Forecast Equity Returns
February 7, 2012
A forecast of the equity risk premium (ERP) tells you how much to save, how to allocate assets between equities and fixed income, and how much you can consume. Given its great importance, the CFA Institute recently convened a group of top-level academics and practitioners to forecast future ERPs – and to reflect on similar predictions they had made a decade ago.
The ERP is defined as the total return, including dividends, that one can expect from a stock index over the long term, minus the expected return or yield on a riskless bond, typically a 10-year U.S. Treasury bond. It is what investors require or expect as compensation for taking the risk of equities instead of investing in (presumably) default-free bonds.
I was honored to be a part of the group the CFA Institute employed in this project. I’ll discuss what I and the other experts foresaw, and then turn to the implications for advisors in their financial planning and asset management practices.
CFA Institute discussions of the equity premium
The CFA Institute convened its original panel of experts on the topic in 2001, just after the stock market reached its tech-bubble peak, to discuss various issues relating to the equity premium. The predictions ran the gamut, with Roger Ibbotson projecting a +6% premium and Rob Arnott expecting -1.5%. Among the other luminaries who contributed to the 2001 discussion were Cliff Asness, John Campbell, Robert Shiller, and Jeremy Siegel, as well as Marty Leibowitz, who organized the group.
There wasn’t a consensus in 2001 but, given the personalities involved, the discussion was as fascinating as you might expect. The most accurate forecaster was the pessimistic Arnott, but even he overshot the miserable decade that was to follow; the realized ERP from 2002 to 2011 was an abysmal -4.14% per year. (This number consists of the S&P total return of +2.92% per year, minus the astonishingly high, and almost certainly unrepeatable, Treasury bond return of +7.06% per year1 – so it is not entirely the stock market’s “fault.”)
A decade later, a respectable subset of the group was reconvened, with me among a handful of new people added to the mix. Our intent was to revisit the previous forecasts, offer new ones, and turn the resulting discussion into a book, which has now been published by the CFA Institute’s Research Foundation under the title, Rethinking the Equity Risk Premium. It is available as a free download, or for purchase in hard copy format at a low price, here.
The estimates were much closer together this time. Most of the participants agreed on a premium of 4% or a little less. My estimate was 3.6% over 10-year Treasury bonds. (These Treasury bonds yielded 3.4% as of April 2011, when I wrote my chapter of the book; now, they yield 1.9%.) The ERP estimate of 3.6% is a geometric mean, so I expected stocks to compound upward at 7% per year in nominal terms, including reinvestment of dividends. The key assumption behind my estimate, and that of several of the other participants, was the link between GDP growth, corporate profit growth, and share price growth. Share prices must grow more slowly than GDP, because new issues are required to bring new companies to market; but the relation between the two variables is pretty tight.1. The 7.06% compound annual return is actually for the Barclays Capital 7-10 Year U.S. Treasury bond index, not for a “pure” strategy of rolling over a single 10-year bond.
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