Key Points:
- The equity risk premium (ERP) may vary depending on the term structure.
- Mean reversion can impact the ERP, with longer time horizons potentially resulting in a decrease.
- Noise in the market can influence the value premium, independent of sentiment or other factors.
- The effectiveness of the CAPE ratio as a predictor of stock returns varies internationally.
- When testing a stock-bond switching strategy, it is important to consider the benchmark in terms of comparable risk.
Does the equity risk premium (ERP) vary depending on the term structure? Does reversion to the mean dictate that it will decrease the longer the time horizon?
In this article, experts including Laurence B. Siegel, Rob Arnott, Elroy Dimson, William N. Goetzmann, Roger G. Ibbotson, Antti Ilmanen, Martin Leibowitz, Rajnish Mehra, and Jeremy Siegel delve into these questions and explore other related topics in the Equity Risk Premium Forum.
Term Structure and ERP
Martin Leibowitz emphasizes that the risk premium should be viewed as a term structure, declining as the time horizon increases. This is because the risk an investor demands for a one-year investment will be different from that of a five-year or 100-year investment. This varying curve is significant because it allows investors to choose their time horizon based on their tolerance for risk.
Rajnish Mehra challenges this notion by highlighting that it assumes mean reversion. If there is an independent and identically distributed (IID) process, the time horizon wouldn’t matter. However, Jeremy Siegel adds that a degree of risk aversion greater than 1 and mean reversion are necessary for a higher equity allocation over longer periods.
Rob Arnott supports the idea of mean reversion, explaining that while it may not be significant in the short term, it becomes more apparent over longer horizons. For example, 10-year real returns for US stocks show a negative correlation with subsequent earnings, indicating mean reversion. However, William N. Goetzmann points out that the evidence for mean reversion is inconclusive and can depend on various factors.
Noise and Value Premium
Jeremy Siegel highlights that value investing can be effective simply in a noisy market where prices deviate from equilibrium for non-fundamental reasons. This noise can create price movements that yield a value premium, regardless of sentiment or other factors.
International Application of CAPE Ratio
Elroy Dimson discusses the cyclically adjusted price-to-earnings ratio (CAPE) and its effectiveness in different countries. While CAPE may work in the United States, Dimson finds limited success when applying it to other countries. The accuracy of CAPE as a predictor of stock returns varies depending on the country’s market dynamics.
Choosing the Right Benchmark for Stock-Bond Switching Strategy
When testing a stock-bond switching strategy, it is crucial to select a benchmark that matches the comparable risk. Simply using a static mix strategy or a balanced portfolio return may not accurately represent the risk profile of the switching strategy. The benchmark should consider the magnitude of potential losses and the chances of extreme events.
Note: This article is a transcript of a discussion and does not constitute investment advice.
