The Federal Reserve’s near-zero interest rate policy has had many far-flung effects, and none more significant than the fattening of the “equity risk premium" (defined as the expectation that stocks will deliver a higher return than “risk-free” investments such as cash).
Amid expectations for rising interest rates, that premium seemed to be on the chopping block. But the Fed breathed new life into it on Wednesday by holding rates steady and saying that it expects fewer rate hikes this year than it initially projected.
Stock investors shouldn’t celebrate just yet. They should instead reconsider whether the equity risk premium is the right gauge for thinking about how much they can expect to get paid for taking risk. Rather than hang on the Fed’s every word to divine the future course of interest rates, they should pay attention to the data and look elsewhere.
Investors’ obsession with the equity risk premium is understandable because, historically, risk-taking has paid a lot. The S&P 500 Index, for example, has outperformed cash -- represented by one-month treasuries -- by 6.5 percent annually since 1926 (the longest period for which data is available; those returns include dividends).
One way to see the Fed’s impact on the equity risk premium, and to gauge what kind of shape the equity risk premium is in currently, is this: Look at the spread between the earnings yield for the S&P 500 -- as measured by the inverse of the cyclically-adjusted price-to-earnings ratio (CAPE) -- and the federal funds rate. That spread has been just 1 percent on average since July 1954. But since the Fed dropped the fed funds rate to the floor in December 2008, that spread has averaged a whopping 4.5 percent, and today it remains a lofty 3.8 percent.
The Fed’s meddling with the equity risk premium has sparked a fierce debate about its continued relevance. The faithful argue that nothing of substance has changed -- what does it matter if the expected return from stocks and cash is 8 percent and 4 percent, respectively, or 4 percent and zero? Either way, the equity risk premium is 4 percent!
Not so fast cry the skeptics: The equity risk premium is only relevant when the market sets prices. But when the Fed artificially lowers interest rates, as it has since the 2008 financial crisis, starved-for-return investors will chase stocks and drive valuations up to dangerously high levels. So while the premium may be the same, the risk associated with a 4 percent expected return from stocks is actually much higher than the risk from an 8 percent expected return.
So what’s going on here -- is the equity risk premium still a useful barometer of expected return from stocks? How should savvy market participants think about it?
To answer that question, I looked at historical equity risk premiums and subsequent seven-year annual returns for the S&P 500 from July 1954 to March 2009. There have been only four periods during that time in which the equity risk premium was equal to or higher than it is today. The subsequent seven-year return during those periods was an average of 12.9 percent annually, as compared to an average of 9.6 percent annually during all other periods. At first blush, higher equity risk premiums seem to point to higher stock returns.
But when you look closer at those four periods, it turns out that the common driver of higher equity risk premiums was lower stock valuations, not lower interest rates. The average fed funds rate during those periods was 3.7 percent -- nothing artificial about that. The average CAPE, on the other hand, was a bargain basement 12.6.
So maybe the predictive power that investors attribute to the equity risk premium is actually attributable to stock valuations.
Consider that the correlation between the earnings yield for the S&P 500 and subsequent seven-year annual returns was 0.67 from July 1954 to March 2009, while the correlation between the equity risk premium and subsequent seven-year annual returns was only 0.19. This implies that valuations have far more predictive power than the equity risk premium.
This should alarm investors who are pinning their hopes for satisfactory stock returns on the equity risk premium at a time when the S&P 500’s CAPE is 24 and the Fed seems weary of seven-plus years of near-zero interest rates.
The Fed gave guidance on Wednesday that it intends to raise rates more slowly than previously expected. Translation: There’s still time for stock investors to ditch the equity risk premium as a crystal ball for determining expected returns.
This column does not necessarily reflect the opinion of Bloomberg LP and its owners.
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Nir Kaissar in New York at email@example.com
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