Equity Risk Premium Drill Down Indicates Bizarre Investor Behavior

Earlier this week in my post entitled, “Adjusting the Scale of the Selloff to Demonstrate Its Absurdity,” I spent quite a lot of time talking about this thing called the “equity risk premium” and some of the interesting data I had calculated based on this measure.  Today I wanted to drill down into that equity risk premium data because it indicates some bizarre investor behavior over the last 46 years.

So what is the equity risk premium?  It is based on the understandable theory that investing in the stock market is riskier than investing in the bond market.  Why would this be so?

Because bond holders have the legal right to the cash flows from a cash paying entity (e.g. a government, business, or individual).  Further, in the event of bankruptcy bond holders are ahead of equity holders in terms of asset disposition.  In other words, they get first dibs on the assets of the bankrupt entity that issued the debt.  Think: car repossession or house repossession on the part of a bank.  They have first dibs compared to the car owner if the owner doesn’t pay the bill.

To take on these additional and certain risks equity holders require a higher rate of return than bond holders.  Does this make sense?  That higher rate of return required by equity holders is known as the equity risk premium.

One technical note before proceeding, the typical calculation of the equity risk premium is as follows:

equity risk premium = earnings yield of the stock market – yield on 10-year U.S. Treasury Note

The 10-year U.S. Treasury Note is usually used because stock market investing is generally considered to be a long-term activity.  Here the assumption is that it will be for 10 years; that’s why you compare the earnings yield of the stock market to a 10-year U.S. Treasury Note and not a 5-year bond.  Apples to apples, not oranges.  Does this make sense?

The reason that the earnings yield of the stock market is compared to a piece of U.S. Treasury debt is that for decades U.S. government debt has been considered to be the most riskless investment in the world.

Now back to our regularly scheduled program…

So the first logical conclusion that we could all make is that the equity risk premium should absolutely never be negative.  If the equity risk premium were negative an investor could sell her or his equity investment (i.e. stock investment) and buy a bond that would pay her or him a higher rate of return and be less risky.

Yet, in the 130 years of monthly data regarding the S&P 500, dating back to January of 1881 the equity risk premium has been negative for 25.1% of the time (source: What My Intuition Tells Me Now blog).  Specifically, the equity risk premium has been negative for an entire month 393 times of 1568 possible months.

Frankly, this result is very surprising and is very likely a strong indication of irrationality on the part of equity investors.

But an alternative explanation might be that equity investors are, in fact, hyper-rational.  Maybe the reason that they are willing to earn less on risky stocks than on a riskless bond is that they feel that the bond is actually riskier than popularly believed.

The current debt crisis in the United States might be this kind of situation.  That is, a period when people actually feel investing in a business, any business, is less risky than investing in the debt of the United States.

To see whether or not this kind of rationality can explain the fact that the equity risk premium has been negative 25.1% of the time you would have to look at the historical context when the equity risk premium has turned negative.  Then you can better assess the smarts of the investment community.

From January 1881 to August 2011 there have been a total of 28 turns in the equity risk premium.  That is, times when it switches from positive to negative, or from negative to positive.  Let’s look at each of those:

Month          ERP Turns?          After Run of Length          What’s Going On Market History-Wise

Jan 1881       Positive                      582 months

Jul 1929        Negative                    3 months                                       lead up to the great crash of 1929

Oct 1929       Positive                      431 months                                  the great crash of 1929

Sep 1965       Negative                    12 months                                     Nifty Fifty era of growth stocks

Sep 1966       Positive                      2 months                                       Nearly 20% correction of the S&P 500

Nov 1966      Negative                    1 month

Dec 1966       Positive                      5 months

May 1967     Negative                     46 months                                    ~12% rise in the S&P 500, Israel’s Six Day War

Mar 1971      Positive                      1 month

Apr 1971      Negative                     6 months                                       Gold Standard

Oct 1971       Positive                       3 months

Jan 1972       Negative                    22 months

Nov 1973     Positive                      75 months                                     Yom Kippur War and Subsequent Oil Embargo

Feb 1980      Negative                     2 months                                       Runaway inflation and a recession

Apr 1980      Positive                      4 months                                       Runaway inflation and a recession

Aug 1980      Negative                    19 months                                     Recession ends

Mar 1982      Positive                      1 month                                          Recession

Apr 1982       Negative                    1 month                                          Recession

May 1982      Positive                      1 month                                          Recession

May 1983      Negative                     12 months                                    End of the recession

Apr 1986       Positive                       35 months                                   Chernobyl nuclear disaster

May 1986      Negative                     1 month                                        End of Chernobyl fears

Jul 1986        Positive                        2 months

Sep 1986       Negative                      1 month

Oct 1986        Positive                       1 month

Nov 1986      Negative                      1 month                                           Beginning of IT/dot.com bubble, balanced budget under Clinton

Sep 2002       Positive                       190 months                                    End of dot.com bubble, September 11, Enron scandal, etc.

