The Incredible Shrinking 'Realized' Equity Risk Premium
24 Pages Posted: 9 Apr 2014 Last revised: 22 Apr 2014
Date Written: April 8, 2014
The realized “trend” equity risk premium has consistently declined since 1925. Given naïve extrapolation of the past, the trend equity risk premium could be 0% by 2050. The lower the trend equity risk premium, the greater the probability that a “safe” asset will outperform stocks. A decades-long decline in the equity share of the “global market portfolio” might be a reaction to the declining trend equity risk premium. A “fundamental” reason for the declining trend equity risk premium could plausibly have been a decline in the stock-“safe” asset “yield spread”, the difference between the “CAPE earnings yield” and a “safe" asset’s yield. More informally, stocks might have been too expensive for too long relative to “safe” assets. Until something reverses the close to 90 year trend equity risk premium decline, active or passive fixed income products with a sufficiently attractive yield could possibly eliminate the equity risk premium problem.
Keywords: equity risk premium, trend equity risk premium, CAPE ratio, bonds, active funds, passive funds
JEL Classification: G10, G11, G12, G15, G28, E58, N20
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