Do equities always outperform in the long run?

An interesting overview of the equity risk premium from the psy-fi blog.

A couple of key takeaways:

First a quote from Buffet:

Warren Buffett, as usual, looks at this differently. Taking a hindsight view of the twentieth century in US markets:

“To break things down another way, we had three huge, secular bull markets that covered about 44 years, during which the Dow gained more than 11,000 points. And we had three periods of stagnation, covering some 56 years. During those 56 years the country made major economic progress and yet the Dow actually lost 292 points.”

And:

So, do stocks always outperform (in the long run)? No, they don’t. And don’t expect long-run market returns in excess of 7% going forward. It might happen, but it probably won’t.

A point I try to drive home in my classes is that the assumption that stocks will earn their historic average return is very optimistic.  I think investors should assume a 2% real return and plan accordingly - which in most cases means saving more.

Damadoran on the current low risk free rate.

Aswath Damadoran has put together an excellent post on the current low risk free rate and the effect that it has on valuation.  His main point is that the risk free rate must be considered with the current expected risk premium.  When these are combined the result is relatively low valuations.   He also touches on another point which I'd like to emphasize.   In an equity valuation model we normally think of the risk free rate as only affecting the discount rate - so a lower risk free rate should result in a lower discount rate and thus a higher valuation.  But - and this is very important - the risk free rate also tells us a lot about the growth rate of the cash flows.  A low risk free rate implies low real growth and also low inflation.  Thus it will also reduce the level of future cash flows.  Failure to account for the two edges of the risk free sword is an example of inflation illusion.

Are stocks overvalued?

Fortune seems to think so.

I have no crystal ball, but it seems reasonable to assume that stocks are not going to earn returns of 5-6% over long treasuries in the future. Somewhere in the 2-4% range seems more reasonable.

How risky are stocks?

The widely held view that stocks are not risky in the long run is attacked by a nice article in today's WSJ.

It states:

Look at the long-term average annual rate of return on stocks since 1926, when good data begin. From the market peak in 2007 to its trough this March, that long-term annual return fell only a smidgen, from 10.4% to 9.3%. But if you had $1 million in U.S. stocks on Sept. 30, 2007, you had only $498,300 left by March 1, 2009. If losing more than 50% of your money in a year-and-a-half isn't risk, what is?

A break down of the equity risk premium

Is the equity risk premium actually zero? This post makes this claim. The author argues for a range of reasons why a risk premium is less than the typical quoted number of 6%.

I am inclined to agree that it is less than 6%, but I think it is probably incorrect to say it is zero.

I have a few issues with some of his arguments:

1.He claims that various studies have shown that the risk premium is declining, particularly since the 2000 market crash. The problem here is that I think he is confusing survey evidence of peoples expectations of the market risk premium with the implied premium that actually generates current prices. Before the market crash, in the late 90s, most investors thought stocks were great, would give high returns, and therefore would expect a high return over bonds. But of course, stocks were very expensive then and the implied premium was very low. After the crash the opposite occurs. Investors think stocks are awful, and expect low returns, but as prices are low, the implied premium is high.

2. He argues that transaction costs are ignored. But the evidence for bid-ask spread induced costs that he quotes are largely from pre-decimilization, when spreads were much higher than they are now. I agree that frequent trading will eat returns, but I don't see how this is really relevant to the equity premium. Nor do I see how poor market timing will impact the equity premium. Both of these factors will impact realized returns, but the equity premium is a fairly refined concept of the return you will earn as a buy and hold investor holding the market portfolio. In essence, someone how has an index fund in his/her 401k.

3. He states that the geometric mean will be much lower than the arithmetic mean due to volatility. No argument here, but this is a straw man as no reasonable person uses the arithmetic mean to estimate historic returns.

4. Peso problem. I completely agree that the US is a special case in that it has posted one of the highest historic premiums of any country. There is no reason to believe that the US should not mean revert to the average of the developed world.

So what is the correct premium? I sort of skirted around this issue here. But I think it is somewhere between say 2-6%. But don't quote me on that.

Finally, what would a zero percent premium mean? Well I doubt it will be along the lines of the Dow trading to 36000..

What do Finance Professors think the equity premium is?

A recent survey shows that in the US, Finance professors think that the equity premium is on average about 6.3%.

I actually participated in the survey and I think I said 6%. Of course more recently, the premium has certainly been higher, although before the credit market problems, I think it was headed lower than 6%.

If it is 6%, then what does this mean? Well, if the long term bond rate is about 3%, then the expected return on large cap stocks should be about 9%.

I have no idea whether or not 6% is the right number, but I am pretty sure about is that at current bond rates, a long term expected return on stocks of 12% (the historic nominal mean) is delusional.

The difference between 12% and 9% is massive.

$1000 per month for 30 years at 9% will grow to $1,830,743. While the same investment at 12% will grow to $3,494,964. Of course this assumes that the investment doesn't grow. The point is that if your financial plans are based on 12%, then you better hope that your kids are smart, because you're going to have to rely on them to pay for your retirement!

Stocks as a leading indicator

Monday's WSJ had a nice article on how stocks can be leading indicators during recessions. The basic idea is that in most past recessions, stocks tend to recover about 6 months before the end of the recession. The reason given is that prices rise as investor's forecasts of more robust growth begin to solidify. At the same time rising stock prices may have an wealth effect on households. Households will then consume more - which further drives the recovery.

However, in this recession, prices are being depressed by more than just lower cash flow growth. Bernanke told congress last week that prices no longer seem to reflect long term profitability, but rather "investor attitudes about risk and uncertainty, which right now are at very high levels".

It's worth remembering that there are two main inputs into stock values. The future cash flows generated by stocks and the riskiness of those cash flows as perceived by investors. While there is no doubt that the future cash flows are being hurt now (for the short run), further out these cash flows should be healthy as the economy expands again.

Investor attitudes to risk are embedded in the risk premium. Historically the risk premium has averaged around 6%, and in the long run this number appears supported by valuations. Towards the end of the tech bubble in the late 90's the risk premium (based on valuation models) was basically zero - consistent with a bubble market. But today I'd wager that the risk premium is 9 maybe 10%. A higher risk premium today means stocks are cheaper - if, and only if your personal view of the risk premium is less that of everyone else's.