Equity markets

Shares and shibboleths

How much should people get paid for investing in the stockmarket?

Mar 17th 2012


IF THERE is a sacred belief among investors, it is that equities are the best asset for the long run. Buy a diversified portfolio, be patient and rewards will come. Holding cash or government bonds may offer safety in the short term but leaves the investor at risk from inflation over longer periods.

Such beliefs sit oddly with the performance of the Tokyo stockmarket, which peaked at the end of 1989 and is still 75% below its high. Over the 30 years ending in 2010, a “long run” by any standards, American equities beat government bonds by less than a percentage point a year.
In the developed world, the period since the turn of the millennium has been a particular disappointment. Since the end of 1999 the return on American equities has been 7.6 percentage points a year lower than that on government bonds (see chart 1).

That has left many corporate and public pension funds in deficit and many people with private pensions facing a delayed, or poorer, retirement. Understanding why equities have let investors down over the past decade will help them work out what to expect in the future.

The long-term faith in equities is based on the theory that investors should be rewarded for the riskiness of shares with a higher return, known as the “equity risk premium” (ERP). That risk comes in two forms. The first is that shareholders get paid only when other claimants on a company’s cashflow, such as workers, the taxman and creditors, have received their due. Profits and dividends are thus highly variable and can disappear altogether when times get tough. The second risk is that share prices are volatile, more so than bond prices. Since 1926 there have been seven calendar years when American equity investors have suffered a loss of more than 20%; investors in Treasuries have suffered no such calamitous years.


The big question, however, is how large that extra return should be. Here it is important to distinguish between the extra return investors actually achieved for holding equities (what could be called the ex post number) and the return they expected to achieve when they bought them (the ex ante figure).

Academics started to focus on this problem in the mid-1980s when a paper by Rajnish Mehra and Edward Prescott indicated that the ex post return of American equity investors had been remarkably high, at around seven percentage points a year. It seems unlikely that investors expected to do so well.

Premium puzzle

There are a number of possible explanations for these very high ex post returns. One is survivorship bias in the numbers. America, which is the benchmark for ERP measurements, turned out to be the most successful economy of the 20th century, but it might not have been. Before the first world war investors doubtless had high hopes for Argentina, China or Russiaonly to be disappointed.

Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School (LBS) have analysed the data for 19 countries from 1900 to 2011 and found that the ERP relative to Treasury bills (short-term government debt) ranged from just over two-and-a-half percentage points a year in Denmark to six-and-a-half points in Australia. They found a premium for America of five percentage points.

Another explanation for the high returns is a paradoxical one: that equities have become less risky. In the early part of the 20th century corporate accounts were more opaque and less reliable (though shareholders in Enron, a bust energy company, may disagree). Most stocks were owned by private investors with only a handful of individual shares. This left them more exposed to the risk of a single firm failing, which meant they put a lower value on shares—or, to put it another way, they demanded a higher premium for owning them.

Today most equities are owned by institutional investors who can assemble a diversified portfolio. Even small investors can own an index fund at low cost. The impact of one company failing is thus far smaller. This reduced risk has prompted investors to pay higher prices for shares; in other words, to accept a lower dividend yield. That may well have increased the ex post risk premium (other things being equal, a fall in the dividend yield from 4% to 2% means investors double their money).

The size and persistence of the ERP led some commentators in the late 1990s to come up with an ingenious, if flawed, argument. In their bookDow 36,000”, for instance, James Glassman and Kevin Hassett argued that the reliable outperformance of shares over bonds meant that equities were not riskier at all. As a result, there need be no ex ante risk premium.

This time is not different

If this belief were correct, equity investors should have been willing to accept a lower earnings yield. (This is the inverse of the price-earnings ratio; if the p/e is 50, the earnings yield is 2%.) In the course of moving to the lower earnings yield, the market would have soared to the 36,000 level of the book’s title. A lower ex ante risk premium implies higher returns in the short term. The authors were proved right in one sense. Investors who bought shares in 1999 did not earn a risk premium. But that will be of scant consolation to those who believed the book, since 13 years later the Dow is at around 13,000, not 36,000.

