What Does The Current Market Risk Premium Tell Us About Future Stock and Bond Returns?
Recently many analysts and commentators have been quoted saying things like ‘Stocks have never been so attractively priced when compared to bonds’, or ‘ equities are a no brainer compared to bonds for the coming decade’, or ‘ beware the bond bubble’. Many of these analysts encourage an overweighting in equities because ‘Over the next 10 years equities should outperform bonds’. This is true, but for any rationale investor to hold ANY significant allocation to equities they better outperform…and by a wide margin! This required excess return is called the market risk premium and is the difference in total return between risky assets (like equities) and risk less assets like treasuries. In order for any rationale investor to accept the MUCH higher risk of holding equities they should demand a much higher return. How much extra return you ask? There is no mathematically correct answer and the risk premium changes with investor sentiment and emotion. But history can give us a guide. Attached
