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Equity Risk Premium Signals Investment Opportunities

Fri, Mar 9, 2012 - 10:55am

Financial theory suggests that stocks, due to the risk of ownership, should provide a greater return than safe investments like Treasury bonds. The ‘equity-risk premium’ is a measurement of how much investors are demanding to own the more risky stocks – it is the excess return that you can expect from the overall market above a risk-free return.

equity risk premiaEquity Risk Premium: The current equity risk premium is roughly twice the historical average according to Thomson Reuters – and some studies claim it is at a 60 year high (see chart at right courtesy Barron’s). One of the key takeaways for investors in 2011 was that concerns over the risks to the global financial system were very elevated – so investors demanded higher equity returns to compensate.

The fundamental outlook for many U.S. companies is excellent, but the high equity risk premium suggests stocks remain undervalued. Historical market data indicates that when the equity risk premium is elevated stocks tend to generate above average returns. This is the case even when economic growth is subpar.

The fact that the equity risk premium has increased over the last three years even as the market has rallied is even more interesting to market historians – normally the equity risk premium declines as the stock market rallies.

While stocks may be attractively valued (note stocks in the LSGI Portfolio increased revenues by a median of 37% over the last four quarters) a number of concerns have kept most investors out of the stock market.

number of days when sp500 moved more than 2 percentVolatility: Volatility has been much higher the last three years than it has historically. Note the chart at right – stocks have moved upward and downward much more frequently, and violently, than they have historically. In addition the correlation of individual stocks and the major stock indexes have been near record highs.

volatility 1999-2011

Due to the volatility, uncertainty and global risks investors redeemed $131 billion from stock funds in 2011 and plowed $128 billion into bond funds. Overall 2011 saw the biggest flight from stock funds since 2008, which was the second-worst annual exodus of the past 27 years (charts courtesy Barron’s).

Investor redemptions from stock funds began in 2007 and have not relented even in the face of recent market gains. Investors have poured money into the less volatile bond funds and cash equivalents. Investors sent eight times as much money into bank accounts last year than into bond funds as risk concerns triumphed.

While investors have been avoiding stock funds several developments could be very positive for investors:

  • J.P. Morgan noted that 11% of the companies in the S&P 500 index gained 15% or more in the first 14 days of trading. This is the strongest performance in a decade. When more than 2% of the companies in the index gain 15% or more the market tends to sustain those gains into year-end (see chart, courtesy JP Morgan).

    trading day analysis yield returns

  • Michael Santoli of Barron’s notes that as of the January 27th close, the Standard & Poor's 500 was up 4.7%. Since 1953, nine prior years had a 4% or greater gain through that date. In each, the index finished positive, with further gains over the remaining 11 months. Santoli notes “one important exception: 1987, when stocks sprinted out of the gate by more than 11%, continued rallying into the summer, then crashed, though did limp to a full-year positive return.”
  • J.P. Morgan examined 55 years of market data and found that when the equity risk premium was high, defined as greater than 4.27%, and economic growth modest (GDP growth below 3%) the market returns over the next seven years were much higher than normal. Annual returns for the high equity risk premium/low economic growth periods like we are now experiencing averaged 8.4%, 31% higher than the average for the period.
  • Richard Bernstein Advisors Investors noted that smaller US companies have been producing positive earnings surprises. They expect these small companies will continue to announce superior gains in the coming year (see chart, courtesy Bernstein Advisors). The Russell 2000 is an index of small U.S. companies. U.S. small caps are expected to generate earnings growth that is “three times that of China’s and nearly four times that of emerging markets in general,” the report notes. Due to the high correlation last year between the individual stock price and the major market indexes these small companies for the most part remain undervalued. Over time earnings will drive the direction of stock prices.

consensus projected 2012

  • Frank Holmes of US Global Advisors notes that a technical signal used by many market traders is called the “golden cross.” This signal is issued when an index’s 50-day short-term average crosses above the 200-day long-term average. “There’s a good historical reason traders use this mechanical trigger” Holmes notes, “over the past 20 years, the 50-day line crossing above the 200-day average of the S&P 500 Index resulted in surprisingly bullish data. Of the nine times this event has occurred in those 20 years, the S&P 500 averaged a 23 percent increase before the market reversed” (see his chart below). Right now the S&P 500 index’s 200-day and 50-day averages have just crossed, issuing the ‘golden cross’ buy signal.

gspc sma 50 and 200 day trading 30 jan. 2012

sp500 returns golden cross

  • On the same topic, but over a longer time period Birinyi Associates noted there have been 26 golden crosses in the 50 year period since 1962. The market gain between the golden cross and when the averages reverse can be seen on Birinyi’s chart below. Stocks have been higher 81% of the time in the six months after those events for an average gain of 6.6% according to Birinyi. Chart courtesy of the Wall Street Journal.

