The perversity of risk
Financial markets have given investors in common shares a return edge over bonds. Over the long haul common shares have generated a return of between 4% and 6% per annum higher than risk free bonds. There have also been times when this percent has spiked higher and fallen much lower.
This excess return of stocks over bonds is called the Equity Risk Premium. It is said to reward investors in common shares for the added riskiness of common shares. Compared to stocks U.S. Treasury Bonds, with a ten year term, are thought of as being risk free; never mind that they expose investors to inflation risks. There are different ways to calculate the Equity Risk Premium and so different authors give somewhat different values.
Why do we need to know about this?
There are two basic reasons learn about this. The first is that investors should understand the perverse relationship between investor confidence and risk. The second is that the Equity Risk Premium is central to coming up with the discount rate that analysts use to carry out a stock valuation using the Discounted Cash Flow (DCF) approach.
We will see that the Equity Risk Premium not only goes up and down but also is in a secular downtrend. Both these things have significant consequences for stock valuations.
What causes the Equity Risk Premium?
From one point of view it can be said the additional riskiness of common stocks relates to the fact that on a breakup of a company common stocks stand behind bond holders. As well, bond coupons are fixed. Common share dividends are only as declared by the board.
The size of the Equity Risk Premium can also, in part, be explained by investors’ aversion to volatility. Many consider the extraordinary volatility of common stocks to be an indicator and measure of their riskiness. The more volatile a stock or sector, the more risky it is seen to be. I personally don’t buy this. I don’t think that volatility, per se, is an indicator of risk. I explain my thoughts here.
The flip side of risk is safety. It has been argued that the Equity Risk Premium is better understood by looking at it as a ‘safety premium’. Falkenstein argues that humans naturally have a logarithmic sense of safety and risk. He writes: “…if we have a log sense of risk, and safe means extremely little risk, the safest assets are insanely unique. It must be 100 times safer than something merely pretty safe, and when you have to give someone credibility that something is that safe, it basically implies there must be decades of proven safety. This necessarily leaves very few assets, so supply cannot take advantage of this cheap funding. Supply is necessarily constrained by this requirement, and keeps the price of safety assets high, and their returns low.” (Falkenstein, 2009)p.155.
The equity risk premium changes over time
Now that we have the basic idea in mind, we can try to take this a step further. The Equity Risk Premium changes over time. This is a big mental leap. And it’s a difficult subject.
To prepare your brain for this discussion, take the case of so called risk free government bonds. When long term interest rates go up, the price of long term bonds fall. When long term interest rates fall, the price of long bonds rises. This latter effect is what has been happening over the last 40 years. The investment quality of the bonds has not changed. They are still said to be risk free. Of course they aren’t risk free because they can suffer capital losses as a result of changes in interest rates. This happens because the present value of the future flow of interest payments on the bonds changes with the current level of interest rates.
So, interest rates change over time. And bond prices change, inversely, to reflect changing interest rates over time.
Earnings, interest rates and investor confidence
Now let’s switch to stocks. Warren Buffett tells us that the price of stocks reflects three things: expectations for earnings; interest rates; and investor confidence.
To some degree stocks act like bonds when it comes to interest rates. Some people say that as rates come down, stocks become more attractive vis a vis bonds. That is simplistic. The value of a stock resides in the present value of its future cash flows available for investors; what Warren Buffett calls owner earnings. As rates come down, the discount rate to value stocks comes down and stocks increase in value. The increase in value typically results in an increase in price. (Readers can search for posts on owner earnings in the tags index on the home page)
What makes valuing stocks more complicated than valuing bonds is the matter of expectations for earnings and then the impact of investor confidence on prices and most importantly, on the Equity Risk Premium.
Investor confidence is inversely related to how investors view the relative riskiness of stocks. If stock are viewed as less risky, investors may be thought of as more confident.
Here’s the difficult part. As investor confidence grows, the equity risk premium decreases. As investor confidence wanes, the equity risk premium increases. So, a high equity risk premium means stocks are cheaper. That is, they are thought more risky, i.e. a higher risk premium, so they are cheaper.
Conversely, as the risk premium decreases, that is, as stocks are thought less risky, they have gone up in price and are more expensive for what you get. Price is what you pay and value is what you get.
Perversity of risk
Howard Marks has a wonderful expression to describe risks going down in down markets and up in up markets. He writes: “Thus, the market is not a static arena in which investors operate. It is responsive, shaped by investors’ own behavior. Their increasing confidence creates more that they should worry about, just as their rising fear and risk aversion combine to widen risk premiums at the same time as they reduce risk. I call this the “perversity of risk.” (Marks, 2013)p.68. (emphasis added)
So, the Equity Risk Premium moves up and down reflecting in large part investor confidence. We can visualize this by looking at some charts.
