MONDAY MORNING: A death knell for the equity risk premium

The equity risk premium has turned negative. In plain English, that means investors will not be rewarded in the long run for investing in equities rather than in bonds.

And if that is so, financial advisers should be taking a careful look at the market assumptions underlying the asset allocations of their clients’ portfolios. Perhaps the client portfolios should be more heavily invested in high-quality bonds.

The equity risk premium is the extra return investors receive for making riskier investments. Historically, according to Ibbotson Associates in Chicago, investors have earned 5.1% a year more, compounded, from stocks than from bonds.

Robert D. Arnott, managing partner at First Quadrant LP in Pasadena, Calif., and Ronald J. Ryan, president of Ryan Labs Inc. in New York, in a paper entitled “The Death of the Risk Premium: Consequences of the 1990s,” say the equity risk premium is dead.

They reach that conclusion by looking at the various components of the real (i.e., inflation-adjusted) long-term return on equities, which, again according to Ibbotson Associates figures, has totaled 8.4% compounded annually since December 1925.

That is made up of the starting dividend yield, the growth in real dividends and the change in the value the market will pay for each dollar of earnings or dividends. The dividend yield at the end of 1925 was 5.4%. Real dividends from 1925 to the present have grown only 1% per year.

The change in what the market would pay for each dollar of earnings added 2% per year as the average price-earnings ratio expanded enormously to its current level of 31.

Subtracting the cumulative real bond yield for the same period of 3.3% from the 8.4% long-term cumulative real return on equities leaves a cumulative risk premium of 5.1%.

Let’s now look at the next 74 years. We are starting with a dividend yield of 1.2%. What growth of real dividends could we logically assume? Real dividend growth can’t exceed real economic growth in the long run, and in fact must be well below the real growth of the economy because a good part of that growth comes from companies in which it’s not yet possible to invest.

Maybe we could stretch to 3% per year, if we can assume real economic growth of 5% per year long term, but even 2% is a bit of a stretch. As Mr. Arnott and Mr. Ryan write: “A faster growth [rate], on a long-term sustainable basis, requires assumptions that must be viewed as very aggressive, even `heroic.”‘

That leaves change in valuation level. I suppose the average p/e could go higher, but how much would you bet on it? Assume it doesn’t go higher. That leaves a cumulative real equity return of 3.1%. Subtract the starting real bond yield and you get a cumulative risk premium of minus 0.9%.

That is, using the above assumptions, investors would be better served in the future by investing in long-term bonds than in equities.

Now what do you tell your clients? As Mr. Arnott writes in another paper: “Even though the arithmetic is simple and compelling, most investors do not buy our thesis that the risk premium is gone.”

Nevertheless, the professional financial adviser will use this analysis as further evidence to clients that the equity returns of the past decade are very unlikely to be repeated over the next decade.

Therefore, they should revisit the current equity-heavy asset allocations and consider adding more fixed-income investments to the equation, and possibly real estate.

For taxable accounts Mr. Arnott advises tax-exempt munis, which are yielding about 5% at present.

“It’s not at all clear equities will deliver that, after tax, over the next decade,” he says. For 401(k)s and IRAs, inflation- indexed bonds fit.

Maybe the volatility of the past few weeks, especially the damage many of the dot-coms and tech stocks have experienced, will make the clients more inclined to listen and consider a change. If not, at least you have tried.

Mike Clowes is editorial director of InvestmentNews.

Related Topics: Just Thinking