– The traditional capital asset pricing model (CAPM) doesn’t always work in practice, so a new model called the Holistic Market Model has been developed to address its flaws.
– The Holistic Market Model re-engineers the CAPM by measuring the equity risk premium (ERP) correctly and accounting for hidden risk premia embedded in US Treasury bonds.
– The model calculates the ERP by using consistent earnings figures and rethinking the real risk-free rate.
– The re-engineered CAPM is based on the four-factor ERP model and provides a powerful explanation of equity valuations.
– The model indicates that the rules that govern stock prices have remained surprisingly stable despite changes in the structure of the US economy.
– The Holistic Market Model has implications for portfolio construction and asset allocation, including insights about equity prices, the likelihood of a crash, cyclical bull and bear markets, and forward-looking risk-adjusted returns.
– The secular bull market that started in 1982 may not be coming to an end yet, but could be affected by factors such as a decline in corporate profit margins, an increase in the real risk-free rate, or inflation.
– Continued secular P/E and margin expansion could bridge the gap between low earnings yields and long-term average market returns.
– The end of the secular bull market has not yet appeared, and there may still be room for optimism in the future.
– The opinions expressed in this article are the author’s own and not investment advice.
– CFA Institute members can record professional learning credits for reading this article.
The capital asset pricing model (CAPM) is one of the marvels of 20th-century economic scholarship, but it doesn’t always work in practice. To address this, a new model called the Holistic Market Model has been developed, which re-engineers the CAPM to provide a more accurate understanding of equity valuations. By measuring the equity risk premium (ERP) correctly and accounting for hidden risk premia in US Treasury bonds, the Holistic Market Model offers valuable insights for portfolio construction and asset allocation.
The traditional CAPM fails because both components of the equity risk premium (ERP) are flawed. Traditional earnings yields rely on inconsistent earnings figures, while risk-free rate calculations ignore hidden risk premia embedded in US Treasury bonds. The Holistic Market Model addresses these flaws by using consistent earnings figures and recalculating the real risk-free rate to provide a more accurate measure of the ERP. By reconstructing these measures from the ground up, the model calculates the ERP in a consistent fashion over the past 150 years.
The re-engineered CAPM based on the Holistic Market Model is a powerful explanatory tool for equity valuations. It uses a four-factor model to quantify valuation drivers, including variations in economic and financial risk, extreme inflation and deflation, intergenerational increases in risk aversion, and variations in the risk arbitrage between equities and Treasury bonds. By considering these factors, the model offers a more comprehensive understanding of the forces driving equity prices.
The Holistic Market Model indicates that the rules governing stock prices have remained surprisingly stable despite significant changes in the structure of the US economy. It provides insights into various market conditions, such as the high equity prices in recent years driven by favorable trends, the likelihood of a crash triggered by financial crises or geopolitical events, and the presence of cyclical bull and bear markets driven by economic cycles and market sentiment.
Looking ahead, the Holistic Market Model suggests that secular forward-looking risk-adjusted returns are at an all-time low, but it does not necessarily signal the end of the 40-year secular bull market that started in 1982. Factors such as a decline in corporate profit margins, an increase in the real risk-free rate, or inflation could affect the future of the bull market. However, the model indicates that the end of the secular bull market may not be imminent and that there is still room for optimism in the years to come.
Overall, the Holistic Market Model provides a fresh perspective on equity valuations and offers valuable insights for managing future uncertainty. Its re-engineered CAPM and four-factor ERP model provide a more comprehensive understanding of equity prices and their drivers. By considering factors such as consistent earnings figures and the real risk-free rate, the model provides a more accurate measure of the ERP and a powerful tool for portfolio construction and asset allocation.
