What is the basic Equity Risk Premium?
ERP is the excess return that an individual stock or the overall stock market provides over a risk-free rate. This excess return compensates investors for taking on the relatively higher risk of the equity market; high-risk investments are compensated with a higher premium.
Also referred to as “equity premium” or “equity risk premium”.
The reason behind this premium stems from the risk-return tradeoff, in which a higher rate of return is required to entice investors to take on riskier investments. The risk-free rate in the market is often quoted as the rate on longer-term government bonds, which are considered risk free because of the low chance that the government will default on its loans. On the other hand, an investment in stocks is far less guaranteed, as companies regularly suffer downturns or go out of business.
If the return on a stock is 15% and the risk-free rate over the same period is 7%, the equity-risk premium would be 8% for this stock over that period of time.
Simple and Complex
While it is a very simple concept to take the risk-free rate and the expected return of equities at any point in time and calculate the current risk premium, we are glossing over that return can be unpredictable. Assuming that long term future returns will average around the median return for all time periods is a weakness of this model in the short to medium term.
It’s no secret that the low rate environment that central banks are pursuing has pushed many yield seeking investors and speculators into higher risk assets. Some investors are likely over their heads in terms of risk to their portfolio.
The chart above from the Federal Reserve Bank of New York shows that, based on the average of across models, equity risk premiums are at an all-time high. Additionally, the S&P 500 price to earnings ratio is slightly below the historical mean of 15. Does this mean that stocks are over-priced or under-priced?
Stock price is really all about the expectations of future growth and dividends. A PE perspective suggests that the market is certainly not exuberantly under-priced nor over-priced.
From the New York Fed blog,
“We find that the equity risk premium is high mainly due to exceptionally low Treasury yields at all foreseeable horizons. In contrast, the current level of dividends is roughly at its historical average and future dividends are expected to grow only modestly above average in the coming years.”
The New York Fed also suggests that based on current equity yields, if rates were at a average mean, then the equity risk premium would be well below the historical average.
From the New York Fed blog,
“The blue and black lines reproduce the lines from the previous chart: the blue is today’s equity risk premium at different horizons and the black is the average over the last fifty years. The new purple line is a counterfactual: it shows what the equity premium would be today if nominal Treasury yields were at their average historical levels instead of their current low levels. The figure makes clear that exceptionally low yields are more than enough to justify a risk premium that is highly elevated by historical standards.”
What about Rising Rates?
There are a few things that will happen with regard to all these models and expectations. We will use utilities to illustrate some points.
The bond rating of a utility’s debt has a strong influence on its equity sensitivity to interest rates. The common stock of highly rated utilities is more interest rate sensitive than that of lower rated utilities. Additionally, larger utilities can be more interest rate sensitive than smaller utilities.
The quickest means of creating higher competitive utility yields in a rising interest rate environment is through share price deterioration.
#1: As rates rise companies that need to borrow money to fund long term business will take a hit to profits.
While utility dividends in general are fairly reliable, the promise of a dividend is only as good as the ability of the utility to generate earnings. If a company misunderstands its costs, receives less-than-expected revenue or has other misfortunes, it may have to cut its dividend. If it costs more to fund future projects due to higher borrowing costs then returns may suffer.
#2: Companies with slower growth will be penalized.
Over the long run, a utility stock will generally get most of its return from its dividend, rather than from capital gains. As such, utilities are known as income stocks. Since long-term capital gains are taxed at a more favorable rate than income, such as the payments from a utility dividend, investors in a high tax bracket may also have more tax consequences than investors buying more growth-oriented stocks.
#3: Equity Risk Premium
If rates rise, making higher dividend yields available in the market, investors will tend to sell existing shares and buy new, higher-yielding investments. This can drive utility prices down until the company either raises its dividend or sees its yield rise to current market levels.
While various measures of market value and expected returns seem to place the market slightly below historical standards and it is possible that the unprecedented bond buying by central banks has skewed standard measures of risk; there are still many basic economic assumptions that will hold true as rates strate to rise.
Investors will evaluate portfolios and determine what allocation of risk versus risk free assets is appropriate. That will almost assuredly mean that if equities do not grow earnings while increasing dividends, to boost yield, then share prices will suffer.
As rates rise, currency factors such as a stronger USD will affect commodity pricing if demand is slow to modest. Supply and demand pressure on commodity prices will effect producer margins, which may change dividends leading to price adjustments in the share price of the equity to balance risk premium with yield.
I will leave you with a series of charts that show historical returns over a 2, 5, 10, 15, and 20 year period. Long term investing isn’t bad, the risk is you might not beat inflation in the long term. Think about these charts below then ask yourself what is better buying highs to hold long term or buying short term pullbacks for the long term. Remember these are indices and by nature have survivorship bias.
Abstract: We surveyed banks, we combed the academic literature, we asked economists at central banks. It turns out that most of their models predict that we will enjoy historically high excess returns for the S&P 500 for the next five years. But how do they reach this conclusion? Why is it that the equity premium is so high? And more importantly: Can we trust their models?
Abstract: The equity risk premium is a long-run equilibrium concept that estimates the future excess return of the stock market over and above the bond market. In this paper, I compare the various ways of estimating the equity risk premium and discuss some of the other premiums in the capital markets.