Wednesday, June 5, 2013

The Equity Risk Premium Puzzle

One of the more interesting, yet to be explained, facts in finance is the fact that common stocks perform so well, as compared to less risky assets.  Treasury bills are earning almost nothing these days, but stocks are on a tear.  Why?

The same pattern has held historically.  The gap between what stocks earn and what much safer assets earn has been much, much bigger than could possibly be explained by aversion to risk.  Something more is afoot.

The question is front and center today.  Usually the question is posed as: "why are short term rates near zero, but other assets -- stocks, housing, e.g. -- doing so well.  Why don't people simply shift from treasuries to stocks and housing?"  Apparently folks are doing just that, but not by enough to narrow the return gap.

You could argue that there is not enough investment by ordinary folks in stocks.  That means that stock prices never get quite high enough to deflate their long run return prospects.  But, what about housing?  It is hard to believe that a similar argument would apply to housing.

I'm no fan of the equity market these days (I became bearish at 1391 in the S&P and the market is 15 percent higher than that today).  But, long run, you can't beat equities.  You just have to somehow ride through the rough patches, which may lie just ahead.

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