. §
None of the InformaJon consJtutes an offer to sell (or a solicitaJon of an offer to buy), any security, financial product or other investment vehicle or any trading strategy. §
MSCI’s indirect wholly-­‐owned subsidiary InsJtuJonal Shareholder Services, Inc. (“ISS”) is a Registered Investment Adviser under the Investment Advisers Act of 1940. Except with respect to any applicable products or services from ISS (including applicable products or services from MSCI ESG Research InformaJon, which are provided by ISS), none of MSCI’s products or services recommends, endorses, approves or otherwise expresses any opinion regarding any issuer, securiJes, financial products or instruments or trading strategies and none of MSCI’s products or services is intended to consJtute investment advice or a recommendaJon to make (or refrain from making) any kind of investment decision and may not be relied on as such. §
The MSCI ESG Indices use raJngs and other data, analysis and informaJon from MSCI ESG Research. MSCI ESG Research is produced by ISS or its subsidiaries. Issuers menJoned or included in any MSCI ESG Research materials may be a client of MSCI, ISS, or another MSCI subsidiary, or the parent of, or affiliated with, a client of MSCI, ISS, or another MSCI subsidiary, including ISS Corporate Services, Inc., which provides tools and services to issuers. MSCI ESG Research materials, including materials uJlized in any MSCI ESG Indices or other products, have not been submi>ed to, nor received approval from, the United States SecuriJes and Exchange Commission or any other regulatory body. §
Any use of or access to products, services or informaJon of MSCI requires a license from MSCI. MSCI, Barra, RiskMetrics, ISS, CFRA, FEA, and other MSCI brands and product names are the trademarks, service marks, or registered trademarks or service marks of MSCI or its subsidiaries in the United States and other jurisdicJons. The Global Industry ClassificaJon Standard (GICS) was developed by and is the exclusive property of MSCI and Standard & Poor’s. “Global Industry ClassificaJon Standard (GICS)” is a service mark of MSCI and Standard & Poor’s. © 2011 MSCI Inc. All rights reserved. RV May 2011 ©2011. All rights reserved. msci.com msci.com 24