High inflation and expensive stocks result in a negative risk-return ratio and drive the equity premium to zero. In the years following this “everything expensive” scenario, low volatility, quality, value and momentum aspects bring significant positive premiums.
Given current market dynamics, investors should avoid stocks with high volatility or hope for a distinct consequence than the historical reality presented on this blog post. I’ll show that while the immediate future is probably not promising for the equity premium, it looks vibrant for factor premiums.
Money Illusion
Money illusion implies that investors don’t take inflation into consideration. It is a cognitive bias that makes it difficult to change from nominal to real returns, especially when inflation is 3% or more. A study by Cohen, Polk and Vuolteenaho (2004) on inflation and the connection between risk and return continues to be relevant today. They use Gordon’s growth model, where an asset price is set by G, the expansion rate of future returns, and R, the discount rate:
They depend on the cash illusion – the speculation that investors discount real earnings at nominal quite than real rates of interest. One example is the widely used “Fed model” by which an actual stock return is in comparison with a nominal bond return. Asness (2003) criticizes the Fed model. In science that is referred to as the Modigliani-Cohn model Inflation illusion hypothesis. And it results in mispricing out there, which causes the empirical risk-return relationship to flatten. The number from their paper, “Money illusion on the stock market”, empirically supports their hypothesis.
Exhibition 1.
Source: Cohen, Polk, and Vuolteenaho (2004). Annualized returns on the vertical axis and betas on the horizontal axis.
When inflation is low, the risk-return ratio is positive, but when inflation is high, it becomes negative. This explains the poor performance of the Capital Asset Pricing Model (CAPM) during times of high inflation akin to the Fifties and Nineteen Eighties and supports the Modigliani-Cohn hypothesis of the inflation illusion.
Inflation: First nail within the coffin of the CAPM
It has been 20 years because the publication of the CAPM study by Cohen et al. (2004), and inflation within the US has been above 3% for the past few years. Therefore, it’s an opportune time to update and review these earlier results. We give attention to predictive relationships quite than timely relationships to offer practical insights for investment decisions.
Based on data from 10 portfolios sorted by volatility dating back to 1929. paradoxinvesting.comwe will test how the CAPM relationship behaves in numerous inflation regimes. We split the sample into two parts, using the one-year rolling CPI at 3% as a threshold and considering the subsequent 12 months’s real yields.
Annex 2.
Source: Paradoxinvesting
Using this expanded database, we will confirm that the cross-sectional risk-return relationship is negative in periods following inflation rates above 3%. The relationship shouldn’t be exactly linearly negative. Rather, it’s initially barely positive before trending downward for higher beta stocks.
Assessment: The second nail within the coffin of the CAPM
In 2024, the cyclically adjusted price-to-earnings (CAPE) ratio for the US would reach 33, near the historical highs of 1929 and 1999. The inverse of this metric, the equity yield, is 3.0%. Since the true yield on 10-year bonds is currently 1.8%, the surplus CAPE yield is 1.2%. This metric is free from the monetary illusion of the Fed model.
Annex 3.
Source: Robert Shiller Online Data
In March 2009, the surplus return was 7.8%, marking the start of a sustained bull market. Today’s value is significantly lower than in 2009 and is below the historical median of three.3%. This low CAPE return suggests that stocks are expensive and expected returns are extremely low. In addition, risk is higher when stock returns are low, as I discussed in my work from 2021.
How does the CAPM relationship behave in years following high and low stock returns? The two graphs in Figure 4 illustrate the risk-return relationship when the surplus CAPE return is above 3% (“stocks are cheap”) and below 3% (“stocks are expensive”).
Annex 4.
Source: Paradoxinvesting
High-risk stocks perform poorly in low-return environments that follow expensive markets (low CAPE excess return). This relationship is stronger and more inverse than in times of inflation above 3%. After inflation, valuation is the second nail within the coffin of the CAPM. Investors should either hope for a distinct consequence this time or avoid high-volatility stocks.
Factor performance in a low-yield world
If inflation and valuation have indeed eroded the CAPM – leading to a negative risk-return ratio – it becomes interesting to judge the performance of value, quality and momentum factor strategies. To this end, we complement our data with data from Kenneth FrenchWe consider long-only strategies with similar turnover, specializing in the highest quintile portfolios by way of low volatility, value and quality, and the highest half portfolios by way of momentum.
Quality is defined as operating profitability and populated with the market portfolio. Value is defined by the price-to-earnings ratio (P/E) and populated with the market portfolio. Momentum is defined by 12 minus one-month returns and Lowvol is defined by three-year volatility. We analyze periods after 1) inflation above 3% and a pair of) the surplus CAPE return below 3%. These regimes have historically little overlap (-0.1 correlation) and each characterize today’s market environment.
Annex 5.
Sources: Kenneth R. French Data Library and Paradoxinvesting
In the 12 months following periods by which inflation exceeds 3%, all factor premiums are positive and contribute about 3% to the equity premium. This corresponds to a recent study within the , which shows that factor premiums – including low-risk, value, momentum and quality – are positive and significant in times of high inflation. Moreover, within the 12 months following expensive equity markets (excess CAPE return <3%), real equity returns were a meager 0.5%, while strategies specializing in low-risk, value, momentum and quality still delivered positive returns.
When these two systems are combined – which accounts for 17% of observations – the equity premium becomes negative. However, all factor strategies proceed to supply positive returns, averaging around 3%.
Key finding
In this blog post, we use publicly available data to substantiate that top inflation results in an inverse risk-return relationship, especially after periods when equities have been expensive. This mispricing of dangerous stocks, driven by way of nominal discount rates and excessive investor optimism, reduces expected returns. However, low-risk stocks are more resilient.
With CAPE excess returns below 3% and inflation above 3%, expected returns are currently low. Historically, market returns have been near zero after such periods, but factor strategies have still delivered positive returns of around 3% after adjusting for inflation. While the immediate future is probably not promising for the equity premium, things are looking good for factor premiums.
