While the stock market performance of the past two decades might not be sustainable, the assertion of the "death of the risk premium" is not proven. The analysis of my firm challenges the contention of Robert D. Arnott and Ronald J. Ryan, who argue that expected returns on equities are now below expected returns on fixed income.* Our analysis indicates the opposite conclusion is more reasonable.
We believe that going forward a real return in excess of 7% can be expected for domestic large-capitalization equities, while high-grade corporate bonds can be expected to have a real return of 4% or less. Thus the equity risk premium, which is the difference in these expected returns, is currently more than 3%, contrary to the thesis of Messrs. Arnott and Ryan.
In the mid-1980s, typical estimates were for a 6% real return for stocks and a 3% real return for bonds over the long term, and thus a 3% equity risk premium. Since then, equities have performed well above expectations, so there is a fear that the future will involve a balancing period of inferior returns. The "death of the risk premium" gives a rationalization for this viewpoint.
Net cash flow vs. dividends
Messrs. Arnott and Ryan base their analysis on the low current levels of dividend yields, which is where they make an oversight. The definition for total return is:
Total return = net cash flow + price change.
It used to be a minor simplification to substitute "dividends" for "net cash flow" in the above equation. However, there has been a paradigm shift from major corporations paying cash dividends. Essentially, it was realized that shareholders' interest in maximizing total return would be served best by de-emphasizing dividends. Thus shareholders and management have come to favor more rapid earnings and price growth that is afforded by retaining earnings and by employing stock buybacks. It is therefore unlikely that dividends will revert to their historical levels, which were typically in the 3.5% to 5% range.
One difficulty is that keeping tabs on net cash flow is much more involved than determining dividend yield, since many transactions are involved. A reasonable estimate of the net cash flow yield on the Standard & Poor's 500 stock index is about 2.5%. This is in contrast to the dividend yield on the S&P 500, which is 1.19% as of the beginning of this year.
Starting with the net cash flow, we can estimate the long-term return on equities as follows:
Net cash flow 2.5%
Earnings increase due to population growth 1.0%
Earnings increase due to productivity 1.5%
Earnings increase due to leverage 0.5%
Earnings per share increase due to buybacks 1.0%
Earnings increase due to reinvestment 1.0%
Total real return 7.5%
Total return 10.5%
This breakdown shows that a 7.5% real return is a reasonable long-term estimate. This is somewhat higher than the traditional 6%.
The prospects for bond returns primarily are determined by their yields. With Treasury yields under 6% as of the beginning of this year, the long-term return on Treasury and high-grade corporate bonds is likely to be in the 6% to 7% range, which is a 3% to 4% real return. This is consistent with the yield on inflation-linked bonds, which is 3.75% as of the first of the year, and is slightly less than the yield on Jan. 1, 2000, which is the date used by Messrs. Arnott and Ryan. Thus on our basis, the equity risk premium is in the 3% to 4% range.
Buying back stock provides a component of net cash flow. It also increases the ownership represented by each remaining share, thus increasing its value. Corporations also use buybacks tactically, to stabilize share price during declining periods, and to reduce capitalization when they consider their own shares underpriced.
Messrs. Arnott and Ryan were concerned that the high valuations placed on stocks would place downward pressure on returns as valuations returned to more normal levels. I've discussed why dividend yields should not be a source of concern. Looking at earnings, the S&P 500's price-earnings ratio is 24.57, as of the first of the year, down from 33.42 a year earlier. Thus the S&P 500's p/e is somewhat high, but not fatally so, given the 22.2% earnings increase in the past year. Small-cap and midcap stock indexes have lower p/e ratios than the S&P 500, which indicates this is not an overly speculative period. If we were pessimistic and presumed that p/e ratios would revert to about 12 over the 75-year horizon discussed by Messrs. Arnott and Ryan, the impact would be to reduce expectations by about 1% per annum.
Another approach to valuation is to compare the net cash flow yield to the yield on Treasury inflation-protected securities. The TIPS provide a consumer price-indexed stream of cash flows with certainty, whereas the net cash flows on the S&P 500 are expected to grow at a much more rapid pace, but with uncertainty. Assuming that net cash flow grows, along with earnings, by 5% real leads to a 3.75% estimate of the risk adjustment used in discounting future real net cash flows, relative to the TIPS yield. This is a substantial risk adjustment, given the generally optimistic long-term economic and political environment.
With the federal government running a surplus, the prospects are for eventual tax cuts. This should stimulate demand over the long term, and thus increase profits. Any move to lower corporate tax rates also would lead to an upward revaluation in stock prices, or a decrease in the p/e ratio, or both, since after-tax profits would be directly increased. Liberalization of limits on contributions to individual retirement accounts and other qualified plans should stimulate savings and thus increase demand for stocks and bonds. The alternative to tax cuts is Treasury debt reduction, which presumably would lead to lower interest rates and higher equity valuations. The prospects for a decrease in government regulation of industry also should increase expectations of profitability in the near term. Our analysis indicates there is a significant risk premium in equities relative to fixed-income investments at the present time that is warranted in the current economic and political environment.
* "Death of risk premium predicted," Pensions & Investments, Nov. 13.
Chester R. Schneider is a vice president with responsibilities for asset-liability modeling services in the New York office of EFI Actuaries Inc., which is based in Washington.