Over the last month I have examined (what I think is) some of the most interesting data about the S&P 500. First up was the level volatility, which demonstrates that the market is not more efficient now than in decades past. Then I covered the history of the volume of the S&P 500; where we learned that almost 90% of the volume of this storied index has taken place in the last 20 years. More recently, I discussed the history of sigma events. Today I want to cover the history of the S&P 500 and its equity risk premium.

Equity Risk Premium Defined

One of my favorite measures of equity market valuation is the equity risk premium (ERP). For those of you not in the know, the ERP is:

The difference in return available by investing in equities rather than a “risk-free rate.”

Setting aside the idea that I do not believe in a so-called “risk-free rate” [see: Rethinking the Risk-Free Rate, Exploding a Fundamental Assumption], my definition is ever so-slightly different than the standard definition. Specifically, my definition states that the ERP is the difference in return rather than the more traditional excess return language. Why?

The Equity Risk Premium Can be Negative

First, and most importantly, there are periods in financial market history where fixed income, including government debts, outperform equities. How does the ERP defined as excess return explain these periods? It cannot.

Second, our understanding of the ERP comes from the Capital Asset Pricing Model (CAPM). Here, by definition, all increases in return over the “risk-free rate” is earned only by taking on additional risk. Consequently, the ERP has to be positive because it is assumed that the “risk free rate” is the starting/base rate for all other rates of return. Because equities are not “risk free” they have to offer an excess return relative to riskless assets. Otherwise, why invest in them? Parenthetically, in a world of constrained-by-style-box/asset-class investment management most investors at the security selection level do not have permission to compare and contrast expected returns in different asset classes. In other words, markets can defy theory. Said another way, theory ought to describe markets, and they don’t. In fact, they contribute to the very outcomes that defy themselves. But I digress.

Third, my preferred mathematical description of the ERP can and does go negative at times. And, it turns out, those are very interesting moments in financial market history. Further, those moments are predictive of future outcomes.

My Mathematical Definition of the ERP

There are many different mathematical definitions of the ERP. However, my favorite ERP mathematical definition, and shared by other investors, though not all, is:

ERP = (1 ÷  Shiller Cyclically Adjusted Price to Earnings (CAPE) Ratio) – current yield on 10-year US Treasury bonds

For those in the know the first part of this equation can also be described as the “earnings yield.” It is simply the inversion of the P/E ratio. I prefer CAPE because of its adjustment for monkey business in financial statements, and its longer term focus on earnings. The academic ideal is to have a CAPE and Treasury whose time horizon matches your own.

Advantages of This CAPE Version

1. Easy to gather the data.
2. Adjusts for monkey business in financial statements.
3. Long time horizon.
4. It makes sense.
5. Predictive of future returns/good buying opportunities.

I talk about number 5 in my relating of the ERP data below. But, regarding “it makes sense” there are several points to make.

Earnings over time (as in the denominator of a P/E) are the yield on me owning the equity of a business. Furthermore, those earnings are purchased in a market for a price (P/E numerator). That said, if the prospects for future returns on equities are bad, to highlight the difference, I want an uncorrelated asset for comparison. In this case, the performance of Treasury securities tend not to correlate well with the equity risk premium. In fact, since January 1881 the correlation between these two measures is -47.3%.

Also, I reject the CAPM as predictive of future securities prices. In fact, it has been so beyond debunked for the past 50 years that it is a miracle it is still given credence. I also reject the idea of a risk free rate. In a universe of preferences and actions, there is always the chance that your preferred outcome after taking an action does not occur. Risk exists in a universe of action…period. I also reject the idea that financial markets are always rational. Instead investors are irrational (see my first Fact File article in this series), and the way assets are allocated in the aggregate is completely irrational and it leads to nonsensical investment choices, like pretending the style box is a valid way to invest. Thus, we ought to expect negative ERPs over time, and ding-ding-ding that is exactly what we see in the data. From a sheer intellectual, logical point of view, equities are always riskier than the safest Treasury, but in practice their pricing does not always reflect that logic.

Contact me so that I can help your investment firm. I make my living as a consultant, not as a writer. My job is to help you and your investment team get better.

Equity Risk Premium Fact File

• As of Friday, 10 July 2020, the ERP was 2.70% with a CAPE earnings yield of 3.35% and a 10-year Treasury yield of 0.65%. In January 2019 the Treasury yield was 2.71%. Meaning that excess returns in equities should not have been expected. Said another way, if not for Federal Reserve actions equities would not be attractive based on the ERP.
• The average ERP since (get ready for it) January 1881 is 2.40%, with a maximum of 15.84% in December 1920, and a minimum of -4.38% in January 2000. I find this result fascinating because equity investors love to plug in equity risk premium values in their valuation models (almost always based on CAPM) of 4.5%-ish. Why? Because of studies done decades ago that suggested this was appropriate. But the number is actually much lower, and especially recently.
• On average, the CAPE earnings yield since January 1881 is 6.91% and the 10-year Treasury is 4.51%.
• There appear to be different epochs in the long history of the market where the ERP is very different in each of the eras. How to contextualize the data is a part of the art of the analyst. You might choose to slice and dice differently. But here are my epochs:

• • EPOCH 1: January 1881 thru September 1929… ERP = 4.03%
  • EPOCH 2: October 1929 thru August 1965… ERP = 4.32%
  • EPOCH 3: September 1966 thru December 2007… ERP = -0.91%
  • EPOCH 4: January 2008 thru June 2020… ERP = 1.74%

What I find fascinating is those halcyon days in EPOCH 3 where, on average, the ERP was negative. If you relied upon the ERP as an asset allocation buying and selling signal during this period you would have for very long periods invested in debt more than equities and you would have been fired by almost every investor. But congratulations, you would have been right. Just after exiting the global financial crisis of 2008-2009 folks were shocked when they saw that for almost 30 years debt outperformed equity. Wowza!

Here, of course, we must resurrect that old Keynesian yarn about, “the market can stay irrational longer than you can stay solvent.” A graph of the history of the ERP is instructive:

What is absolutely fascinating to me is the multi-decade time period in which the ERP was negative. This extreme result defies logic and I believe ought to be the source of much academic investment research. Why was it negative for so long? I dunno.

However, what I do know is that for all other EPOCHs that when the ERP turns negative there is a nearly immediate correction in the price of equities. For example, in EPOCH2, the ERP turned negative in that famous October of 1929 and immediately there was a correction. That turned out to be roughly true in the 1960s, too. This era was known as the Nifty Fifty period in market history and it saw an extended period of a negative ERP. But then again in the early 1980s there was a multi-decade period of negative ERP, then a tech bubble burst, then a recovery, then a real estate bubble burst and then a new EPOCH. Subsequently, during our current EPOCH, an approaching negative ERP always results in an almost immediate equity market correction.

In other words, the ERP seems to be predictive of future equity market returns. However, the length of the EPOCH3 anomaly was very, very long. So, use this measure with caution.

Last, comparing the CAPE earnings yield to the 10-year Treasury yield is also fascinating. Dig if you will the picture [hint: blue line ought to be higher than red line]:

Contact me so that I can help your investment firm. I make my living as a consultant, not as a writer. My job is to help you and your investment team get better.