Hypothetical Equity Return Models Under Rising Rates
Martin L. Leibowitz
Q Conference
Dana Point, CA
October 16, 2012
For Illustrative Purposes Only
This presentation depicts a series of hypothetical return models
under the assumption of rising rates.
These models should be viewed as strictly hypothetical
illustrations and are not intended to be taken as market
projections.
2
Basic Assumptions
BONDS
0-Coupon Duration = 5
Starting Yield = 2%
Rate Volatility = 1%
EQUITIES
Standard Equity Risk Premium over Bonds = 3.5%
Volatility = 16%
3
Yields over Time with + 0.30% Drift
8.0%
7.0%
6.0%
5.0%
5.0%
80th
Yield 4.0%
3.0%
3.5%
A vg
2.0%
20th
1.0%
5th Year
0.0%
0
2
4
6
8
10
Year
4
Duration Targeting Bond Returns with + 0.30% Drift
5.0%
80th
4.0%
3.0%
1.7%
2.0%
1.0%
Annualized
0.0%
Bond
Return
0
-1.0%
-2.0%
0.9%
Avg
2
4
6
8
10
20th
-3.0%
-4.0%
5th Year
-5.0%
Year
5
Multi-Year Returns for 5-Year Duration Bonds
Average Rate Average Yield
Drift Per Year 1yr 5yr 10yr
0.0%
Annual Return
1yr
5yr 10yr
2.0% 2.0% 2.0% 2.0% 2.0% 2.0%
Annualized Return
5yr
10yr
2.0%
2.0%
0.3%
2.0
3.5
5.0
0.5
1.8
3.2
0.9
1.7
0.5%
2.0
4.5
7.0
-0.6
1.5
4.0
0.4
1.6
6
The 2001 and 2011 CFA Forums on the Equity Risk Premium
Held at TIAA-CREF
From 2001 Report
From 2011 Report
Estimates of the Equity Risk Premium
A rn o tt & B e rn ste in (20 01 )
C a m p b e l l a n d S h il le r (200 1)
M cG ra tta n a n d P re sc o tt (20 02)
B ro w n , G o e tz m a n n & R o ss (1 995 )
R e i ch e n ste in (2 00 1)
C a m p b e l l (2 001 )
P h i ll ip s (200 1)
S e i g e l (20 01b )
B a n sa l a n d L u n d b l a d (200 1)
S h o v e n (2 001 )
S e i g e l (20 01a )
A sn e ss (20 00 )
G ra h a m a n d H a rve y (200 1)
Ib b o tso n a n d C h e n (200 2)
G o ya l a n d W e l ch (1 999 )
F a m a a n d F re n ch (2 001 )
C o rn e ll (19 99)
Ib b o tso n a n d S in q u e fe ld (1 976 )
W e lc h (2 000 )
A v e ra g e
R an ge
0 .0
0 .0
0 .0
lo w
1 .3
1. 5 - 2. 5
1. 0 - 3. 0
2 .0
2 .5
3 .0
3. 0 - 4. 0
4 .0
4 .0
4 .0
3 -5
4 .3
5 .0
5 .0
6. 0 - 7. 0
After 10 years of low and high
volatile equity returns, there is little
consensus about the stability of the
ERP over changing regimes and
time horizons. Interestingly, the
group appears to be in agreement
more on the actual size of the ERP
over the next few years (most
agree that it is in the 4% range)
than on its stability.