One obvious problem with their reasoning was that, although equities might have beaten bonds over most long periods, the horizon of the average investor is much shorter. There have been many equity bear markets in history and investors are exposed to the real risk that they will have to sell in the middle of one. Most shares are owned by professional fund managers, who have to report to their clients every three months. If a big bet on equities goes wrong they cannot wait 20 years to be proved right. Clients will have deserted them long before then.

The late-1990s debate illustrated a familiar pattern at the top of bull markets. When share prices have already risen a lot, commentators scramble for reasons why they should rise even further.

In the 1980s those who queried whether the Japanese stockmarket was expensive on a minimal dividend yield and a sky-high price-earnings ratio were told that “Western valuation methods” did not apply in Tokyo. At the turn of the century many assumed that, because the achieved ERP had been high in the past, it would be so in the future. But investors had their reasoning backwards. When share valuations are high, future returns are likely to be low and vice versa.

Given the history of the risk premium, what will the future reward for equity investors be? This question is discussed in a new set of papers* issued by the Chartered Financial Analysts Institute. The collection is a follow-up to a similar exercise undertaken in 2001, where the range of estimates of the premium varied from zero to seven percentage points a year.

The first step is to define the equity risk premium more exactly. Mssrs Dimson, Marsh and Staunton break it down into the following components: the dividend yield, plus the real dividend growth rate, plus or minus any change in the price/dividend ratio (the inverse of the dividend yield), minus the real risk-free interest rate.

In the period 1900-2011, the average world dividend yield was 4.1%; real dividend growth was just 0.8%; and the rerating of the market added 0.4%. That comes to a real equity return of 5.4% (the calculation is geometric, not arithmetic). Stripping out the risk-free interest rate, the ERP was 4.4% versus short-term government debt and 3.5% versus longer-term government bonds (see chart 2).

The dividend yield comprised the vast bulk of the return. This was true across all the countries studied by the authors. Had investors consistently bought the highest-yielding quintile of equity markets over the past 112 years they would have earned an average nominal annual return of 13.3% compared with a return of just 5.4% for those buying the lowest-yielding quintile. High-dividend markets have also performed best so far this century.

The importance of the dividend yield is ironic, given the lack of focus on the measure in most modern investment commentary. Many analysts argue that the dividend has been superseded by the share buy-back which (particularly in America) is a more tax-efficient way of returning cash to shareholders. But Robert Arnott of Research Affiliates points out that, although buy-backs reduce share capital, companies are also finding ways to add to it. Firms issue shares to pay for acquisitions, for example, or to reward executives through incentive schemes. Historically, net share issuance has been around 2% of total equity capital a year. This dilution of existing shareholders is part of the reason why real dividend growth has been so low, well below GDP growth.

As a starting point for estimating the future ERP, this is not encouraging. The current dividend yield on stockmarkets is lower (at 2.7% in the countries covered by the LBS data) than the historical average. Dividends tend to grow (at best) no faster than GDP, and usually slower because of the dilution effect. Nor is there much hope of a boost from a revaluation of the market. Since the yield is low, relative to history, it is more likely that any revaluation will subtract from returns. In another paper, Cliff Asness of AQR Capital, a hedge-fund group, uses his estimates of dividend yield and likely dividend growth to come up with a forecast for future real equity returns in America of around 4% a year.

Future imperfect

Although this figure is lower than the historical average, it still means that equity investors will earn a risk premium. The real yields on short- and long-term debt are zero, or negative in some cases. Nominal yields are close to historic lows. If the risk-free return is zero, then the entire return from equities will count as a risk premium. And a 4% premium would be only a little below the long-term average for America.

That still would not be high enough for many pension funds. In America, local-government pension funds base their contributions on the assumption that they will earn 8% (in nominal terms) on their investment portfolios. Treasury bonds yield 2% at the moment, so a 4% risk premium suggests a nominal return of 6% on equities. That means pension funds will fall well short of their targeted return.

