EQUITY RISK PREMIUM: EXPECTATIONS GREAT AND SMALL

North American Actuarial Journal,  Jan 2004  by Derrig, Richard A,  Orr, Elisha D

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Shoven (2001) began by explaining why the traditional Gordon growth model is not appropriate and suggested a modernized Gordon model that allows share repurchases to be included, instead of only using the dividend yield and growth rate. By assuming a long-term price-earnings ratio between its current and historical value, he came up with an estimate for the long-term real equity return of 6.125%. Using his general estimate of 6-6.5% for the equity return and the OGAGT assumptions for the long-term bond yield, he projected a long-term ERP of approximately 3-3.5%.

All the SSA experts begin by accepting the long-run historical ERP analyses and then modifying that by changes in the risk-free rate or by decreases in the long-term ERP based on their own personal assessments. We now turn to the major strains in ERP puzzle research.

11. ERP PUZZLE RESEARCH

Campbell and Shiller (2001) began with the assumption of mean reversion of dividend/price and price/earnings ratios. Next, they explained the result of prior research (Campbell and Shiller 1988) that found that the dividend-price ratio predicts future prices, and historically, the price corrects the ratio when it diverts from the mean. Based un this result, they then used regressions of the dividend-price ratio and the price-smoothed-earnings ratio-"smoothed" by using 10-year averages-to predict future stock prices out 10 years. Both regressions predict large losses in stock prices for the 10-year horizon.

Although Campbell and Shiller (2001) did not rerun the regression on the dividend-price ratio to incorporate share repurchases, they pointed out that the dividend-price ratio should be upwardly adjusted, but the adjustment only moves the ratio to the lower range of the historical fluctuations (as opposed to the mean). They concluded that the valuation ratios indicate a bear market in the near future.20 They predicted negative real stock returns for the next 10-year period. They also cautioned that, because valuation ratios have changed so much from their normal level, they may not completely revert to the historical mean, but this does not change their pessimism about the next decade of stock market returns.

Arnott and Ryan (2001) took the perspective of fiduciaries, such as pension fund managers, with an investment portfolio. They began by breaking down the historical stock returns (for the 74 years since December 1925) by analyzing dividend yields and real dividend growth. They pointed out that the historical dividend yield is much higher than the current dividend yield of about 1.2%. They argued that the changes from stock repurchases, reinvestment, and mergers and acquisitions, which affect the lower dividend yield, can be represented by a higher dividend growth rate. However, they capped real dividend or earnings growth at the level of real economic growth. They added the dividend yield and the growth in real dividends to come up with an estimate for the future equity return; the current dividend yield of 1.2% and the economic growth rate of 2% add to the 3.2% estimated real stock return. This method corresponds to the dividend growth model or earnings growth model and does not take into account changing valuation levels. They cite a TIPS yield of 4.1% for the real risk-free rate return (see Section 16). These two estimates yield a negative geometric long-horizon conditional ERP.