3 .7
0 .0 - 7 .0
Note: ERP estimates are expected long-term geometric return of equities in excess of the real risk-free rate
Source: Rethinking the Equity Risk Premium, edited by P. Brett Hammond, Martin L. Leibowitz and Laurence B. Siegel, December
23, 2011, Research Foundation of CFA Institute
7
Yields and Equity Return Expectations
6%
5.5%
5%
4%
Risk
Prem ium
3.5%
Yield Drifts
2.0%
3%
2%
1%
0%
1
8
Equities: Average Drift per year 0%, Min Return 0%, 0
correlation with rates
20.0%
80th
15.0%
10.0%
An nualized
E quity
Retu rn
Avg
5.9%
5.7%
5.0%
0.0%
0
-5.0%
2
4
6
8
10
20th
-10.0%
Year
9
Rising Yields and Equity Return Expectations
9%
8.5%
3% Drift
8%
7.0%
3.5%
7%
6%
5.5%
3.5%
Risk P remium
5%
4%
3.5%
5.0%
3%
2%
1%
Yield Drifts
3.5%
2%
0%
1
5
10
10
P/E Ratios vs. Real Rates: 1978-2011
18.00
16.00
14.00
12.00
P/E
Ra tio
10.00
8.00
6.00
4.00
2.00
0.00
le ss than
0%
Source: Morgan Stanley Research
0-1%
1-2%
2-3%
3-4%
4 -5%
5 -6%
ab ove
6%
R eal 10 -Y ea r Trea su ry R ate
11
P/E Frown
20
Market Conditions
18
16
P/E
Ratio
Buoyant
Balanced
Dismal
P/E Frown
14
12
10
Discount Rate
Smile
8
Risk Premium
Smile
6
0%
1%
Source: Morgan Stanley Research
2%
3%
4%
5%
6%
Real Rate
12
Equity Return Expectations with 7% Minimum
9%
8.5%
8%
7%
7.0%
7.0%
3.5%
6%
3.5%
Risk P remium
5%
4%
3.5%
5.0%
3%
2%
1%
Yield Drifts
3.5%
2%
0%
1
5
10
13
Equities: Average Drift per year 0.30%, Min Return 7%,
0 correlation with rates
20.0%
80th
15.0%
10.0%
7.7%
7.1%
Annualized
Equity
Return
5.0%
Avg
0.0%
0
-5.0%
2
4
6
8
10
20th
-10.0%
Year
14
High Risk Premiums Do Not Necessarily Imply Bargain
Valuations
An asset’s return premiums can be viewed as incremental returns
for accepting the prospective risks.
Thus, higher premiums may not be a “bargain” in themselves,
but may be an indication of greater prospective risks and/or
lower growth prospects.
As such, they may not be cheap or a bargain in themselves,
especially if the greater perceived risks should in fact be
realized.
The models presented here are inherently overstated in accepting
higher expected returns without fully addressing the greater
prospective risks.
15
Multi-Year Equity Returns
Starting Yield =2%
Standard Equity Risk Premium = 3.5%
Probability of
Average Rate Minimum Equity Equity/Rate 1yr Expected Annualized Return Below 5%
Drift Per Year Return Expectation Correlation
Return
5yr
10yr in 10th year
0.0%
0.3


0.0
0.0
5.5%
5.5
5.7%
6.2
5.9%
6.9
53%
44
0.3
0.3
7.0
7.0
0.0
0.3
7.0
7.0
7.1
8.2
7.7
8.7
38
34
0.3
0.3
7.0
0.0
-0.3
-0.3
7.0
5.5
6.8
5.2
7.6
6.3
38
49
16
References
1) Leibowitz, Martin L. and Anthony Bova. “The Risk Premium
Smile Behind the P/E Frown”, Morgan Stanley Research,
April 24,2012
2) “Rethinking the Equity Risk Premium”, edited by P. Brett
Hammond, Martin L. Leibowitz and Laurence B. Siegel,
December 23, 2011, Research Foundation of CFA Institute
3) Leibowitz, Martin L. and Anthony Bova. “P/E’s and Pension
Fund Ratios”, Financial Analysts Journal, January/February
2007
17
Additional References
1) Leibowitz, Martin L. and Anthony Bova. “Duration Targeting
Over Multiple Yield Pathways”, Morgan Stanley Research,
May 9, 2012
2) Leibowitz, Martin L. and Anthony Bova. “Convergence to
Yield”, Morgan Stanley Research, May 24, 2012
3) Leibowitz, Martin L. and Anthony Bova. “Barclays Index and
Convergence to Yield”, Morgan Stanley Research, July 16,
2012
18
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