ERP-RIP

If we compare like with like, we find that the semi-mythical ‘equity risk premium’ may not be quite the yardstick it’s made out to be. In fact, the right sort of bonds have proven every bit as rewarding as stock, over the years and it’s cheap to bet they might do so again.

One of the hoariest constructs of finance theory is that of the ‘equity risk premium’ – a concept which is one of those infuriating Cheshire Cat unobservables, escaped from the mainstream macroeconomics game reserve. It is supposed to help explain why stocks tend to return more to their lucky investors than bonds do to theirs but it never quite manages to do so to the satisfaction of all those involved.

Ideas abound about the ‘optionality’ involved in the ownership of equity as a reason. Some simply project forward from empirical results to argue past is prologue. Some hammer often-contrived ‘discount rates’ and analyst ‘expectations’ squarely into round holes of data. Others invoke arcana like the ‘Arrow-Debreau model’ and similarly prize-winning, but usually impractical, complexities. Some abandon attempts at exegesis entirely and simply form a statistical bundle of all the available approaches.

The only problem is that, for 40 years at least, it has not been an EQUITY risk premium, but a CORPORATE – or maybe simply a private sector – one since BAA bonds (and not the Treasuries usually used for comparison) have performed every bit as well as stocks – at least since Paul Volcker played the role of the Last Central Banker with Cojones, and crushed runaway price inflation at the start of the 1980s.

We say this because if you regress BAA bond (log) returns on those for the S&P500 over that stretch, you get a horizontal trend and an r-squared of 0.97. In short, they match, with each returning a trend 10.6% p.a., meaning that equities in general currently lie around 14% above where bonds suggest they should be.

The unparalleled rise of Growth v Value these past four years has become a commonplace, but what it has also done is throw up a marked divergence vis-à-vis bonds

Growth is ~45% too rich if the past 40 years’ relative pricing to corporates is any guide (NB: Trend returns have been only 25bps p.a. above bonds and 65bps above Value in that time). Conversely, the cyclical turn, followed by the COVID disaster, has pushed Value to a ~12% discount to corporate fixed income.

This all suggests, that the nascent rotation of the past few weeks, away from the years’ big winners, could yet have some way to run, if the past outcomes still offer any useful pointers to future pricing in this topsy-turvy world of ours.

One more reason to bear in mind that it’s no good just buying dealers in electrons: that we also need protons and neutrons to build and maintain the world around us.

As for bonds, the surplus of funds created by the Fed, coupled with the market imperatives unleashed by the lower yields, per se, have pinned them in an exceptionally narrow range for much of the past six months.

As a result, asset manager interest is starting to wane (as the COT plots show for all but the old T-Bond contract) and volatility has crashed to unheard of lows, both outright and relative to stocks. Roughly every four years since 2008, they have bounced off a low.

Given this general apathy, is it time to buy a cheap lottery ticket, in anticipation of a repeat?