Equity Risk Premium and DCF
Remember out second point was that the Equity Risk Premium is integral in coming up with a discount rate to carry out a discounted cash flow analysis. Imagine that simply because of these fluctuations all DCF stock valuations will be fluctuating as well. And these fluctuations in part are caused by fluctuations in investor confidence. Let’s hold that thought and look at the evidence of fluctuations in the Equity Risk Premium.
Fluctuations in the Equity Risk Premium
The first chart show the Equity Risk Premium from 1983 to the end of 2019. The black line show price earnings ratios. High price earnings ratios suggest stock are more expensive. Low price earnings ratios suggest stocks are less expensive. So, in the early 1980s stocks were relatively cheaper. By the late 1990s in the Dot Com bubble price earnings ratios were much higher, it was a time of maximum optimism. Stocks were more expensive. By the depths of the financial crisis in 2008 and 2009 price earnings ratios had come down. It was a time of maximum pessimism. Stocks were cheaper.
Let’s look at the same period through the eyes of the Equity Risk Premium. It is displayed inverted so as to help visualize the relationship with price earnings ratios. From 1983 to 2000 as price earnings ratios were increasing we know that stock prices were also increasing. It is quite common for price earnings ratios to expand in a bull market. It known as multiple expansion. Multiple expansion can reflect different things. It can reflect decreasing interest rates and also increasing investor confidence. The red line on the chart shows that during this period the Equity Risk Premium was decreasing (don’t forget it’s inverted). It makes sense. A decreasing equity risk premium literally means that are investors are coming to think stocks are becoming less risky.
The next extreme on the chart is 2009, the financial crisis. The chart suggests price earnings ratios had been decreasing over the previous nine years from the high point of the Dot Com bubble. What is most fascinating is that the Equity Risk Premium increased in that nine year period and continues today to be higher (inverted) than the zero line. A higher Equity Risk Premium is noted on the chart as consistent with stocks being “cheap” in relation to fair value. The other noteworthy thing is that price earnings ratios have been going up the last three years, from 2017 to present, while the Equity Risk Premium diverged by increasing (inverted). As noted, a higher Equity Risk Premium means investors will earn a higher premium for the riskiness of owning stocks.
Right now there are some weird things happening with price earnings ratios. I have written that they may be becoming obsolete. See here. So, I’m not surprised to see this divergence the last three years.
Another thing at work is interest rates. Both short term and long term rates are artificially low because of actions by central banks. That distorts bond prices and stock prices, and may distort their respective relationships with indicators like price earnings ratios, discount rates and the Equity Risk Premium.
Riskiness of stocks over the long term
Our topic is the Equity Risk Premium. We’ve already seen that it fluctuates over time. I’ve suggested that the fluctuations probably reflect the ebb and flow of investor confidence towards equities. That confidence can change through bull and bear markets and through bubbles and crashes.
Something else is happening. Over the last 120 years there has been a secular decline in the Equity Risk Premium. There have been a lot of fluctuations, as can be seen in the next chart giving the long view. During this 120 years there have been occasions when stocks were thought of as almost no more risky than bonds. These dates, 1907, 1929, late 1960s and late 1990s were stock bubbles. There have been eras where stocks were thought so risky that prices went down enough that investors could expect returns on stocks of more than 10% above the return on ten year treasury bonds.
But, as the heavy red line (I have drawn) seeks to show, the trend over the last 120 years is a reduced Equity Risk Premium. This probably reflects the fact that stock market and securities regulation has improved. There are requirements now for timely material disclosure, a clamp down on insider trading and market manipulation and other stock market fairness measures. This has likely made stocks less risky than they were. As well we enjoy deeper more liquid markets.
A secular decline in the Equity Risk Premium would tend to increase acceptable Price/Earnings ratios, including CAPE. See my post here. Over the last 30 years there has been a shift by companies to intangible investments which are often expensed rather than capitalized. This would have tended to reduce reported earnings while at the same time increasing free cash flow, again impacting CAPE. See my post here.
Risk on and Risk off. One often reads or hears these terms used. They are used to describe times in the stock market and other financial markets when investors are more or less willing the take risks. In a ‘risk on’ environment, it may be thought that investors generally are more willing to invest in common stocks compared to bonds or that they are more willing to invest in more speculative stocks rather than the so called ‘blue chip’ stocks.
In a ‘risk on’ environment, it may be thought that investors actually think of stocks as less risky. Perversely, they are more risky. That is, in such an environment, many investors consider investments they are making are low risk when, in fact, they are higher risk. Put another way, in a ‘risk on’ environment, the Equity Risk Premium would be lower as a result of higher prices. And, in such an environment discount rates used in DCF valuations would also be lower, resulting in higher ‘valuations’.
It’s worth understanding the equity risk premium and how investors’ risk appetite changes over time.
To read more about the use of the Equity Risk Premium in discounted cash flow value estimates see:
For readers wishing to look further into risk and volatility take a look at:
To learn more about asset allocation between stocks and bonds check out the Motherlode Part 5: Asset Management
And specifically Chapter 28. Asset allocation
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