Equity risk premium change with "good" and "bad" times

 

The macro market regime can be classified as risk tolerance, macro outlook, macro stability, and risk-on conditions. Each of these regimes can be either in a good or bad state. A set of macro state variables like the short rate, term spread, credit spread, dividend yield, effective spread, price impact and systematic volatility can be used to define these regime states.

The size of the equity risk premium will differ based on the market regime state. Conditioning on the market regime can create higher performing risk premium portfolios relative to any unconditional portfolio. See "Macroeconomic Risks in Equity Factor Investing: Part 2/2"

Factor risk premium can have low unconditional correlation but in reality have high sensitivity in different regimes. Momentum and high profitability are highly sensitive to the risk tolerance regime. These two risk premium have correlated regime sensitivity. What is surprising is that the size premium seems to be independent of macro regimes and hence will be a good diversifier in all states. Also surprising is the fact that the low volatility risk premium has high sensitivities to many market regimes. Low volatility is not a strategy for protecting a portfolio given this high regime sensitivities.

Understand your market regime and realize that equity risk premiums are regime sensitivity.  An unconditional correlation may not tell us about the true risk between equity risk premiums.