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resillent1

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Wednesday, August 20, 2008 - 04:11 pm:

A home for the discussion of Equity Risk Premium

resillent1

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Wednesday, August 20, 2008 - 04:19 pm:

Rudy following on from your post in Daily Bread

Left axis is the Equity Risk Premium based on AWPE figures you supplied and the overnight cash rate.

Right axis is the one month BBSW rate.

Looks like the BBSW started anticipating rate cuts back in mid June. Equity market started accepting a reduced equity premium around mid July.

But is the reduction in ERP partly, fully or nothing to do with Interest rate expectations?

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resillent1

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Wednesday, August 20, 2008 - 04:30 pm:

Rudy

You also supplied PEG data

Left axis is the Equity Risk Premium based on AWPE figures you supplied and the overnight cash rate.

Right axis is the PEG data you supplied. With PEG the lower the better.

Is the decrease in equity risk premium as a result of anticipated interest reductions as per previous chart or perhaps the market was anticipating the fall in PEG (increase in earning expectations) that has resulted from a reasonably good reporting season to date?

Perhaps the decrease in ERP is just a result of an increase in risk appetite (reading the press, I don't think so)

The final consideration is that the data used could be rubbish in which case we’ve just got garbage in garbage out.

(Message edited by resillent1 on August 20, 2008)

rdumas

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Wednesday, August 20, 2008 - 05:04 pm:

Hi Resillent1,

Thanks so much for the work that you went to in preparing those interesting charts. You are right that it's extremely difficult to determining which of the many parameters at play causes the changes. I guess it's why there are so many variations in predictions of economists. The system that they're dealing with is so complex that it's difficult to determine which is the chicken and which is the egg.

resillent1

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Thursday, August 21, 2008 - 12:38 pm:

Considering the interest rate cycle looks to be turning south (at least for now)and reporting seasons hasn't been too bad to date the Equity Risk Premium looks rather inviting.

rdumas

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Thursday, August 21, 2008 - 04:04 pm:

Hi Resillent1,

I've been out for most of the day and just noticed your post. That chart does look inviting doesn't it? I suspect that it will become even more so over the next couple of months.

resillent1

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Friday, August 22, 2008 - 12:03 pm:

G'day Rudy

rdumas wrote on Thursday, August 21, 2008 - 04:04 pm:
I suspect that it will become even more so over the next couple of months

I just don't know Rudy - Anything is possible but we are already in pretty extreme territory.

Look at the x-axis on the chart – it includes the 2003 bear market – where ERP only went to 4% before things started to improve. The interesting thing about the last bull market is that ERP never really contracted much. It implies that we are in a very large secular bear market for valuations. I've heard this theory often applied to the American Market.

Maybe we are going to blow off the secular bear market in valuations. Maybe debt will be the catalyst. 1930’s: 1970’s: 2010’s it almost seems cyclical.

Looking at my long-term data the Equity risk premium currently on offer is greater than any time since the seventies.

Though back in the seventies when the equity risk premium was larger than today, real interest rates were decidedly negative. Under these circumstance cash is a really crap asset to hold – even worse than equities because the damage done to cash is permanent.

I think to get 70’s style valuations in equity than housing has to totally crap it self and the Reserve Bank has to be out of options so as it reverts to inflating the debt away with negative real interest rates. (Sounds like the USA doesn’t it)

The above paragraph may happen in time but there is still much water to pass under the bridge (ie 5% in interest rate cuts up the sleeve and a federal fiscal reserve to blow). We aren’t going to go straight down.

All in all I think the ERP looks pretty good NOW and the valuations on particular stocks look unbelievable. In fact I feel like a kid in the lolly shop. But I don’t think we’ve’ seen the bottom of the market in aggregate – that could be years away and a decade in a really big range wouldn’t surprise me.

rdumas

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Friday, August 22, 2008 - 02:21 pm:

Hi Resillent1,

I have to admit to being a complete dunce on this subject. I can understand from your chart that the ERP is the delta between the Total Equity Yield and the Inflation Adjusted Risk Free Rate of Return.

I'm trying to use common sense to come up with some assumptions. I'd appreciate at it if you could let me know which of the following assumptions are incorrect:

1) during bear markets the equity yield tends to go up because the share prices go down.

2) bear markets tend to happen when economic growth goes down. The RBA attempts to increase economic growth by lowering interest rates.

3) Our current bear market has relatively high inflation which the RBA originally attempted to reduce by increasing interest rates but now finds itself in the position where growth in parts of our economy is slowing so rapidly that it is having to consider lowering rates because they believe that the slowing economy and other overseas influences will tend to have a downward pressure on inflation anyway.

