From 1928 to 2014, stocks earned 4.6% per year more than 10 Year U.S. treasury bonds — 9.6% vs. 5.0%. In finance-speak, this is called the risk premium that stocks earn over bonds.
Academics have tried to explain why the risk premium in stocks exists — they carry more risk, the returns are more erratic and equity owners are at the bottom of the capital structure for repayment. No one really knows the answer. It probably comes down to the fact that equity holders require a higher return on their capital than debt-holders.
Because interest rates around the globe are currently so low (and negative in some cases), many investors have come to the conclusion that stock returns should also be lower in the future. In theory, this makes sense because the long-term returns on bonds will certainly be lower than average based on the current yields. The risk premium is far from stable over time, but it’s reasonable to assume that lower interest rates should lead to lower equity returns.
Turning theory into reality can be tricky when you add in the human element of the markets. Let’s test this one out to see if it holds water. I looked back at the starting 10 year treasury yield at the beginning of each year going back to 1928. Next I calculated the subsequent 3, 5, and 10 year annual returns on the S&P 500 and separated each by their initial interest rate level. Here are the results showing the average annual returns for the S&P 500:
Starting with the highest yields at the top and working your way down it appears that the risk premium theory holds. As the starting interest rate deceases the future stock market returns also fall. That is, until you move under the 3% level. At that point average annual returns jump back up again.
I’m not sure exactly why this is the case, but my guess is that most of these low rate periods came after economic crises, so the low yields came about because Fed lowered rates. The returns are above average because they likely came after sharp stock market sell-offs. So even though it doesn’t make sense from a risk premium perspective, it makes sense from a common sense perspective that low interest rates would lead to higher returns based on the timing of those low rates.
The 10 year yield started out in 2015 at just above 2.1%. Does that mean investors should expect similar above average performance going forward? If it were only that easy. Market averages are never quite as clean as they appear. You always have to consider the range of outcomes that caused the averages you’re looking at. Here are the minimum and maximum annual returns for the averages from above:
By far the narrowest ranges have come from the highest interest rate environments. It’s counterintuitive to invest in stocks when bonds yields are double digits, which is exactly why the returns have been higher from those starting yields. Investors gave up on stocks when interest rates were so high, which pushed down valuations and increased future stock returns.
You can see that once the interest rates were closer to average levels the range of returns were fairly wide for nearly every period, although they do narrow as the time horizon is extended. So while low interest rate environments have led to above average returns in the past, there are always going to be outliers and a wide range of possible outcomes.
As with most historical data, there are scenarios that can work for both bullish and bearish arguments. Stocks have already given investors strong gains from the extended period of low interest rates since the financial crisis, but based on historical performance stocks don’t have to be doomed simply because of low interest rates.
What the Risk Premium Can Tell Us About Future Returns
Here’s the stuff I’ve been reading this week:
- The only basic financial advice you’ll every need (Prag Cap)
- The surprising investment experts who use index funds (Monevator)
- Benjamin Graham’s greatest gift (The Sova Group)
- Yes stocks will crash eventually, but historically they’re up 20% a year 40% of the time (Irrelevant Investor)
- Is diversification really worth it? (Asset Builder)
- A new kind of investment outlook (Above the Market)
- Most of the research we see isn’t as beautiful as it appears (Research Puzzle)
- Kahneman: “Hindsight induces us to believe we understand the world because we understand the past.” (Think Advisor)
- Everyone is bad at this so work on improving yourself (Fat Pitch)
- It’s impossible to compare investments without considering costs (Malice for All)
- Cry me a river that leads to Omaha (Micheal Santoli)
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