Estimating the equity risk premium—the return on stocks over a “safe” asset such as the 10-year Treasury or 3-month T-bill—is at the heart of investment research and portfolio analysis. “It is the ‘number’ that drives everything we do,” writes Aswath Damodaran, a finance professor at the Stern School of Business at NYU. The premium “depends strictly on expectations for the future because the investor’s returns depend only on the investment’s cash flows,” advise the authors of the CFA Institute’s Equity Asset Valuation.
There are three basic methods for estimating the premium, Damodaran notes. You can survey investors and other sources for insight about expectations. You can also analyze history as a guide for thinking about the future. A third approach is crunching the numbers on any number of data sets for clues about the implied premium going forward. Two of the many methodologies in the implied category show up on these pages every so often. Recent examples include estimating the equity risk premium with the dividend yield via a basic application of the Gordon growth model and calculating expected equilibrium risk premiums. There are many other ways to estimate the implied premium, including a methodology that uses consumer confidence metrics, as explained in an intriguing new paper from the Investment Management Consultants Association: “Does the Stock Market’s Equity Risk Premium Respond to Consumer Confidence or is It the Other Way Around?”, by Abdur Chowdhury and Barry Mendelson of Capital Markets Consultants.
“The increase in the equity risk premium [i.e., a fall in stock prices] since the beginning of the 2007-2009 Great Recession has led many analysts to believe that risk aversion among stock investors has moved to a permanently higher range in recent years,” Chowdhury and Mendelson write. “Whether the equity risk premium stays within its new wider range—seen in the pre-1960s period—or returns to the range exhibited during the past four decades will prove critically important for stock investors.”
The authors outline a methodology for modeling an idea inspired partly by a recent research note from James Paulsen of Wells Capital Management—“Could ‘Confidence’ Add 50 Percent to the Stock Market?”. Paulsen shows that the equity market’s premium generally tracks the ebb and flow of confidence in the economy, as measured by the Reuters/University of Michigan U.S. Consumer Sentiment Index. “Since at least 1950, premium and discount valuations of the stock market to its trendline have corresponded closely with periods of strong economic confidence and periods of broad economic fear,” he notes. As a result, “a slow but steady revival in U.S. confidence could represent the biggest driver of stock market performance in the next several years!”
Chowdhury and Mendelson advise that their research tells them that “the recent increase in the equity risk premium primarily reflects a temporary collapse in consumer confidence.” They go on to explain that
As long as consumer confidence in the sustainability of economic recovery remains low, today’s elevated risk premium will persist. In fact, this has significantly improved the stock market’s risk-reward profile because lower confidence has introduced a bigger buffer relative to competitive interest rates. Investors should track leading economic indicators (LEI) and their components closely if they want to gain comfort with the direction of the ERP. The higher risk premium seen in the past few years has significantly enhanced the risk-return profile of the stock market.
For some perspective on how consumer sentiment compares with the stock market’s price changes over the decades, Paulsen compares the detrended S&P 500 with the Reuters/University of Michigan Index since 1950:
Paulsen observes that “with the exception of the late 1990s when the index briefly reached above 110, ‘normal’ economic recovery confidence peaks have been around 100. Stock investors should consider what could happen should confidence slowly recover to normal again in the next five years eventually reaching a level between 95 and 100.” He goes on to consider the stock market in the context of a rising Reuters/University of Michigan Index.
Assume confidence improves from its current level to about 95 boosting the investor valuation of the trendline from its current 25 percent discount to about a 25 percent premium in five years. A trendline target in five years of about 2100, combined with a valuation premium of about 25 percent implies a target price for the S&P 500 of about 2600—nearly a double from today’s level!
Paulsen wrote that a few months ago, in July 2012. Fast forward to today’s October update of Reuters/University of Michigan Index, which “unexpectedly rose in October to its highest level in five years as optimism about the overall economy improved,” Reuters reports. The consumer sentiment index is now at 83.1, up from September’s 78.3 reading and the S&P is trading at roughly 1434–up nearly 14% year-to-date. It’s anyone’s guess where we go from here, but Paulsen’s reminder to consider what might happen to stocks if the consumer index returns to a 95-to-100 range resonates a bit stronger at the moment.