Aug 2003      Negative                     11 months                                        Beginning of Real Estate Bubble

Jan 2008       Positive                       53 months                                       Real Estate Bubble POPS!

Present           Still positive               44 months                                      The Great Recession and post-Great Recession

Source: What My Intuition Tells Me Now blog and Jason Apollo Voss

Forgive the very long enumeration above.  However, what’s very interesting is to note the moments when switches between positive and negative happen.  Almost all of the switches happen when there is major global or economic news.

Particularly interesting is to see that when the equity risk premium goes negative the typical environment is not one of disaster, where a government’s debt might be called into question.  No, instead the negative equity risk premium is strongly associated with stock market bubbles.

Interestingly enough the bubble that led to the October 1929 crash was preceded by the first negative equity risk premium in history – 3 consecutive months worth.  October 1929 was the first of 431 months of positive equity risk premium.  Put another way, between January 1881 and August 1965, or 1,016 months, only 3 of them saw a negative equity risk premium.  That’s a paltry 0.3% of the months over 84 years, 8 months!

Then the equity risk premium turned negative again in 1965 as the “Nifty Fifty” stock market bubble started to take off.  There was only a minor correction in 1966 and then much more negative equity risk premium until 1971.  Again, there was a small correction, and then more negative equity risk premium until the recession and massive correction precipitated by the 1973 oil embargo.

While there were small bursts of stock market lift-off, that 1973 stock market decline seemed to correct investors of their bizarre behavior until about 1983 and the end of the double-dip recession.  Then until about 2002, or 19 years (!), there was near continuous negative equity risk premium.  Remember, it only took 3 months of this in 1929 to trigger a massive sell off of equities.

In fact, overwhelmingly, the negative equity risk premium years have happened since 1965 with 390 of the 393 months being logged since that turn in September 1965.  Furthermore, since that fateful month the stock market has traded with a negative equity risk premium for 70.7% of the time through August 2011.  This is stunning in comparison to the 0.3% of the time up until September 1965.

What I am trying to highlight here is that the sort of bizarre behavior that led to the stock market crash of 1929 has been replicated at a 130x magnitude since September 1965!  What has propelled this gigantic, truly massive stock market bubble?  There are myriad answers, but here is a sampling:

• Social Security created in the 1930s instills a belief in the public mind that retirement is an important goal
• Baby boomers came of investing age as they exited high school starting in the early 1960s and exiting college in the late 1960s
• Starting in the early 1960s academic research demonstrated the disproportionate wealth created by investing in stocks vs. other asset classes
• Wall Street begins marketing stocks to Baby Boomers as the natural vehicle for funding retirement
• Federal Reserve policies of injecting money into the economy post the October 1987 stock market crash and post September 2001 to allay investor fears leads to massive amounts of nearly free money
• Sophisticated Wall Street products allow for mortgages to be bundled together into securities and then bought and sold as assets.  Effectively, this turns the hard, illiquid asset that is real-estate, into cash

To summarize it all: a negative equity risk premium is evidence of irrational, euphoric, bubble behavior.  While a positive equity risk premium is associated with a rational investment community.

Put another way, negative equity risk premium is strongly associated with a very overvalued stock market.  Whereas a positive equity risk premium is evidence of a more rationally minded investment community.

Most importantly, where are we now?  Have the two generations of folks, myself included, who grew up with a relentless stock market march upward returned to their old wayward ways?  Is the equity risk premium negative again post the real estate bubble popping?

We have now had 44 consecutive months of a positive equity risk premium and as of Wednesday the equity risk premium stood at exactly 3.0%.  This compares to a historic average equity risk premium of 2.4%.

The interpretation would be that investors currently need more return on stocks to induce them to take on their greater risk.  Another interpretation would be that investors have behaved rationally for almost four years and to me this is a very, very good thing.

Jason