What’s Happened to the Equity Risk Premium?

Jasper asks, in the comments:

Can you comment generally on how much less risky it is to invest in the stock market now than it was 3 months ago? In other words, now is obviously a better time to invest in stocks than it was 3 months ago, if you were going to invest in stocks anyway. But has the risk fundamentally changed, so that investors should dramatically shift allocations away from bonds and treasuries into stocks?

The short answer is no, don’t go doing anything dramatic. Indeed, Calstrs is making a determined effort not to start moving money around right now, and that makes perfect sense: moving money around is a form of trading the market, and trying to trade this market is a really good way of losing money.

What’s more, a common-or-garden portfolio rebalancing strategy will, in and of itself, mean that you’re probably going to move money from Treasuries (which have gone up) into stocks (which have gone down a lot, and therefore now account for a smaller part of your total portfolio). If you want to keep your asset allocation at where it was a year ago, you’re already buying quite a lot of stocks right now, so you don’t need to change your big-picture asset-allocation strategy in order to achieve that end.

But all that said, stocks do seem to be a better long-term bet today than they were three months or a year ago. I asked Brad DeLong, who’s something of an expert on the equity risk premium, whether it goes up when stocks go down, and he replied:

Yes–it does. We’re reviisng a paper for the Journal of Economic Perspectives now. it’s supposed to come out in the winter, and all the numbers are changing…

Start with the Gordon equation for the market as a whole: P = D/(r-g), and turn it around

r = D/P + g.

D/P has just gone up, and the long-run g of dividends hasn’t gone down by very much–so the expected rate of return r must have risen by a lot.

This doesn’t mean that stocks are cheap, of course, or that they won’t fall quite a long way from current levels. But if you’re investing for the long term, you can probably sleep better investing now than if you invested back when they were obviously much more overvalued.

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