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There's been a lot of discussion in the press, and elsewhere regarding this
paper, penned by Arnott and Bernstein.
I was able to find it online via SSRN (570KB):
http://papers2.ssrn.com/sol3/delivery.taf?24038&_UserReference=FB534036A2488C79
3D3084F9
SSRN has a wealth of info, if only I had time to read it all. :)
I find it interesting that only now these valuation articles are coming out in
the refereed journals. Some of the articles that I've seen were authored in
2000!, but are filtering out only now. With the market down, I guess it is more
socially acceptable
----------------------------------
What Risk Premium Is "Normal"?
Robert D. Arnott
Managing Partner
First Quadrant, L.P.
Peter L. Bernstein
President of Peter L. Bernstein, Inc.
Consulting Editor at The Journal of Portfolio Management
Introduction
We are in an industry that thrives on the expedient of forecasting the future
by
extrapolating the past. As a consequence, investors have grown accustomed to
the idea
that stocks "normally" produce an 8% real return and a 5% risk premium over
bonds,
compounded annually over many decades.1 Why? Because long-term historical
returns
have been in this range, with impressive consistency. Because investors see
these same
long-term historical numbers, year after year, these expectations are now
embedded into
the collective psyche of the investment community.2
Both figures are unrealistic from current market levels. Few have acknowledged
that an
important part of the lofty real returns of the past has stemmed from rising
valuation
levels and from high dividend yields which have since diminished. As this
article will
demonstrate, the long-term forward-looking risk premium is nowhere near the 5%
of the
past; indeed, it may well be near-zero today, perhaps even negative. Credible
studies, in
the US and overseas, are now challenging this flawed conventional view, in
wellresearched
studies by Claus and Thomas [2001] and Fama and French [2000, Working
Paper], to name just two. 3 Similarly, the long-term forward-looking real
return from
stocks is nowhere near history's 8%. Our argument will show that, barring
unprecedented economic growth or unprecedented growth in earnings as a
percentage of
the economy, real stock returns will probably be roughly 2-4%, similar to
bonds. Indeed,
even this low real return figure assumes that current near-record valuation
levels are
"fair," and likely to remain this high in the years ahead. "Reversion to the
mean" would
push future real returns lower still.
Furthermore, if we examine the historical record, neither the 8% real return
nor the 5%
risk premium for stocks relative to government bonds has ever been a realistic
expectation, except from major market bottoms or at times of crisis, such as
wartime.
Should investors require an 8% real return, or should a 5% risk premium be
necessary to
induce an investor to bear stock market risk? These returns and risk premiums
are so
grand that investors should perhaps have bid them away a long time ago -
indeed, they
may have done so in the immense bull market of 1982-1999.
Intuition suggests that investors should not require such outsize returns, and
the historical
evidence supports this view. This is a topic meriting careful exploration.
After all,
according to the Ibbotson data, stock market investors earned 8% real returns
and stocks
have outpaced bonds by over 5% over the past 75 years. So, why shouldn't
investors
have expected these returns in the past and why shouldn't they continue to do
so?
Expressed in a slightly different way, we examine two questions. First, can we
derive an
objective estimate of what investors should have had good reasons to have
expected in
the past? And, why should we expect less in the future than we've earned in the
past?
[...]
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