Thursday, October 22, 2009

Equity Risk Premiums: An Update

As many of you are probably aware, I am fixated on equity risk premiums. To me they are at the center of almost every debate about equity markets - whether stocks are too low or too high, whether current market conditions are the norm or an aberration, and whether equity investors truly understand the risk associated with investing in equities.

I had a few posts during the crisis, where I noted that the implied equity risk premium for the S&P 500 had climbed at a rate never seen before in history during the twelve weeks between September 12, 2008 and late November. In fact, I reported an implied equity risk premium of 6.43% at the start of 2009, up from 4.37% at the start of 2008. The big debate at that point was whether this crisis had damaged investor psyches so much that it had caused a permanent upward shift in risk premiums, or whether this was just another bump in the road and that we would revert back to the 4% implied equity risk premiums, pre-crisis.

I have just posted an updated version of my equity risk premium paper online:
In the paper, I graph out the implied equity risk premium from January 2009 to September 30, 2009. On September 30, 2009, the implied equity risk premium stood at 4.86%. While I had anticipated at the start of the year that the premium would drift back down, I expected it to take much longer than 9 months. One more reason for constantly updating equity risk premiums! Markets are full of surprises.

The new debate that is unfolding is whether markets have gone up too far and too fast, thus exposing themselves to a correction. I don't know the answer to that question but it can be framed around the implied equity risk premium. If you think that the crisis should have changed people's attitudes about risk and that a 6% equity risk premium is the new steady state, markets are over bought and the correction will be painful (a 15%-20% drop in the S&P 500). On the other hand, if your view is that what happened last year is just part and parcel of equity risk and that investors will soon forget the scars and go back to the 4% risk premiums of 2007 and 2008, the bull market has a lot of steam left on it (a 10% up movement in the S&P 500). I am not giving away too much when I say that the long term equity risk premium that I am using for mature markets, when valuing companies, has been 5-6% since January 2009. At its current level of 4.86%, I am within reaching distance, but I will respond to the market on this number. I am not a market timer!


jbor said...

How does responding to the market preclude market timing?

Seems like you are market timing using risk premium estimates? No?

Aswath Damodaran said...

If you use an equity risk premium close to the current implied premium, you are being market neutral... i.e, you are valuing your company, given where the market is today. If you decide to take a stand and go to a 4% or 6% equity risk premium today, you are market timing.

yogesh.swami said...

I haven't fully read the paper, but I think the reason risk premiums have gone down in 9 months is because most marginal investors (those who ultimately set the price) are large institutional investors. Most decisions (and/or analysis) made in these companies is done by their salaried employees, who naturally have a bigger appetite for risk because they hardly have anything at stake.

I don't have the data, but I think there would be high correlation between job loss in the financial sector last year and the implied risk premium (maybe it would be good to shift the job loss data by a week before computing the correlation, to allow for delayed panic response :-) ).

James said...

Yogesh, that's an interesting thought.

Do marginal buyers always behave like marginal buyers?

yogesh said...

@james: I don't know the answer to that. Probably, they are. But there is ample evidence from psychology (Daniel Kahneman's research on risk taking, for example) that people who take massive risks, tend to become extremely risk averse when they actually get exposed to the negative side of risk. If this is true (which I believe is true, based on my own risk-taking behavior), then the risk premiums should have shot up and remained high for a longer period of time.

I am not an economics/finance professional, but I think Wall street is more of an Oligopoly than the Laissez Fair self-correcting machine that is normally assumed. But, I might be totally wrong.

Aswath Damodaran said...

In an oligopoly, oligopolists makes tons of money. On equity markets, the biggest professional investors (whether they be mutual funds or hedge funds) lose money, both relative to completely passive investors and to the index.

I think it consoles investors who lose money to believe that they have been victimized by a conspiracy. Unfortunately, that is not the case.

As a general proposition, Wall Street is full of market followers, not leaders.

Gaurav Mehta said...

