The Capital Asset Pricing Model (CAPM) is one among the marvels of twentieth century economics. In fact, its founders were awarded Nobel Prizes for his or her efforts, and its insights have helped drive asset allocation decisions for the reason that Nineteen Sixties. To this present day, many graduate school finance professors hold him as gospel for how one can value stocks.
The problem, in fact, is that it doesn’t all the time work in practice. So we fixed it.
Correctly measure the equity risk premium (ERP).
My team and I even have spent the last five years studying this Behavior of the US stock market over the past century and a half. Our efforts culminated in a brand new approach to valuing stocks and government bonds: we call it the holistic market model. This model goes far beyond the boundaries of traditional finance to incorporate accounting, big data and analytics, history and sociology. When developing it, we first had to revamp the CAPM to make it work for each the last 150 years and the 2020s and beyond.
The CAPM fails primarily because each components of the equity risk premium (ERP) are flawed. First, traditional earnings returns depend on inconsistent earnings numbers. Second, risk-free rate of interest calculations ignore the hidden risk premiums embedded in U.S. Treasury bonds. Therefore, to higher understand the forces that determine stock prices, we reconstruct these metrics from the bottom up.
First, we determine which earnings numbers are one of the best input aspects for calculating stock earnings returns. We use the concept of “owner profit” that Warren Buffett originally developed for individual stocks and extend it to the S&P 500 Index while taking investors’ personal taxes into consideration. Building on Buffett’s comparison of a stock index with a real perpetual bond, we convert the earnings yield of the S&P 500 into the equivalent return of a perpetual bond. To do that, we must confront the undeniable fact that stocks generally profit from growth over time, but bonds don’t.
Second, we reconsider the actual risk-free rate of interest, which is traditionally derived from nominal U.S. Treasury securities less expected inflation. Our research shows that this measure is a poor approximation. In fact, we discover so many 10 Treasury risk premiums that the majority fixed income investors don’t learn about, but should know.
These two steps allow us to calculate the ERP consistently over the past 150 years by subtracting the actual risk-free rate from Buffett’s real earnings yield, which is comparable to a perpetual bond. The resulting ERP may be very different and way more stable than the Fed model and other traditional measures.
Building an explanatory model of ERP
Because our ERP is consistent and reliable, we generate a CAPM that works in practice. Its fluctuations may be explained by a four-factor model: the primary factor is cyclical/subcyclical; the last three are secular. They quantify steadily mentioned valuation drivers:
- Business cycle and sub-cyclical fluctuations in economic and financial risk.
- Quantified levels of utmost inflation and deflation related to poor stock performance.
- Generational rise in risk aversion as a result of long-term secular bear markets.
- Variations in risk arbitrage between stocks and government bonds depending on the extent of the actual risk-free rate of interest.
In summary, our revised CAPM relies on the appropriately calculated real risk-free rate of interest and the four-factor ERP model and provides a meaningful explanation of stock valuations. The model has a single framework that covers the 150-year period: It shows that the principles governing stock prices have remained surprisingly stable despite massive changes within the structure of the US economy.
Revised CAPM model: Real price per share of the S&P 500, in US dollars, January 1871 to December 2021
What it means for coping with future uncertainty
The work has produced quite a few insights which have critical implications for portfolio construction and asset allocation, including:
- Stock prices have been high in recent times due to a bubble, but somewhat due to extremely favorable and strange trends which have pushed secular corporate profit margins to 100 years and the secular real risk-free rate of interest to an all-time high.
- A crash is now less likely than if the ERP were unsustainably compressed as a result of a bubble. However, a financial crisis, a serious geopolitical event or a natural disaster could trigger a crash if fears of significant consequences of such an event for the actual economy and inflation develop into overwhelming.
- Cyclical bull and bear markets are common. They are driven by the ever-changing dance between the business cycle, the Fed cycle, and Mr. Market sentiment. As of this writing, we’re already in a cyclical bear market if the 20% decline is measured in real terms, and are on the verge of it if measured in nominal terms.
- Without future P/E or margin increases, secular, forward-looking, risk-adjusted returns are at all-time lows. However, this isn’t enough to conclude that the 40-year secular bull market that began in 1982 is coming to an end. However, this also doesn’t mean that a brand new paradigm has immortalized the present secular bull market.
- In fact, our work shows that this secular bull market may fail for one or a mix of three reasons: The 30-year upward trend in corporate profit margins is unlikely to proceed for an additional 40 years; The downward trend of the secular real risk-free rate of interest after the worldwide financial crisis can be not observed; and even a milder type of Nineteen Seventies-style inflation could spell its death knell.
- However, there may be a giant difference between these three assassins. The first two usually are not yet in sight, but will strike sooner or later in the subsequent 40 years – the timing largely determined by the ballot box. The third factor, inflation, is apparent immediately, but it would only destroy the secular bull market if it defeats the Federal Reserve, not the opposite way around.
So is there room for optimism in 2023 and beyond? Yes, because despite the cyclical headwinds and gloomy headlines, the evidence that might reliably predict the tip of the secular bull market has not yet emerged – and will not for a few years. Until that happens, sustained long-term P/E and margin expansion could well close the complete gap between historically low earnings yields and long-term average market returns and not less than half of the gap with long-term average bull market returns.
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Photo credit: ©Getty Images/Visoot Uthairam
