The Capital Asset Pricing Model (CAPM) is one of the marvels of 20th century economic study. In fact, its creators took home Nobel Prizes for their efforts, and their insights have helped drive asset allocation decisions since the 1960s. To this day, many graduate finance professors consider it gospel on how to value stocks.
The problem, of course, is that it doesn’t always work in practice. So, we fixed it.
Correctly measure the capital risk premium (ERP).
My team and I have spent the last five years studying the behavior of the US stock market over the past century and a half. Our efforts culminated in a new approach to stock and Treasury bond valuations: we call it the Holistic Market Model. This model goes far beyond the boundaries of traditional finance to include accounting, big data and analytics, history and sociology. In developing it, we first had to re-engineer the CAPM to make it work both for the last 150 years and for the 2020s and beyond.
The CAPM fails primarily because both components of the capital risk premium (ERP) are flawed. First, traditional earnings returns are based on inconsistent earnings numbers. Second, risk-free rate calculations ignore hidden risk premiums built into US Treasuries. Therefore, to better understand the forces driving stock prices, we reconstruct these measures from scratch.
First, let’s determine which earnings numbers are the best inputs for calculating equity earnings returns. We take the concept of “owner income,” originally devised by Warren Buffett for individual stocks, and extend it to the S&P 500 index, while accounting for investors’ personal taxes. Based on Buffett’s comparison of a stock index to a real perpetual bond, we convert the earnings performance of the S&P 500 into its real yield equivalent of perpetual bonds. This forces us to address the fact that stocks generally benefit from growth over time, but bonds do not.
Second, we reframe the real risk-free rate, which is traditionally derived from nominal US Treasuries minus expected inflation. Our research shows that this measure is a poor approximation. In fact, we uncover up to 10 Treasury risk premiums that most fixed income investors don’t know about but should.
These two steps allow us to calculate the ERP consistently over the last 150 years by subtracting the real risk-free rate from the real real return equivalent to Buffett’s bonds. The resulting ERP is quite different and much more stable than found in the Fed model and other traditional measures.
Construction of an explanatory model of the ERP
Because our ERP is consistent and reliable, we generate a CAPM that works in practice. Its variations can be explained by means of a model of four factors: The first factor is cyclical/subcyclical; these last three are secular. They quantify the valuation factors that are often referenced:
- Economic cycle and sub-cyclical variations of economic and financial risk.
- Quantified levels of extreme inflation and deflation that are associated with poor equity performance.
- Intergenerational Increases in Risk Aversion Driven by Long Secular Bear Markets.
- Variations in the risk arbitrage between equity and Treasury bonds depending on the real levels of the risk-free rate.
In summary, our redesigned CAPM is based on the correctly calculated real risk-free rate and the four-factor ERP model and is a powerful explainer of equity valuations. The model has a unique framework that covers the 150-year period: it indicates that the rules governing stock prices have been surprisingly stable despite massive changes in the structure of the US economy.
Redesigned CAPM model: Real price per S&P 500 share, in US dollars, from January 1871 to December 2021
What it means for managing future uncertainty
The work has yielded numerous insights that have critical implications for portfolio construction and asset allocation, including:
- Stock prices have been high in recent years no because of a bubble, but rather because of very favorable and unusual trends that have brought secular business profit margins to 100 years. high and the real secular risk-free rate at a historical level down.
- A crash is now less likely than if the ERP was unsustainably compressed due to a bubble. However, a financial crisis, a large-scale geopolitical event, or a natural disaster could trigger a crash if and when fear of the severe consequences of that event on the real economy and on inflation becomes overwhelming.
- Cyclical bull and bear markets are common. They are driven by the ever-changing dance between the business cycle, the Fed cycle and the mood of Mr. Market. At the time of writing, we are already in a cyclical bear market if the 20% drop is measured in real terms, and on the brink of one if measured in nominal terms.
- In the absence of future P/E or margin expansion, future secular risk-adjusted returns are at record lows. But that’s not enough to conclude that the 40-year secular bull market that began in 1982 is coming to an end. This does not mean, however, that some new paradigm has immortalized the current secular bull market.
- In fact, our work shows that this secular bull market will die for one or a combination of three reasons: the 30-year upward trend in corporate profit margins is unlikely to persist for another 40 years; neither is the downward trend in the secular risk-free real rate after the financial crisis (GFC); and even a milder form of 1970s-style inflation could also sound its death knell.
- However, there is a big difference between these three killers. The first two are not yet in sight, but will arrive sometime in the next 40 years; the ballot box will largely determine when. The third, inflation, is in sight at the moment, but it will kill the secular bull market only if it defeats the US Federal Reserve and not the other way around.
So is there room for optimism in 2023 and beyond? Yes, because despite cyclical headwinds and gloomy headlines, the evidence to reliably call the end of the secular bull market has not yet appeared, and may not for many years. Until it does, the continued secular expansion of P/E and margins could bridge the entire gap between the all-time low earnings yield and long-term average market returns, and at least half the gap with average long-term bull market returns.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Jacques César