Pension providers have two options: increase contributions or cut benefits. Cutting benefits will be difficult for many American states since pension rights are legally or constitutionally guaranteed. So taxes will have to go up or other services will have to be cut.

Companies that have offered pensions linked to final salaries may have to divert money into their pension schemes, cash that could have been invested to boost the economy. Individuals who rely on private pensions (or on so-called defined-contribution benefits, where the company does not promise a payout) face the same problem.

Equities are not a miracle asset that will turn measly contributions into a generous pension. Those who want to retire in comfort should save more.

March 15, 2012 2:26 pm

Bond bulls caught in US Treasuries sell-off

All of a sudden, it is one-way traffic in the bond markets. US Treasury bonds, the choice asset of the cautious investor, are tumbling in prices. Yields on benchmark 10-year jumped on Thursday to five-month highs as the latest positive jobs news stoked hopes for economic recovery.

This sharp turnround in the world’s most liquid bond market has occurred within a matter of days. Only on Monday, bond yields were below 2 per cent. Now, amid a stock market rally that has taken equities to their highest levels since the before the global financial crisis, yields have topped 2.3 per cent. Bond bulls are getting nervous.


Until this week, and since last November, the yields on Treasuries had been confined near historic lows, stuck in a tight range. The view in the markets was that the Federal Reserve’s huge bond-buying programme under “Operation Twist” and prospect of “quantitative easing” to come would underpin demand for Treasuries, keeping yields, which move inversely to prices, at very low levels.

The extent of this week’s selling, then, suggests the bond market is at a crucial juncture. As evidence of economic recovery builds, and with the Fed dialling back on hints of further monetary easing, investors are reassessing that consensus trade. The question being asked is how long the US central bank will maintain ultra-loose policy to encourage the lending by banks deemed essential for recovery.

For some bond investors, notably Pimco, the rise in yields spells trouble. Pimco is among those that have recently bet yields will stay at very low levels for this year. Official data released on Thursday revealed that foreign investors and central banks were also big buyers of Treasuries in January and are now facing losses on those purchases.

That may well be the case. Indeed, Ben Bernanke, Fed chairman, will not want to see yields climb further as rising interest rates now could still kill off signs of economic revival and, moreover, derail the confidence-boosting rally in equities. It will not take long for the jump in yields to translate into higher mortgage costs at a time when the housing market remains firmly in the doldrums.

Eric Green, strategist at TD Securities, says: “This sell-off has legs, but not much more over the near term. Housing is the Achilles heel of the recovery and Bernanke is not about to let borrowing costs move too far against him.” Moreover, the sharp rise in petrol prices, now breaching $4 a gallon, will drag on the economy and could lead to a summer slowdown.

Martin Murenbeeld, chief economist at Dundee Wealth Economics, says: “The risk here is that a lot of people are now betting on this recovery, even though the Fed itself is saying the data is not that conclusive.

All it will take is a weak US gross domestic product reading in April for ‘QE3 talk be back to the table and yields to fall.”

Nevertheless, as evidence mounts that the US economy is picking up pace, the need for the Fed to undertake further easing via large-scale asset purchases lessens, removing a key prop for Treasuries. In turn, the risk grows that bond investors will capitulate and pour money into equities, and financials particularly, which are still cheaply valued.

There is scope for a Treasury correction. As it stands, this year’s 11 per cent rally in the S&P 500 leaves the benchmark at its best level since the summer of 2008. At that time, the yield on 10-year Treasuries briefly traded above 4 per cent.

Mike Materasso, senior vice-president at Franklin Templeton fixed income group, says: “There’s a great disconnect, if not the greatest disconnect, between Treasury yields and economic fundamentals.”

Investors are also mindful that the 10-year yield remains below the 2.9 per cent annual rate of inflation, entailing a loss of purchasing power for bond buyers at negative real yields.

Michael Kastner, principal at Halyard Asset Management, says: “The rule of thumb is that the 10-year yield should be 100 basis points over the current inflation rate, which suggests a yield closer to 4 per cent.”

