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What Does The Current Market Risk Premium Tell Us About Future Stock and Bond Returns?

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What Does The Current Market Risk Premium Tell Us About Future Stock and Bond Returns?

Recently many analysts and commentators have been quoted saying things like 'Stocks have never been so attractively priced when compared to bonds', or ' equities are a no brainer compared to bonds for the coming decade', or ' beware the bond bubble'.

Many of these analysts encourage an overweighting in equities because 'Over the next 10 years equities should outperform bonds'. This is true, but for any rationale investor to hold ANY significant allocation to equities they better outperform…and by a wide margin!

This required excess return is called the market risk premium and is the difference in total return between risky assets (like equities) and risk less assets like treasuries. In order for any rationale investor to accept the MUCH higher risk of holding equities they should demand a much higher return.

How much extra return you ask? There is no mathematically correct answer and the risk premium changes with investor sentiment and emotion. But history can give us a guide.

Attached you will find a graph of the market risk premium over the last 70 years.

This graph illustrates the difference in yield for the subsequent 10 year period between the 10 year treasury and the S&P 500. The bold line is the long term average.

For example between 1949 and 1959 (look at the 1949 data point) an equity investor was rewarded with a 16.5% per year ‘excess’ return over holding a risk less 10 year treasury. Most would agree this is extreme, as most would happily accept a lot of excess risk in order to achieve an additional 16.5% per year in return.

In stark, and idiotic contrast between 2000 and 2010 an equity investor was penalized with a -6.6% per year ‘excess return’ over holding a risk less treasury. Investors were so enamored with stocks that they priced them to deliver 6.6% LESS than a risk less Treasury bond. This represented historic equity overvaluation.

Those were the extremes over the past 70 years, but where are we now you ask?

If you use the cyclically adjusted price to earnings valuation method developed by Robert Schiller (further info here: http://www.irrationalexuberance.com/index.htm) to estimate the future 10 year total returns of the stock market we are currently right around 3.5%.

So an investor in equities currently should expect to receive 3.5% per year more in ‘excess returns’ over the 2.6% available in a ten year treasury. This compares to a 70 year average of about 5.4%. Therefore a case can be made that on a long term risk-adjusted historical basis bonds are still somewhat undervalued when compared to equities.

Although it is true that equities are at the most attractive levels compared to bonds since about 1994.

The analysts are indeed right that equities should return more than bonds in the future, but stock valuations are not at a level to make the out performance enough to justify the risk.

  • Market Risk Premium

    1940 - 2010 Market Risk Premium
 

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