Last week I authored an article about the long history of the equity risk premium (January 1881 thru June 2020). A number of folks privately asked me why for a very extended period of time – what I called Epoch 3 – the equity risk premium was negative.

That period of time was September 1966 thru December 2007 and the equity risk premium averaged -0.91%. Not only that, but it was negative a staggering 76.9% of the months for that 42.25 years! Put that in your pipe and smoke it.

If we dive a bit deeper into Epoch 3 we see that it is interrupted by the OPEC-driven catastrophe of the 1970s, creating in my mind three sub-Epochs.

Here is how the ERP looked during each sub-Epoch, on average:

• A) September 1966 thru October 1973 (97 months)…ERP avg. = -0.66%
• B) November 1973 thru January 1980 (74 months)…ERP = 1.77%
• C) February 1980 thru December 2007 (334 months)…ERP = -1.58%

Now, as to a theory of why it was negative, and for so long, I do not have one. But, I do have some thoughts and what I think are some logical explanations about those three sub-Epochs.

Thoughts About Why the Equity Risk Premium was Negative for So Long

1) Post World War II economics.

First, both the World War II generation, sometimes called, “Greatest Generation” and their spawn, the Baby Boomers, were coaxed by waves of marketing delivered to them by the sensorial phantasmagoria of television to become well-behaved and consistent consumers. This led to a whole wave of a new type of business to be minted: those that served consumers.

Oh, and it helped that the United States was not only the source of global re-construction post-World War II, but also financiers of that re-construction. Furthermore, technologies developed post-World War II led to a whole new wave of tech businesses that many called the Nifty Fifty era in market history.

What all of this meant was that U.S. businesses thrived (i.e. profits swelled), pushing out the value of equities. These thoughts help to explain sub-Epoch A where, on average, the equity risk premium was -0.66% and for most of its 97 months.

2) Demographics: Greatest Generation and Baby Boomers.

Both the Greatest Generation and Baby Boomers were in their peak earning years during Epoch 3, and for all sub-periods. The Greatest Generation hit their economic “blow out” phase during sub-Epoch A. Undoubtedly, this helps to explain its -0.66% equity risk premium during that period.

But then the gargantuan Baby Boomer generation started saving in earnest for their retirements in the late 1970s. Most demographers date the start of the Baby Boomer generation in 1945 as World War II ended. So, by 1963 they were 18 years old and began earning money in the workforce. By 1970 they were 25 years old which is roughly where most people begin saving for their retirement. By 2007, the oldest Baby Boomers were 62 and their peak earning years were behind them.

I think these demographics really help to explain sub-Epoch C, February 1980 thru December 2007, a 334 month Boomer thunder clap that led to an average equity risk premium of -1.58%!

3) Professional financial advice.

A whole generation of stock brokers, financial planners, financial advisers, and others began quoting academic research and spread the good news of asset allocation being able to reduce your volatility of return. This movement is hard to date, but in the mid-1960s many academic finance departments were proud adherents of Modern Portfolio Theory (MPT). Academics also began publishing long-term data about the performance of different asset classes in service to MPT. Thus, the advising community tended to strongly recommend that equities were clients’ best long-term bets. This had the effect of creating a generational and almost permanent bid for equities.

But this “saving for your retirement” conversation really did not start, in earnest, until the late 1970s, early 1980s. This, I think also helps to explain sub-Epoch C, especially. It also might explain sub-Epoch B a bit, because the habit of saving for your retirement every month did not lift stocks up during the OPEC era.

4) Long-term financial products.

Congress got busy minting new long-term retirement products in the early 1970s. Thanks Kodak, thanks ERISA. What? Why is Kodak in there? Employees from Kodak pushed for the 401(k) to be invented. Yes, really. But ERISA launched a whole ton of new incentives to get busy with saving for your retirement, and especially on a monthly basis. Thus, creating a monthly and perma-bid for equities.

This really helps to explain sub-Epoch C, don’t you think?

5) Dollar cost averaging.

Dollar cost averaging into either a retirement account (e.g. 401(k), IRA, and so on) or a brokerage account meant that there was a philosophical justification to sink money into the financial markets regardless of the fundamental story. Again, a force in the direction of a permanent bid for equities and blind stock market buying in defiance of economic or equity fundamentals, and a great explanation for sub-Epoch C.

6) Shareholder Value and M&A.

A rise in the corporate philosophy of shareholder value where share buybacks were preferred over dividend payouts, as well as a long rise in the number of mergers and acquisitions is a part of our negative equity risk premium story. These activities reduced the supply of equities. There are now half of the total listed equities of the mid-90s. When that diminished supply collides with a very large increase in demand…well: WHAMMO! Stocks rise and equity risk premiums collapse.