I don't think it is true that people who take big risks become extremely risk averse. Infact big risk takes who lose money on a 2008 year and have been long enough in the market know pretty well that its just part of the game... investors confidence shifts faster than what most of us can anticipate.

Example: Goldman a beaten down bank last year was one of the first one to buy cyclicals in March this year and has been making huge profits this year. They might have been forced to become a bank but they are doing what they had been doing and what they are known for... taking risks and bigger risks.

Also the idea that people sitting on trading desks take risks because they dont have much at stake is quite skewed because they take risks for investors who want great returns and who very have an idea about the risks that go into equity.

I think what happened last year was just an excess of the system getting owt... which always happens at the end of a bull market... i.e. precisely how a bull market ends.. you had it in 1987, 92, 2000-01 and now in 2008.

The fact that markets have moved up so swiftly has not allowed the excesses to go out completely, there is a chance we might have problems sometime next year when the growth in US just wont be able to match up with the run in the equity markets. How ever timing the market is a useless excercise... stay with flow and when the tide turns, be aware that the tide may not just end with a correction

yogesh said...

Let's take a different context to understand risk premium. (I'm just trying to understand.)

Let's say I fall sick and go to my doctor to ask him how to get better. My doctor suggests that I need to undergo a risky surgery now, or I will die in the next 2 years. However, he also mentions that if the surgery doesn't go well, I will die right on the operation table. The payoff of doing the surgery for the doctor are as follows: If the surgery goes well, he gets a hefty bonus and facetime on NBC. On the other hand, if the surgery goes badly, he will feel bad and not get the bonus. (He might also get fired, but the government will bail him out :-) )

So, my question is that is the risk premium for the doctor and the patient same for the surgery? They are both better off if everything goes right, and they are both worse off if something goes wrong (so there's no moral hazard or agency problem here), but I am reluctant to think that they both have same risk premium.

To me a fund manager is like a doctor, who benefits if you benefit and loses if you lose, but I am very reluctant to accept that the fund managers at Fidelity have the risk premium as people whose money they are investing. Since institutional investors determine market prices, the implied risk premium is therefore measuring the risk premium of doctors and not of the patient.

As for professor Damodaran point that investors who lose money feel good by blaming on Wall Street, well I, for one, have greatly benefited from the crisis. And that's because I am hit-and-run investor (By and large, I don't trust corporate governance in this country to consider stocks as a long term investment vehicle.) I invest all my saving in 10-15 companies when the market value of these stocks goes below 30% of my own valuation of these stocks (I use Investment Valuation book and excel spreadsheets on your website to do this; both the book and the spreadsheets are priceless), and I get completely out of the market (and even close the brokerage account) once the stocks have appreciated by 5% (after taxes) from my valuation number. Double dip within an year is my biggest risk.

That said, I guess what you call market followers, I call it Oligopoly.

Manu said...

Thank you very much for this update on the equity risk premium. Like you, I do believe this is a core concept in valuation and pay a lot of attention to it.

It would be very useful if you could update monthly the implied equity risk premium on your webpage. I would love to calculate it myself, but I don't have access to the S&P estimates for the next 5 years....

Best regards

Immortal said...

in todays highly volatile mke sense to shift & stick to implied ERP....but Prof isnt this approach susceptible to forecastin error..key input of dividend n growth in earnings for the index chosen may vary than the actual numbers we forecast...

on the other side historical premium has actual numbers that average outs the variation(wtever chosen arthemtic or geometric)...this approach has relative confidence since i m using a number that has been historically demand....

how am i better off in chosin implied...if my estimation abt key inputs is wrong since i will be forecasting...doesnt it squares off the merits n demerits of the two approach???


Wenger J Khairy said...

I have to thank you for your lecture on Equity Risk Premium - especially when you correctly required that the Dividends received be entered into the calculation for the overall Market expected return.

My background is in engineering, truth is I have never ever been remotely close to working in any financial profession, yet I could tell a thing or two to my Investment banker friend.