Is the Equity Premium only in the USA?

Long term small cap US vs bonds vs World
data from Yahoo Finance, 5/3/2017

The “Equity Premium” was discovered by my associate Rajnish Mehra, together with Edward Prescott, in the late 1970s, though only published in 1985.  See Wiki article, original paper, and Mehra’s 2008 review.  The finding was a “surprise” because finance theory suggests if one investment consistently gives higher returns, investors or arbitrageurs will bid up the price of it.  From a higher price base, the return is lower assuming the same final price.

Thousands of papers were published proposing solutions to the problem, many mentioned in Mehra’s review.  Mehra also states in the review that the premium “is observed  in  every  country with a significant capital market.”  However, he also states “The United States together with the United Kingdom, Japan, Germany, and France accounts for more than 85 percent of the capitalized global equity value.

Two of those countries, Japan and Germany, were forbidden from funding large military forces after WWII, and most of their defense funded by the U.S.  They also benefited from postwar reconstruction assistance and planning.  Two of the most advanced industrial economics, both space and nuclear powers, did not have capital markets at all for most of the 20th century, Russia and China.  China now is the world’s second largest economy, making even Mehra’s recent 2008 assessment obsolete.

Japan’s markets fell after the peak of the late 1980s.  Since the Equity Premium is observed at 20+ year time horizons, it was the late 2000s before it could be evaluated whether Japan’s market still had a premium.  Currently it appears that after 35 years, it has not yielded a premium over bonds for investors who bought after 1982, and has presented a loss for many of them:

Nikkei 225
data from Yahoo Finance, 5/6/2017

Russia’s market begin in the early 1990s, only beginning to give valid Equity Premium data on the first few years of operation in the middle 2010s, i.e. just recently.  In 2011 when Putin was re-elected Russia’s market crashed badly, and in 2014 the twin disasters of the Ukraine war and the sanctions it entailed, and the fall of oil prices.  Still it does have a premium due to early gains from low value in the 1990s, but there is not enough data to assess whether it will continue.

China’s market since 1990 shows steady gains – IF you didn’t buy during one of the two large peaks.  See chart:

china

The peaks are when most people bought, and when you would have bought if you were permitted.  But of course, this wasn’t a free market at all.  Holdings by outsiders were strictly limited during this time frame, and still have serious limits.  China is still a tightly controlled and planned economy.  Perhaps it is no longer socialist enough to be called communist, but the ruling Communist Party has given up neither planning nor control.

In fairness, the U.S. economy is planned too, with growth targets set by the Federal Reserve, which “prints” money (actually electronically, buying bonds and mortgages and lending to banks) to meet those targets, balancing inflation and unemployment.  In my book The Equity Premium Puzzle, I argue this is the real reason for the equity premium.  By printing money to lend, the Fed suppresses interest rates, and no arbitrageur has deep enough pockets to fight a printing press.  The European Central Bank is charged only with preventing inflation, due to Germany’s fears from the 1930s.

Looking at the chart at the top of the page, with one bond fund and the rest small cap ETFs, which I deem to be more indicative of a particular country’s economy, and which usually perform as well or better than large caps, it appears only the U.S. market over the last 15 years has a clear premium over bonds.  Note that these are price plots, not total returns.  You have to add about 32% to the end of the bond plot for comparison, giving it a total return since 2010 (starting date for the bond ETF chosen) of 51% or about 5.2% per year.  But the U.S. small caps have a return over the same period, not even counting dividends, of 163%, or 12.8% per year.  That is not a long range return, as it was recovering from a market crisis.  From 2004, a 14 year period and as far back as that ETF goes, the return, sans dividends, is is 7.4%.  Add about 1% for dividends making it 8.4%, for a 3% advantage over bonds.

The only other countries on the chart showing a premium over the bonds are Britain and Canada.  Britain’s premium is small, and Canada has a premium only if one ignores the early data, the inclusion of which actually gives a negative premium.

I think it is time to admit that the Equity Premium is only striking in the U.S., and only exists in “planned” economies in which a central bank suppresses interest rates and prints money to fund growth.  Britain essentially “invented” the concept of the central bank, and the modern version of the stock corporation by which borrowed money is leveraged against equity to create excess growth (see book for details).

Britain probably suffered from membership in the EU with its paranoid banking policies.  The bank chief Mario Draghi “gets it,” but his German “overlords” do not.  They are punishing Greece and Spain, et. al., for their borrowing immorality (deserved) instead of funding growth and insisting the debtor countries use the funds for growth rather than welfare (pragmatic).  Yes it is warmed over Reaganomics, but the data show it works regardless of what one thinks of it morally, whereas welfare does not.

Japan’s central bank is waking up recently, but for decades was widely thought to be too tight, explaining their lack of premium.  China has a chance of holding its course, but its population has a great tendency to invest in bubbles.  Russia has a surprisingly strong central bank, and I expect if they ever get their politics straightened out they will have a strong equity premium.  But the U.S. is a much safer bet.

What if the U.S. is the only country with a really noticeable Equity Premium (3% or more), and we really don’t know why?  Then invest in the U.S. and don’t break it.  Globalization is a kind of unremitting equalization that will eventually break every equity premium on the planet unless all nations have one.  We’ve seen how well that works with currency policy in the EU, and it won’t work even that well with the EP.  If you invest, invest in the U.S.  If you invest in the U.S., oppose globalization.  It boils down to your pocket book, and whether central bankers and their overlords invest in growth.

I am not, by the way, saying unlimited growth is good.  But if it exists and you do not invest in it, then you are giving up your say in the world by falling behind in economic power.

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