Question

Can you please explain the non-sequitur from Prof. Damodaran blog.

STATEMENT 1: “In particular, the higher ERP over the last five years can be entirely attributed to the risk free rates dropping to historic lows.”

STATEMENT 2: “While the relationship between the level of the ERP and the risk free rate has weakened over the last decade, the two numbers have historically moved in the same direction: as risk free rates go up (down), equity risk premiums have risen (fallen).”

Statement 1 does not demonstrate the historical correlation has “weakened”, but it rather entirely dismisses the notion of any positive correlation at all.

Further:

“An investor betting on ERP declining in 1979 had two forces working in his favor: that the ERP would revert back to historic averages and that the US treasury bond rate would also decline towards past norms” THIS STATEMENT CONFLICTS WITH 1 ABOVE

“An investor in 2013 is faced with the reality that the US treasury bond rate does not have much room to get lower and, if mean reversion holds, has plenty of room to move up, and if history holds, it will take the ERP up with it.” WHY WOULD A RISING T RATE MYSTERIOULSY TAKE THE ERP UP WITH IT WHEN IN FACT , AS STATEMENT 1 SAYS, A DROPPING T RATE ACCOUNTS FOR THE ENTIRE RISE IN ERP OVER THE LAST 5 YEARS???….

“Thus, if risk free rates move to 3% and the equity risk premium drops to 5%” THE ASSUMED SCENARIO DESCRIBED HERE IS IMPLAUSIBLE BASED ON STATEMENT 2. IS THE RELATIONSHIP BETWEEN ERP AND RISK-FREE MORE AKIN TO STATEMENT 1 OR STATEMENT 2?? IT CANT BE BOTH OTHERWISE EVERY FORECAST MODEL THAT IS PREDICATED ON A RELATIONSHIP BETWEEN RISK-FREE AND ERP WOULD BE INVALID AS ONE RELATIONSHIP IS POSITVELY CORRELATED AND ONE IS NEGATIVELY CORRELATED.

Answer 1

Your ready activation of the caps-lock suggests 'ole Aswath's blog post really riled you up. Remember: It's just a blog post--he probably didn't even proofread it--so give him some slack if some point of his is not entirely clear. But, if you're still interested, I may be able to clarify some points he's making (though, admittedly, I've only had a cursory glance at the aforementioned post).

Ok, here it goes: At the time of the initial post (last May), two economists at the New York Fed had recently argued that:

1.) Equity Risk Premiums were at a historic high.
2.) This historic high was a result of low treasury yields

And, (after analyzing the results of some 29 popular models) concluded that:

3.) Stocks should perform well in the future (they probably had a timeframe in mind of 5-10 years)


Damodaran agrees with #1 and #2 but is hesitant about accepting #3 as readily as the Fed economists do because, he believes, the current state of affairs (re: ERPs, treasury yields, etc.) is categorically different from any other time over the previous, say, 50 years.

This is where things get confusing because Damodaran very quickly transitions from a basic explantation of ERP (including the mention of certain methodological considerations) to his description of the historical relationship between expected returns, risk premiums, and treasury yields (which itself covers a number of different time periods--the past 10 years, the past 5 years, the past 50 years, the 40 years left over when you look at the past 50 years and exclude the last 10 years) all while laying the groundwork for his aforementioned argument. *IT'S EASY TO GET CONFUSED!!*

Anyway, if you're still interested, I can go over some of the questions you might still have regarding said blog post. Just as long as we take them one at a time...

-Steve