Not helping matters is that March is usually a bearish time for US interest rates, as tax refunds buoy spending.

With foreigners accounting for half the Treasury market and some 70 per cent of of those holdings in the hands of official institutions, there are fears that the rise in yields could trigger further selling.

For now, the latest official data shows foreign buying is supportive. China, the largest foreign holder of Treasuries, in January added to its holdings, which rose from December’s $1.1519tn to $1.1595tn. Its holdings, though, had been falling and Beijing, if it added more in February, could become wary.

Much will depend on economic data and whether the Fed alters its long-term forecasts for interest rate policy at next month’s meeting. Already the bond market doubts the central bank can reiterate this week’s pledge of near zero overnight rates through to at least the end of 2014, let alone sanction QE3 should the jobs market improve further and inflation nudge higher.

Mr Green says: “Bernanke cannot press rates back to where they have been, that was the old policy regime. The new policy regime is to try to keep rates in a sweet spot of 2 per cent to 2.5 per cent for as long as possible.”

Copyright The Financial Times Limited 2012.

03/15/2012 08:08 AM

Not Out of The Woods Yet

Despite Progress, Euro Crisis Is Far From Over

An Analysis by Christian Rickens

The Greek debt cut worked and the rescue package has gone through. So is the euro crisis over? By no means. The situation in Greece will take a turn for the worse again in a few weeks. The other euro nations will have to use the time until then to get their own houses in order -- especially Germany.

For a change, everything has been going according to plan in the fight to save the euro in recent weeks. On Wednesday, euro-zone finance ministers gave the green light to the €130 billion ($170 billion) second rescue package for Greece. It's a pure formality after a satisfyingly large proportion of creditors agreed to a debt cut for Greece. Perhaps the most significant success of recent days is that even though the debt cut was deemed a so-called credit event, triggering the payment of the financial contracts known as credit default swaps, hardly anyone seemed to care.

For more than two years, the international financial lobby had been warning the public and governments that these credit default swaps must under no circumstances be triggered, because that would cause a disaster similar to the meltdown that followed the 2008 collapse of Lehman Brothers. Their message, effectively, was that taxpayers should cover all the losses, rather than private-sector creditors. But the CDS horror scenario has failed to become reality.

So has Greece been rescued and financial markets been tamed? Is the euro crisis a thing of the past? Unfortunately not. With their successes in the last few days, euro-zone politicians have done little more than bought themselves time. They must use this window to brace themselves for the next wave of the euro crisis which is about to crash down on Europe.

It's already clear that the Greek economy can't survive with a government debt to GDP ratio that will -- at best -- still be at 117 percent in 2020, especially given the record pace at which the country's GDP is contracting. There is still no coherent strategy for making Greece competitive again inside the euro zone, or for raising the capital for the huge investments needed -- let alone for the wholesale revamp of the country's entire public administration.

.Greek Crisis Will Escalate Again

.And so Greece is likely to report the next set of disappointing budget figures in a few months, and the wrangling over a new debt cut and a new rescue package will start shortly afterwards. Maybe the next wave of the crisis will hit us even sooner: Greece is scheduled to hold an election on April 22 which is expected to produce a left-wing majority deeply opposed to the austerity program imposed by Brussels.

The other euro-zone governments have at most a few more months, perhaps only a few weeks, before the situation in Greece worsens again. They must use this time to make clear that Greece is the exception within the euro zone, not the rule. The other euro states must quickly arrive at a point at which the fate of Greece simply isn't relevant for the future of the euro -- which of course doesn't mean that the Greeks should be left to their fate.

That means that Portugal, Spain and Italy, the three other problem countries in the south of the euro zone, must perform the magic trick of stimulating growth while reducing their budget deficits. That can only succeed with a lot of pragmatism -- austerity without growth is as pointless as growth without austerity.

