Kiss the Equity Premium Goodbye

This article won't win me a lot of friends in the money management industry. Here's the skinny: Stocks are unlikely to return much more than bonds over the next 10 to 20 years.

Most investment consultants tell people to invest in equities because, in the long run, stocks beat bonds and cash. I agree, but how big is this advantage? Many studies suggest that the equity premium is somewhere in the vicinity of 6%; i.e., stocks beat cash by 6 percentage points a year. Against bonds, the advantage is said to be 4% or so.

However, there are persuasive arguments that the value of the equity premium will be much lower going forward. In the book Triumph of the Optimists, Elroy Dimson, Paul Marsh and Mike Staunton argue that the future equity premium in the U.S. is likely to be closer to 4% over cash for two main reasons:

Corporate cash flows have grown faster in the last 50 years than in the prior 50, and investors have bid up stocks as a result. However, the authors believe that such high rates of growth will not continue. If corporate cash flow growth reverts to the rate of the first half of the 20th century, future returns based on current equity values will be poor indeed.

Perceived risk in stock investing has diminished. Investors have bid prices up in anticipation that the equity premium is higher than it should be, and on the belief that it is not risky to try to capture it.

The researchers Peter Bernstein and Robert Arnott draw similar conclusions, but they get there in different ways. They point out that over the years, the size of the future equity premium has varied with the level of belief in its existence. When market players deny its existence, equity valuations are low, past equity performance has probably been poor, and the future equity premium is large -- think of 1931, 1937, 1974, 1982, November 1987 and 2002. When everyone believes in the inevitability of stocks, à la "Dow 36,000" (we'll get there by 2025 or so), equity valuations are high, past equity performance has probably been great, and the future equity premium is small -- think 1929, 1972, August 1987 and February 2000.

I believe stocks have been bid up because of the benefit needs for the retirement of the baby boomers. Though the savings rate is low, investment vehicles such as pension plans have made large commitments to equities, partially because plan sponsors can justify lower contributions to benefit plans by assuming a high rate of return, which stems from assuming that the equity premium will persist.

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David J. Merkel, CFA, FSA, is a senior investment analyst at Hovde Capital responsible for analysis and valuation of investment opportunities for the FIP funds, particularly of companies in the insurance industry. Previously, he managed corporate bonds for Dwight Asset Management. At the time of publication, neither Merkel nor his fund had any positions in the securities mentioned in this column, though positions may change at any time. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. While Merkel cannot provide investment advice or recommendations, he appreciates your feedback; click here to send him an email.

Analyst Certification: All of the views expressed in the report accurately reflect the personal views of the research analyst about any and all of the subject securities or issuers. No part of the compensation of the research analyst named herein was, is, or will be, directly or indirectly, related to the specific recommendations or views expressed by the research analyst in this report.

Merkel is employed by Hovde Capital Advisors LLC (the "firm"), a registered investment advisor with its principal office located in Washington, D.C. The Firm and/or its affiliates have or may have a long or short position or holding in the securities, options on securities, or other related investments of the issuers mentioned herein.

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