What Risk Premium is 'Normal'?

Abstract

We are in an industry that thrives on the expedient of forecasting the future by extrapolating the past. As a consequence, investors have grown accustomed to the idea that stocks normally produce an 8% real return and a 5% premium over bonds, compounded annually over many decades. Why? Because long-term historical returns have been in this range, with impressive consistency. Because investors see these same long-term historical numbers, year after year, these expectations are now embedded into the collective psyche of the investment community. Both figures are unrealistic from current market levels. Few have acknowledged that an important part of the lofty real returns of the past has stemmed from rising valuation levels and from high dividend yields which have since diminished. As this article will demonstrate, the long-term forward-looking premium is nowhere near the 5% of the past; indeed, it may well be near-zero today, perhaps even negative. Credible studies, in the US and overseas, are now challenging this flawed conventional view, in well-researched studies by Claus and Thomas [2001] and Fama and French [2000, Working Paper], to name just two. Similarly, the long-term forward-looking real return from stocks is nowhere near history's 8%. Our argument will show that, barring unprecedented economic growth or unprecedented growth in earnings as a percentage of the economy, real stock returns will probably be roughly 2-4%, similar to bonds. Indeed, even this low real return figure assumes that current near-record valuation levels are fair, and likely to remain this high in the years ahead. Reversion to the mean would push future real returns lower still. Furthermore, if we examine the historical record, neither the 8% real return nor the 5% premium for stocks relative to government bonds has ever been a realistic expectation (except from major market bottoms or at times of crisis, such as wartime). Should investors require an 8% real return, or should a 5% premium be necessary to induce an investor to bear stock market risk? These returns and premiums are so grand that investors should perhaps have bid them away a long time ago - indeed, they may have done so in the immense bull market of 1982-1999. Intuition suggests that investors should not require such outsize returns, and the historical evidence supports this view. This is a topic meriting careful exploration. After all, according to the Ibbotson data, investors earned 8% real returns over the past 75 years, and stocks have outpaced bonds by nearly 5% over the past 75 years. So, why shouldn't investors have expected these returns in the past and why shouldn't they continue to do so? Expressed in a slightly different way, we examine two questions. First, can we derive an objective estimate of what investors should have had good reasons to have expected in the past? And, why should we expect less in the future than we've earned in the past? The answers to both questions lie in the difference between the observed excess return and the prospective premium, two fundamentally different concepts that unfortunately carry the same label, risk premium. If we distinguish between past excess returns and future expected premiums, it is not at all unreasonable that the future premiums should be different from past excess returns. This is a complex topic, requiring several careful steps to evaluate correctly. To gauge the premium for stocks relative to bonds, we need an expected real stock return and an expected real bond return. To gauge the expected real bond return, we need both bond yields and an estimate of expected inflation through history. To gauge the expected real stock return, we need both stock dividend yields and an estimate of expected real dividend growth. Accordingly, we go through each of these steps, in reverse order, to form the building blocks for the final goal: an estimate of the objective, forward-looking equity premium, relative to bonds, through history.