One of the great mysteries of the world when I was learning about macroeconomics back in the mid-90s was the size of the equity premium. In the long run, shares used to offer something like six percentage points greater annual growth than 'risk-free' government bonds – and it wasn't clear to anyone why shareholders should need such a large incentive to invest in firms.
Since then, of course, share prices have fallen and become more volatile, simultaneously reducing the equity premium and increasing the level at which it would become explicable to economists. So the mystery has been largely or entirely squeezed out.
Even so, a recent column in The Economist reports (with slightly unconvincing drama) that the Capital Asset Pricing Model (CAPM) on which this view of markets is based has outgrown its usefulness. In fact all they're really reporting is an attempt to refine the use of a figure known as 'beta'. This is a measure of the typical size and direction of movements in the share price of a given company in relation to movements in the stock market as a whole – and it's a key part of the CAPM. The refinement in question involves splitting beta into two so the that the effects of changes in profits and discount rates can be separated. This is important because the share prices of different types of companies appears to respond differently depending on whether the news is about profits or discount rate.
The same piece in The Economist also quotes an interesting report from McKinsey that argues for a recalculation of betas to remove the effect of the high-tech bubble. This would reduce the betas of high-tech firms and increase the betas of other companies (because, by definition, the beta of the whole market is equal to one). All this is important because the beta is used to calculate a company's cost of capital, so it affects decisions about which investments are and are not worth making.
The Economist's conclusion in response to all this seems spot on to me: The equity premium itself, treated for so long as an inexplicable but stable fact of financial life, appears to be something that rises and falls with time, albeit much more slowly (thank goodness) than share prices themselves.
Posted by timo at July 4, 2003 07:53 AM | TrackBack