    sp500 since 2009

  • The Wall Street Journal reports that the last seven appearances of the golden cross, going back to December 1998, preceded average gains over the next two months of 5.5%. The largest gain--14%--followed the golden cross that appeared in June 2009, while the smallest gain—2.2%—followed the November 2004 event.
  • Birinyi Associates also published a note that the S&P 500 has gained more than 20% in the past 78 trading days, a phenomenon seen only 15 times since 1945. On average, they say, the market has gained 6.96% in the six months after those episodes and fallen only twice.
  • Investment advisor Don Coxe noted that with the recent Federal Reserve statement on monetary policy, and the new European Central Bank policies, the global financial system will be provided with ample liquidity. This should be a good environment for stocks and commodities. Coxe raised the equity weighting of his portfolio. He also predicted that this environment will spur more mergers and acquisitions, which will also be good for share prices.
  • best january for sp500

    Since 1972, after posting gains in January stocks have finished lower for the year only three times according to Jeffrey and Yale Hirsch of the Stock Trader's Almanac. The Almanac created the "January Barometer" in 1972. This barometer states that "as the S&P 500 goes in January, so goes the year." Over a longer period this market prediction tool has been correct 89% of the time since 1950, suffering only seven major setbacks, With the S&P 500 up 4.5% in January, its biggest first-month gain since 1997, the Barometer indicates that 2012 should be a good year for stocks. A ‘momentum effect’ is also in play here according to analysts. Chart courtesy USA Today.
  • Those interested in market history have reviewed the years where the markets have performed the best and found several factors are usually present. Generally, the consistent themes are that (1) credit conditions are easing, (2) corporate profits are rebounding, and (3) excess pessimism moderates or inexplicably gives way to optimism. The very best performance occurs when stock prices are depressed (see equity risk premium discussion above) and when the credit easing is sudden and unexpected (see note on Fed and European Central Bank policies above). The current conditions certainly have a bullish cast, meeting most if not all of these criteria. For details see: Martin S. Fridson, “It Was a Very Good Year”, John Wiley & Sons.
  • Don Hays of Hays Analytics notes that his indicators remain bullish. His comments last month:
“Not counting the last two years, the S&P 500 is as under-valued as any bottom of any previous bear market. That certainly shows the fear existing in today’s investment community. Remember, fear is good if you are an investor.”

He continues the theme:

“We continue to say that over the next three months history will tell you that these conditions can result in a possible gain of 21.9%, with a possible risk of -18.3%, not far from even odds. The next 6 months starts to improve, with a possible gain of 31.7% with an historically maximum loss of -15.1%, almost 2 to 1. That’s not bad, but the real story is what these conditions have generated in the next 12 months, a possible gain of 54.4%, and a very minimum risk of -4.5%. The average 12-month gain has been 16.7%. . . . Today, my friends, with about equal odds of success for the next 3 months, but HUGE odds of success for the next one year…”

Don’s charts, based on historical market data, remain bullish:

bear bull meter

  • Academic studies indicate that over time the segment of the market we are targeting in the LSGI Portfolio – very small companies – tend to outperform large stocks and other asset classes.

Dr. J. Benson Durham with the Division of Monetary Affairs, Board of Governors of the Federal Reserve System, prepared a study of 37 years of market data entitled “The Extreme Bounds of the Cross-Section of Expected Stock Returns”. He found that of the 23 variables he tested over that period very few were statistically ‘robust’ in forecasting future stock returns.

lessons of history 1925-2005

One of the most statistically significant factors he found to predict future returns was the size of the firm – in general the smaller the size of the company the larger the stock’s return. Historical data from Ibbotson & Associates also supports this thesis (see long term performance chart courtesy of Goetzmann and Ibbotson, ‘The Equity Risk Premium’, note the vertical scale is logarithmic).

price appreciation 1930s-2011

  • Historical data indicates that when the market performs poorly over a ten-year period it generally performs better in subsequent periods. The decade of the 2000’s was the worst ever for market performance on a total return basis with a negative total rate of return – something not even seen in the era of the Great Depression. Chart courtesy Barron’s.
  • Historical market data indicates that during expansive monetary periods like those presently in place stock returns are significantly higher than during other periods. This is especially true for small cap stocks which tend to be more sensitive to monetary conditions. An academic study of historical monetary policy and stock returns concluded that the “findings indicate that investing in small firms was a more favorable strategy during expansive monetary periods”. See: The Role of Monetary Policy in Investment Management, Jensen, Johnson, and Mercer.

stock performance of size deciles 1960-1998

Bottom line: The authors found that during expansive monetary periods very small company stocks returned roughly 31.3% annually versus 19.0% for large company stocks – a significant difference that compounds over time (see chart of long term performance at top of page).

About the Author

SMU School of Law Professor
jdancy [at] smu [dot] edu ()
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