Now how all of these things play together to either increase or lower the Equity Risk Premium I'm not really sure because it is not a subject that I have spent any time on in the past.

I seem to recall recently briefly reading an article written about the US market where the author was proposing that we had recently gone from a secular bull market and had now entered the early stages of a secular bear market which would last for 17 years. If I recall correctly I think he said that the bull/bear cycles usually last about 34 years. This is an area which causes a bit of confusion within me because it appears that whilst we go through these long secular bull/bear markets we still enjoy much shorter bull/bear market superimposed over the longer term secular markets.

If that is the case then can you explain in really simple terms how this is possible? For example if we have just come through 17 years of a secular bull market, how come we experienced a number of bull and bear markets cycles during that period? What is the underlying issue that determines whether we are in a secular bear or bull market?

Having said all of that I have to agree with your last paragraph. I feel much the same way.

resillent1

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Friday, August 22, 2008 - 03:50 pm:

Hi Rudy

The equity yield is just the flip side of the P/E ratio.

The equity yield changes when prices and earnings change at a different rate. If price fall faster than earnings the equity yield will increase. I’m sure you can work out all different the permutations.

I use an inflation adjusted risk free rate of return because over the long term company’s earnings should reflect inflation without them doing anything special.

The equity risk premium is the difference between the two.

Prices are just one thing that affects the equity risk premium. It’s quite possible for the ERP to spike up in a bull market if prices are not rising as fast as earnings etc. ERP reflects risk appetite. It shows what premium people are prepared to pay for equities based on their outlook for earnings and interest rates.

Personally over the long term I would choose Equities even if there were no premium to real rates of return on cash, because they can retain earnings and grow beyond the rate of inflation.

The premium is in the price because of the shorter run volatility and because of the possibility that you could select a dud. If you can avoid the duds and don’t care about the short-term volatility, than the long-term return is yours for the taking.

What’s an equity risk premium of 7% get you above a real return for cash of 2.5% over 30 years?

$1000 becomes approx $2,000 with cash

$1000 becomes approx $15,000 with equities.

This difference with just one decision - At what price will you purchase.

The risk in reading Equity Risk Premiums is that they can be distorted upwards by cyclically high earnings and that's where I think we potentially are now.

rdumas

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Friday, August 22, 2008 - 04:13 pm:

Hi Resillent1,

Thanks for that explanation.

What about this magic secular bull and bear market discussion? If secular bull and bear markets tend to average around 17 years each then how come during the last 20 years we in fact have had a number of what we normally define as bear markets.

What actually defines a secular bear market for instance that makes it different to a normal bear market? I find it rather confusing.

captain_chaza

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Friday, August 22, 2008 - 04:58 pm:

Apologies if this is a little Off Topic

BUT From my limited vision of Bull and Bear markets
IE: when all ships are supposed to rise on a rising tide
etc etc and Visa versa etc etc

I havent seen one of them for decades
Hence I say in my limited vision

What or where do all these discussions of Bulls and Bear markets lead to?
What do they get out of it?
How does anyone gain from such pedantic/academic crits?

Is all this cheap talk only written by journos/paper traders trying to fill Newspaper print?

When was the last time they called "It" a Bull Market before the obvious and A bear market before the obvious

Is it just me or have they all gone crazy just trying to fill up space in newspaper print/internet space

This is not meant to refer to Ody in any way but the broader population of wordsmiths who have by virtue of their livelihood/employment need to post so many words per day

Some I have note always use many more words that is necessary
I can only guess that these journalists are being paid by the word

Salute and Gods' speed

"While we stop and think, we often miss our opportunity." Publilius Syrus, 1st century B.C.

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"There are two times in a man's life when he should not speculate: When he can't afford it, and when he can." Mark Twain, 1897

resillent1

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Friday, August 22, 2008 - 05:01 pm:

resillent1 wrote on Friday, August 22, 2008 - 12:03 pm:
It implies that we are in a very large secular bear market for valuations

I used the word secular to describe the bear market in "valuations" as separate to market price bull and bear runs. I see the bull market in price we had between 2003 & 2007 as taking place inside a bear market for valuations. The P/E’ for the peak of 2007 were lower than the P/E for the 2001, The P/E is now lower than the 2001 trough etc – that’s a bear trend for valuations.

I'm not familiar with the 17-year cycle you refer too; maybe you could post a link

resillent1

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Friday, August 22, 2008 - 06:12 pm:

Capt

I guess your saying, there's no use in looking at the aggregates if that's not relevant to what your'e trading. There’s always something going in the opposite direction that you can latch on to whilst it behaves.

Populist opinion doesn't tell you when the tide is turning or even that it has in the early days - probably the opposite is true.

Both points I would agree with.

