Comments on: The Equity Premium is No Longer a Puzzle

By: David Merkel

David Merkel — Thu, 16 Jul 2009 19:44:33 +0000

Note to all readers: the search function has been moved to the upper left of the website for easier use. Thanks to Mike C for the impetus to move it.

By: David Merkel

David Merkel — Thu, 16 Jul 2009 19:43:28 +0000

10-year Treasury normal term premium over short t-bills: 1.7% or so — higher during periods of stress and inflation fear, and vice-versa.

By: Aki_Izayoi

Aki_Izayoi — Thu, 16 Jul 2009 18:02:04 +0000

I do think the equity risk premium will increase; it usually does when bear markets bottom. I currently see stocks as trading instruments now where traders can simply go long or short. These are nice instruments if one seeks short-term gains. I do not think there will be significant economic growth in the future due to the overcapacity and lack of aggregate demand (even in developing countries) due to lower intertemporal discount rates (because of increased savings), wage arbitrage, and the contraction of private sector credit. The VIX is still in the mid 20s and is historically high (although tame under these standards). The low dividend yield doesn’t compensate for downward volatility (nor can we reasonable expect rising corporate profits). Since there would be no growth, the risk premium would be higher as a lower risk premium reflects positive expectations of growth.

I’ll start going long on stocks when people stop trying to play the greater fool game, and when policy makers become protectionist to protect their own markets from the effects of wage arbitrage.

BTW, what do you think would be risk premium (the term premium) on 10 year Treasuries relative to the risk free asset? Unlike in Japan, the US Treasury market is very volatile, and I think a larger term premium would be required to deal with potential upwards volatility on bond yields. I am not saying this as a person who thinks inflation is around the corner because I am a deflationista, but I think yield volatility would increase the term premium (relative to a lower duration bond) so a steep yield curve would be expected. I still think 10 year Treasuries might close the year at 310 basis points though.

By: Mike C

Mike C — Wed, 15 Jul 2009 20:55:24 +0000

David,

The search function appears to not work well at all. I was trying to find the “Do Half” post and whatever website the search function took me to shows nothing. Is it possible to make an improvement here?

By: Mike C

Mike C — Wed, 15 Jul 2009 20:55:23 +0000

David,

By: dave.d

dave.d — Wed, 15 Jul 2009 19:38:35 +0000

“Companies tend to sell stock when it is advantageous; IPOs happen more frequently when valuations are high, and buybacks happen more frequently when valuations are low. This suggests a project for future study: Calculate the dollar-weighted return for the public equity market as a whole, and compare it with the time-weighted return figures.”

This has been done. Google a paper by Ilia Dichev (now of the University of Michigan): “What are Stock Investors’ Actual Historical Returns? Evidence from Dollar-Weighted Returns.” From the abtract: “[A]ggregate dollar-weighted returns are systematically lower than buy-and hold returns. The annual difference…averages 1.5 percent for 19 major stock markets around the world over 1973-2004.” This explains a lot of the mystery of the equity premium.

By: Jeff

Jeff — Wed, 15 Jul 2009 17:47:55 +0000

Sad but true. Well done. The vanishing equity premium is the subject of many of our posts and an underlying tenet supporting Hybrid Portfolio Theory.

http://venturepopulist.com/2009/06/hybrid-portfolio-theory/

By: IWantCookieNow

IWantCookieNow — Wed, 15 Jul 2009 13:32:54 +0000

“PS — this makes the old dictum on the cost of equity valid again — the cost of equity capital for a firm should be 2-3% above their longest bond yield. Bye, bye, CAPM.”

IF the company has standard financing, right? Modigliani-Miller still holds… (At least approximately)