Divining the future by dissecting the past is, like parachuting and wrestling crocodiles, a venture saddled with more than a little risk. Yet each is thrilling in its own way, and at times may even offer perspective–assuming you don’t lose an arm and a leg, figuratively or literally, depending on the sport.
Ours is a quantitative adventure in the land of investing, and among the various statistics we routinely review is the equity risk premium (ERP), and so the risk is limited to those little bits of paper with images of George, Abe, Alex, et. al. There is much debate about the underlying rationale for the ERP, or the excess return thrown off by stocks relative to the risk free rate, which we define here as the 12-month rolling total return on the S&P 500 less the same on 3-month T-bills. Nonetheless, the ERP is quite real, or at least it has been in the past. The question is whether it will continue in the future, and if so, by how much?
As our chart below illustrates, the ERP is hardly a static number. Back in July 1997, the trailing 12-month ERP was an extraordinary 47%; in September 2001, the ERP over the previous year had turned negative to the tune of -31%. The average ERP turns out to be around 7.9% since 1987 through the end of last year.
The ERP in recent years has tended to stay with in a range of 4-12%. Over time, that could deliver a tidy gain for the patient, long-term investor. Ah, but deciding if 4-12% will be high, low or middling is the asset allocator’s dilemma. Of course, there is no good answer, given the history of prognosticating investment returns and the myriad of factors that ultimately go in to determining how the future unfolds.