How has stock market behavior during the 2000s affected estimates of the U.S. equity risk premium? In the February 2009 version of their paper entitled “The Equity Premium Revisited”, Bradford Cornell, Robert Arnott and Max Moroz update estimates of the equity risk premium to incorporate the generally weak U.S. stock market performance through 2008. They consider three models to estimate the premium relative to an annualized real commercial paper yield: (1) dividend yield plus capital gains; (2) dividend yield plus dividend growth rate; and, (3) dividend yield plus earnings growth rate. Using historical data for dividends, earnings, stock market returns (for the S&P 500 and antecedents) and six-month commercial paper yields spanning 1872-2008 (with focus on 1951-2008), they conclude that:
- For 1951-2008, the annual equity risk premium derived from dividend yield plus capital gains is 5.93%. However, the high variability of capital gains makes this estimate unstable (a few years of new data can substantially change it).
- Dividend yield plus dividend growth rate indicates an annual 1951-2008 premium of 3.03%. Adjusting this result to reflect the much lower variance of dividend growth compared to capital gains increases this estimate to 4.42%.
- Dividend yield plus earnings growth rate indicates an annual 1951-2008 premium of 4.02%, which is close to the estimates of 4.17% and 4.41% produced by the dividend growth and the capital gain models during 1872-1950.
- Because of the disruption of dividend growth by stock buybacks, the earnings growth model is arguably the best choice for estimating the equity risk premium using post-1980 data, despite the high variability of earnings growth
In summary, evidence from the most credible models of the historical U.S. equity risk premium converge to an annual value in the range 4% to 4.5% during 1872-1950 and 1951-2008.
