Measuring the equity risk premium
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Peter Best* is a senior portfolio manager at Old Mutual Asset Managers in London, where he manages international equities using quantitative models.
Alistair Byrne is Head of Investment Strategy at AEGON Asset Management in Edinburgh and is also responsible for the firm’s quantitative research team. Peter and Alistair have been working on risk premium analysis since 1995, when they were both at Scottish Equitable. *Old Mutual Asset Managers Limited, 80 Cheapside, London EC2V 6EE, UK. Tel: ⫹44 20 7332 7558; e-mail: [email protected]
Abstract We use surveys of economic forecasts to derive a forward-looking estimate of the US equity risk premium (ERP) relative to government bonds. Our ERP measure helps predict short-term relative returns between stocks and bonds. Over the period we studied, low readings of the ERP tended to adjust back to the mean via a rally in the bond market rather than a fall in stock prices. We do not generalise from this result, however, as our sample period is characterised by strong trends of falling inflation and rising stock prices. Our estimate of the expected ERP — averaging just over 2 per cent — is markedly lower than the premium that historical studies show has been realised. Data from the UK paint a similar picture to the US experience. Keywords: equity risk premium; survey data; asset allocation
Introduction In this paper, we use surveys of consensus economic forecasts to produce a forward-looking estimate of the equity risk premium (ERP) relative to government bonds for the US market. Using this novel data source, our model provides a more realistic estimate of the ex ante ERP than assuming that realised returns accurately indicate what investors expected. Furthermore, the ERP offers the potential to be used as the basis of a tactical asset allocation strategy by active investment managers. We find that our ERP measure shows a tendency to mean revert and helps predict relative returns between US
䉷 Henry Stewart Publications 1470-8272 (2001)
stocks and bonds; high values of the risk premium are associated with above-average short-term equity–bond return spreads. Also, when the ERP is low, the correction typically takes place via a rally in the bond market rather than a fall in stock prices. We need to be cautious in generalising this result, however, as the period we investigate is characterised by strong trends of falling inflation and rising stock prices. In the sections that follow, we outline our measure of the ERP and describe the underlying data. We then test the power of the measure in predicting relative returns between stocks and bonds and look in detail at what contributes to
Vol. 1, 3, 245-256
Journal of Asset Management
245
Best and Byrne
this. In particular, we look at the process by which extreme values of the series adjust back towards the mean. We also look briefly at UK data to assess the similarity with the US experience.
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Table 1 (%)
US stock and bond returns, 1900–1999
Arithmetic average annual return Standard deviation
Stocks
Government bon
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