Obviously this helps to explain sub-Epoch C.

My colleague Michael Falk, CFA, CRC and I have our third episode of our new podcast, From the Research Chair on 23 July 2020 and our topic will be portfolio construction. Click on the embedded link to register for it.

7) A profligate Federal Reserve.

Federal Reserve policy has been, shall we say, exceptionally friendly to investors for decades. In fact, we have the lowest interest rates in the 5,000 years of recorded financial history. When coupled with fractional reserve banking and its money spewing result we have huge amounts of excess liquidity.

That excess liquidity has found its way into dozens of markets, from equities, to debt, to real estate, and so forth. But the equity market is far smaller than the debt market. That means that any excess liquidity is going to have the tendency to push up prices. Yes, there is a reduction in the price of goods inflation, but the price of financial assets is off the charts.

Sub-Epoch C has as its drunken uncle at the equity party, the Federal Reserve.

8) Ignorance on the part of the average investor.

I began my career as a stock broker and I remember being shocked that our fellow citizens could easily explain equities to me, but not bonds; despite the fact that equities are more complex. It makes sense at a certain level, though. We grow up in the U.S. and hear myriad stories of entrepreneurs who launch new businesses and about fortunes being made in stocks. But we hear very, very few stories of debt investor fortunes being minted. This creates a bias toward equity investing.

Again, this is a strong force for sub-Epoch C and maybe sub-Epoch A. I have not talked to old timer stock brokers and checked these thoughts with them, though. Anyone out there want to add color?

9) A permanent reduction in the cost of information.

Our business, investing, has as its most valuable input, information. Information is much more important to equity investors than to debt investors because of the greater number of factors that may go FUBAR, as well as the ability for equity markets to earthquake much faster than debt markets.

The rise of the internet increased access to information in crazily powerful ways. This means that the risks of investing in public equities are probably lower now than ever before. That justifies a reduction in the equity risk premium and helps to explain sub-Epoch C. Furthermore, a permanent reduction in the cost of information also means that businesses are much, much more efficient than ever before. Thus, expenses are permanently lower. Again, this ought to lead to multiple expansion and a lowering of the earnings yield, and reduction of the equity risk premium. Exactly what we have seen.

10) The rise of the Asian Tigers, the Chinese Dragon, etc.

Successive waves of inexpensive southeast Asian manufacturers have lowered the cost of goods globally. First was Japan. Then Korea and Taiwan. Then China. This has reduced the price of the supply chain and finished goods far faster than the demand for goods. On a unit sales basis there is a massive increase in demand. But, on a price basis most consumers have seen a reduction in prices. In other words, a huge anti-inflationary force and a huge boost to equities and sub-Epoch A and C.

11) A mutual admiration society.

All of the factors I have named above led to a lift off in equities, and for a very long period of time. Most of the above factors were demand steroids for equities that encountered puny supply. This alone helps to explain the long march upward of equities because over rolling 5+ year time periods the volatility of absolute return was lowered. Further, this phenomenon combined with behavioral factors like herding, confirmation bias, and more, which created a recursive situation: you should invest in equities because they always go up. This mutual admiration society of buyers love stocks and stocks love buyers certainly resulted in a lift off in share prices in sub-Epoch C.

12) Index Investing

Again, when talking about perma-bids for equities look no further than the blind buying in defiance of individual security fundamentals that is index investing. Worse, when coupled with many of the preceding factors there is a huge excess demand for huge numbers of equities, rather than those cherry picked by savvy investors. A blind bid for lots of equities reduces the earnings yield and the equity risk premium, all other things held equal.

Mitigating factor: the real risk of indexing has been more recent, and in what I labeled Epoch 4, our current era. So, of the reasons I have listed, this is the one I am least certain of.

Conclusion

There are many statements triggering in my mind all at once to make here. But one is to note that the current equity risk premium of 2.70% (June 2020) is not that different than the average equity risk premium throughout the long history of the S&P 500: 2.40%. But when we look at the components of the current ERP we see something very interesting. Namely, the current earnings yield is just 3.35% vs. its historical average of 6.91%; which is only supported by millennia low interest rates of 0.65% vs. a historical average 4.51%.

In other words, do we have a demographically driven and central bank forestalled correction? Or do we have a permanent reduction in the equity risk premium justified by something systemic (e.g. a lowering of the cost of information)? I think we have more of a delayed correction than a reduction in the ERP.

One other final thought is that one possible explanation of the stuttering in the stock market beyond COVID-19, might be that the demographic wind in the sails that was present for decades is leaving. The Millennial and Digital Natives generations are larger than the Boomers, but they just do not trust the stock market in the same way. Is this a prescription for a re-appearance of a higher equity risk premium? Who knows?

I would love it if you would share your thoughts.

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.