Equity Risk Premiums though show you when crowd sentiment starts to skew valuations and knowing when valuations are at an extreme helps you to know when it’s time to leave the crowd and be an individual. It’s not a precise instrument though – for that you better look in the TA tool kit.

Equity risk premium is an aggregate measure and as such its usefulness to an individual stock situation is limited, but I find it generally useful information. Just as the Allords is generally useful but specifically useless to individual situations.

Journos never cater to the individuals taste - they're interested in appealing to the majority and the majority get it wrong, it’s just the way it is.

rdumas

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Saturday, August 23, 2008 - 08:15 am:

Hi Resillent1,

"I used the word secular to describe the bear market in "valuations" as separate to market price bull and bear runs. I see the bull market in price we had between 2003 & 2007 as taking place inside a bear market for valuations. The P/E’ for the peak of 2007 were lower than the P/E for the 2001, The P/E is now lower than the 2001 trough etc – that’s a bear trend for valuations'

You have just enlightened me by that perfect description. I now understand.......Thanks. Come to think about it the article was talking about valuations. Next time I should read it more thoroughly.

I can't recall who wrote that article about the 17 year cycles but will try and find it for you and provide a link.

rdumas

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Saturday, August 23, 2008 - 09:17 am:

Hi Resillent1,

You will be pleased to know that I have managed to find that article that I unfortunately didn't read thoroughly enough last time. As you mentioned in your post secular markets do relate to bull and bear valuations and not to price. The article does relate to the US market but I suspect that there are parallels in our market. The writer suggests that whilst valuations have become very cheap so far, there is still a way to go as Paddy puts it. I hope that you find it interesting and would be interested to know if you agree with his insights.

Here it is:

http://www.compareshares.com.au/zeal52.php

captain_chaza

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Saturday, August 23, 2008 - 02:58 pm:

Ahoy Officer Resilient #1

Want I forgot to say is

If you can lose half your bank in Bear markets and the other half in Bull markets
What is the point of having Bull and Bear markets?

Crikey! If you get it wrong most of the time it is just PLAIN BAD LUCK!

Salute and Gods' speed

NB I have never ever lost a ship except for twice!

Once when my Broker went broke
and then when I tried out that new fangled idea of "Leveraging your bets"

(Message edited by Captain_Chaza on August 23, 2008)

captain_chaza

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Saturday, August 23, 2008 - 04:21 pm:

I have never ever lost a ship except for twice!

Once when my Broker went broke
and then when I tried out that new fangled idea of "Leveraging your bets"

BUT MOST IMPORTANTLY THAN ALL

Has anyone ever Documented the START of a Bull Market
AT THE START!

I have only ever noted their calls for a Bull Market at the end / Top of the market

TIME FRAMES are escape clauses designed by the brokers for doing business everyday of the week
AND As we all at sea know
Times frames are excuses only a mother would believe

We also know that
Wives are are lot more difficult to convince than mothers

It is just one of those "Facts of Life" we all have to face at Sea or on Land

In times of marriage
"TIME FRAMES" is your best friend
Use it for as long as you can get away with it

You can always change wives and repeat the process!

TIME FRAMES never fail!

Salute and Gods' speed

resillent1

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Monday, August 25, 2008 - 11:03 am:

Captain

I'm confused, are you trying to tell us something about time frames - or have you just got woman trouble?

Cheers

resillent1

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Monday, August 25, 2008 - 11:30 am:

Rudy

Thanks for the link - It's similar to what I have seen on valuation cycles before.

All the research I have seen on cycles for valuations has been based on the American market. I thinks the ebb and flow of valuations would apply to all markets but the their respective position in the cycle would be different.

Due to the fact that we are a resource driven economy and the US is a service driven economy - I think our cycle timing for valuations would be logically quite different.

Developing economies cycles are likely to be quite different to developed country cycles. Whilst business cycles may be converging globally - I doubt that valuation cycles are.

I believe valuation cycles are more important than business cycles which in turn are more important the economic cycles - when it comes to what price markets attribute to equities.

For Australian Equities, I like where we are now in the valuation cycle, But history indicates that if pricing becomes unstable due to excessive inflation or deflation than valuation will get even cheaper. It happened in the 30's and the 70's - It could happen again, but even if it does a well chosen equity portfolio would be be the best defence unless you can time things and trade on the short side.

rdumas

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Monday, August 25, 2008 - 12:17 pm:

Hi Resillent1,

What you say makes a great deal of sense. It would be interesting to see if we also go through 30~34 year cycles and if so where we are currently in the cycle.

I'm afraid that I have lived so long in the 'price' market world rather than the 'valuation' market world that I still have to get a better feel for the latter. I will only get there by reading a lot more on the subject than I have in the past.