That pragmatism also means that the other European finance ministers should keep calm in reaction to the news that Spain has revised up its projected 2012 budget deficit to 5.8 percent from a previously forecast 4.4 percent. Spain, too, is in a deep recession. It is an impressive feat even to have reduced new borrowing at all -- in 2011, Spain's budget deficit was 8.5 percent of GDP.

.Beyond Doubt

.It is petty of the Euro Group to insist that the country curb its 2012 deficit to 5.3 percent. What is far more important is the message: Rome, Madrid and Lisbon are heading in the right direction with their reforms. Italy, Spain and Portugal have -- unlike Greece -- competitive industrial sectors, a functioning public administration and a political consensus, admittedly fragile, that they have to pull themselves out of the mess they got themselves into by running up debts over years.

Germany itself doesn't warrant such tolerance. The country is the euro zone's growth engine and its anchor of stability. If the debt crisis escalates again and engulfs other states, everything will depend on Germany -- and the long-term stability of Germany's finances must be beyond any doubt.

.Germany's tax revenues are at a record high and the interest it has to pay on new debt is close to zero. Despite this, Germany still missed its own cost-cutting targets in 2011 and is also falling behind on its goals for 2012. Before Germany admonishes Spain about its budget, it must make a greater effort itself.

Has Europe learnt from the mistakes made in Greek debt crisis?
Lorenzo Bini Smaghi
March 15, 2012

The markets seem to have coped relatively well with “the biggest sovereign restructuring ever” last week. But they are already focusing on the next possible victim: Portugal’s bond yields have soared to levels close to those on Greek bonds a few months ago.

European authorities have declared that Greece was unique and that there will be no more debt restructuring. Undoubtedly, though, they will be tested in the coming months. Two strategies are possible.

One is to behave in the same way as in the past. This means helplessly observing the widening of credit default swap spreads on sovereign bonds until it becomes obvious that the country in question will not be able to refinance itself in the markets; then publicly denying that restructuring is even an option, but privately considering involving private creditors and even discussing the details with some market participants; finally, hastily putting in place an additional package and asking the various countries’ parliaments for approval, which they might be willing to consider but only in exchange for debt restructuring.

Unless this approach is quickly abandoned, Greece will turn out not to be an exception after all. Markets would turn to the next prey, like in Agatha Christie’s Ten Little Indians. Who will be next? Ireland? Spain? Italy? Where would the process stop?

The alternative strategy is to immediately build a firewall that would ensure Greece is an exception. First, it should be recognised right away that Portugal may not be able to return to the markets next year and needs an additional bailout package. If it is unable to finance itself until 2016, it will need approximately €100bn. The European Financial Stability Facility has sufficient capability to provide these funds.

Second, the same could be done for Ireland, which requires an additional €80bn. The procedure to allocate these funds should be started right away by the national and European authorities. Third, the size of the EFSF and European Stability Mechanism should be further increased to allow them to provide additional funds to other countries. Fourth, the International Monetary Fund’s European shareholders should arrive at its spring meetings with sufficient support from other advanced economies, including the US, and from emerging markets to obtain an increase in the funds available to the IMF.

The problem with this strategy is avoiding moral hazard. How can it be ensured that countries receiving increased financial assistance, starting with Portugal, will implement the agreed adjustment programme and not become complacent, as happened with Greece?

One way is to agree that the rules and procedures foreseen by the proposed fiscal compact, including sanctions, become immediately enforceable, even before ratification. There must be stronger monitoring of whether budgetary adjustments are being implemented, to avoid a repeat of the embarrassing situation in Spain, where it was discovered on Monday morning that the budget deficit was 30 per cent higher than expected the previous Friday. Countries receiving upfront assistance should also be required to present privatisation programmes, involving their banking system, that would be automatically triggered if the country failed to meet the adjustment target.

Only by acting forcefully, in anticipation of what the markets will focus on next rather than under their pressure, can European authorities convince us that Greece was an exception and prove their commitment to do all that is needed to preserve the euro as a currency.

The writer is a visiting scholar at Harvard’s Weatherhead Center for International Studies and a former member of the ECB’s executive board