Expected Returns: An Investor's Guide to Harvesting Market Rewards

8

Equity risk premium

• The historical annual excess returns of U.S. stocks over government bonds average 3% to 5% over long data windows, a further 1% over short-dated bills and about another 2% higher if arithmetic means are used. Global excess returns of stocks over bonds are somewhat lower.

• Forward-looking measures of the equity–bond premium—based on a yield ratio or Gordon model (dividend discount model or DDM)—exhibit significant time variation, probably for both rational and irrational reasons. Extreme values range between zero (or even negative) and 10%.

• The Gordon model states that long-run real equity returns equal the sum of the dividend yield and the real dividend growth rate (assuming no valuation changes). Both inputs can be debated but estimates in the 2000s point to modest real returns (say, 2%+1% = 3%) and an even thinner premium over Treasuries. Any higher expected return estimates must be justified by broader yield measures, more optimistic growth inputs, or expanding valuation multiples.

• Real long-run growth in dividends and earnings per share has clearly lagged the GDP growth rate. Aggregate earnings growth also includes net new equity issuance, which does not benefit existing shareholders.

• Equity market valuations have been especially high amidst stable mild inflation and low macro-volatility, which is not a promising sign for future multiple expansion.

• Standard economic models suggest that the equity premium should be negligible (<1%). A cottage industry ...