Revisiting the equity premium
Allison Schrager takes up the question of the equity premium today:
The return equities generate in excess of the risk-free rate (which is normally short-term Treasuries), is often assumed to be between 5% to 8%. In my experience risk managers go silent when asked where exactly this number comes from.
Schrager herself isn’t much more exact, concluding that “for now it remains a difficult question”. But I think even so she’s a bit too optimistic about the outlook for equities:
A zero long-term equity premium assumes firms in most industries will not be very productive or profitable for decades.
I don’t think this is true at all. For one thing, stock prices tend to have some kind of productivity and/or profitability gains priced in to them: especially in the technology sector, it’s perfectly commonplace for a company to see rising profits which still disappoint the market so much that the stock price falls. Rising profitability or productivity do not by any means mean rising stock prices.
More to the point, improvements in productivity can end up either as returns to labor or as returns to capital; and returns to capital can end up either with bondholders or with stockholders. If productivity improvements end up flowing overwhelmingly to employees and to creditors, then there might well be very little left for shareholders, even if the company is becoming much more efficient over time.
Schrager then continues her argument with this:
Equities are inherently riskier than Treasuries. Equity prices must ultimately reflect and compensate investors for that risk or no one would hold them in their portfolio.
I’m not sure where that “must” comes from: maybe it’s some kind of corollary of the efficient markets hypothesis. Investors certainly hope that returns on equities will be commensurate with the risk that they’re taking. But there’s no rule saying that any given asset class will “ultimately reflect and compensate” those hopes. After all, if there were such a rule, then really there wouldn’t be any risk at all!
When I see people like David Merkel and Eric Falkenstein do the math and come to the conclusion that the equity premium is somewhere between 0% and 2%, I generally come away much more convinced than I am by the vague arguments of those who put it at 5% or higher — arguments which often boil down to “the future will be like the past, if you ignore the really bad bits of the past”. In any case, it’s pretty clear that the number of people with large stock-market investments is much greater than the number of people who really understand the full range of possible outcomes and are comfortable with how much they could lose in the markets if things go badly.
But I’m thinking that maybe the current bout of volatility is helping to bring that home, at least a little.