A quantitative focused manager has to have an opinion on the relative value of equities. This is not a question of whether you should buy based on a momentum or other technical factors but whether the market is rich or cheap from a macro perspective. What are the headwinds coming from valuations.
The simplest valuation approach is to look at equity risk premia; however, the key current issue with this type of analysis is whether the current environment is so different that the equity risk premium is not giving us a good signal. What makes this time so different is not what may be going on with stocks but rather what is going on with bonds and the risk-free rate of return.
The simplest valuation approach is to look at equity risk premia; however, the key current issue with this type of analysis is whether the current environment is so different that the equity risk premium is not giving us a good signal. What makes this time so different is not what may be going on with stocks but rather what is going on with bonds and the risk-free rate of return.
Let's use a simple example. If the equity risk premium is the difference between the expected returns on equity and the risk free rate of return and the expected return on equity is the same through time, a decline in rates will lead to higher premiums. The market will look richer even without any change in stock return expectations. It would be even richer if there is a clear link between expected equity returns and change in rates. If a decline in rates is correlated with a decline in expected equity returns then the market would be richer. Unfortunately, there has been a breakdown between movement in rates and economic behavior because rates have been kept at the zero bound for five years.
The current low rate environment means that the risk-free rate does not provide useful signalling of excess returns. This gets more complex when we are at a zero lower bound (ZLB) rate environment. In the case that rates should actually be lower the risk premium would be even higher. So we now have an another interesting issue with what could be the natural rate of interest. If rates are being kept intentionally low, high valuations may be false. The risk premium may be lower. If the natural rate is low or actually negative, the equity risk premium is actually higher. Rates matter in telling us whether risk premiums are high or low.
The current low rate environment means that the risk-free rate does not provide useful signalling of excess returns. This gets more complex when we are at a zero lower bound (ZLB) rate environment. In the case that rates should actually be lower the risk premium would be even higher. So we now have an another interesting issue with what could be the natural rate of interest. If rates are being kept intentionally low, high valuations may be false. The risk premium may be lower. If the natural rate is low or actually negative, the equity risk premium is actually higher. Rates matter in telling us whether risk premiums are high or low.
No comments:
Post a Comment