Debate over the equity risk premium is unlikely to be covered in the supermarket tabloids anytime soon, but a war of words among financial literati is getting pretty sensational.
Roger Ibbotson, chairman of Ibbotson Associates and a professor of finance at Yale School of Management, recently fired back at those who have disagreed with his way of forecasting long-term equity returns. With Peng Chen, the director of research at Ibbotson Associates, Ibbotson recently wrote “Stock Market Returns in the Long Run: Participating in the Real Economy,” a paper that will be published in coming months in Financial Analysts Journal. In it, Ibbotson revises downward his forecast for long-term stock returns by revising his forecasting method.
Financial advisors who give advice every day to retail investors sometimes dismiss the academic literature as, well, ivory tower discussions with little real-world effects. But the debate over the equity risk premium is important to advisors. It provides a framework for assumptions that you need to make when you tell clients how to invest so they can retire securely and not run out of money.
In addition, since the debate over the equity risk premium began to heat up about two years ago with the release of a sobering paper entitled, “The Equity Premium,” by professors Eugene Fama of the University of Chicago and Kenneth French of the Sloan School of Business at MIT, the stock market has suffered the worst bear market in decades.
So the fact that Ibbotson, the granddaddy of stock return forecasters, has reworked his forecast and revised it downward, if only slightly, is big news.
In 1976, when Ibbotson was a doctoral candidate, he co-authored a paper with one of his graduate students, Rex Sinquefield, in which they deconstructed historical stock returns dating back to 1926 and then extrapolated that data forward to make a long-term forecast. Ibbotson and Sinquefield forever changed the way long-term investors would look at the market by breaking a stock return into its component parts. Stock returns, they said, were composed of the rate you get on U.S. Treasury bills, which implicitly includes inflation, plus an extra chunk of return called the Equity Risk Premium (ERP).
Based on their historical study, Ibbotson and Sinquefield made a 25-year projection. They forecast an ERP through the end of 2000 of 7.9% compounded annually, which was not far off from the ERP of 6% actually realized during this spectacular bull market period for the stock market.
Keep in mind that in 1976, when the forecast was made, the excess return above the risk-free rate of return was low. Stocks were in the middle of a terrible slump. In 1965, the Dow was at 1,000 and would not top that mark until 1983. As late as 1979, three years after the Ibbotson-Sinquefield forecast, Business Week’s cover called the market era of the time “The Death of Equities.”
However, the actual forecast arguably was not as important as the way Ibbotson looked at things. Prior to this, stock forecasts were made based on total return. It was only after this 1976 paper that financial economists began to focus on its components.
Ibbotson’s Ideas Questioned
Ibbotson capitalized on his academic success by founding Ibbotson Associates. This Chicago-based consulting firm explains the behavior of stocks, bonds, inflation, diversification, and other issues of central importance to investors, and makes software for financial professionals. His method of extrapolating long-term history into the future became the industry standard in the 1980s and 1990s.
But in the last couple of years, Ibbotson’s ideas about the future of the stock market have come under attack by other respected academics and money managers who have published forecasts of their own, and who calculate the ERP differently from Ibbotson. They also predict lower returns over the long haul.
In 2000, Fama and French published “The Equity Premium.” In the article, the two men argue that the ERP is 2.55% over bonds, much lower than the long-term equity risk premium of more than 7% that you’d get by simply extrapolating history the way Ibbotson did with Sinquefield in 1976.
Fama and French used a dividend and earnings model to forecast long-term equity returns. Basically, what Fama and French show in their paper is that stocks have paid out more in returns than companies can make on their money. The return on equity of corporate America is lower than the returns on stocks. Having lately become accustomed to being paid too well, stock investors, according to Fama and French, should expect lower returns in the future. This differed sharply with forecasts from Ibbotson.
Jeremy Siegel’s Critique
Circulation of Fama and French’s working paper had followed an article published in The Journal of Portfolio Management in 1999 by Jeremy Siegel. In the article, Siegel, of the Wharton School, said Ibbotson’s 1976 forecast was off the mark when his inflation forecast was considered. Siegel said that Ibbotson had forecast an inflation rate of 6.4% when the actual inflation rate was 4.8%. Siegel also argued that Ibbotson’s forecast underestimated real returns, especially on fixed income assets.
More recently, Rob Arnott, CEO of First Quadrant, an institutional money management firm in Pasadena, California, co-authored a paper with Peter L. Bernstein, consulting editor at The Journal of Portfolio Management, about the equity risk premium. They dispute Ibbotson’s argument that when P/E ratios are high and the market is expecting higher earnings growth, that the market is right and earnings will grow. They also disagree with Ibbotson’s assertion that corporate earnings not paid out in dividends will come back to the investor in the form of increased growth, an idea relying on the Nobel Prize-winning research of Miller and Modigliani in the early 1960s. Arnott and Bernstein found that retained earnings do not improve future earnings growth and in fact degrade future earnings growth.
Here’s what Ibbotson said about all of this in a recent interview.