Jamil Baz, Chief Investment Strategist at GLG

Written February 5th, 2013

Jamil Baz, Chief Investment Strategist at GLG posted an article in FT.com analyzing the equity risk premium under different scenarios.

He starts by looking at the bullish case:

Who can blame the equity bullish consensus? Earnings yields – a proxy for real equity yields – stand at comfortably high levels. For example, the forward earnings yield on the S&P 500 is 8.3 per cent.

Contrast real equity yields with real bond yields: with the US Consumer Price Index at 1.7 per cent and the nominal Federal Reserve funds rate at 15 basis points, real bond yields are at -1.55 per cent.

Then goes on to show why this analysis is misguided. For starters, he says, we should be comparing earnings yield to long dated bonds, since equity is a long dated asset. Then, assuming we’re talking about long dated equity assets, we might be better off using the dividend yield as a better proxy than forward earnings yields based on bullish-biased analysts with a poor track record. Long story short, using a discounted dividend model, our rosy equity premium starts to look pretty slim. But then he adds another layer: leverage.

It can be assumed conservatively that the total-debt-to-GDP ratio needs to fall by 100 per cent before the debt position becomes sustainable in advanced economies. This would bring the US back to 1995, when the profit-to-GDP ratio was 45 per cent lower.

We can value the S&P under the following scenario: dividends fall by 45 per cent over a zero-growth period of 10 years. Then they resume their real growth of 1.25 per cent per year. Again, assuming a real yield of 0.4 per cent and a required risk premium of 4.5 per cent, fair market value is only one-third of current market levels.

Read the full article here.

Where does that leave us? I’m not sure. For anyone who’s actually managing money right now, as opposed to just writing about it, the pressure of performance from clients is intense. And with that pressure, the risks to the system are increasing. The VIX, as only one indicator, certainly doesn’t give me confidence that this rally is sustainable.


I don’t know about a 2/3 decline in the markets, but a serious decline that wipes out the gains all the way back to 2009 and beyond would not only not surprise me, it is starting to look increasingly likely.

Here’s just one measure to put things in perspective:

Q-Ratio-arithmetic-mean (From www.dshort.com)

One of my favorite metrics is still showing a 40% overvaluation, and that’s just to the mean, which we would expect a mean reverting series to overshoot.

So…just as hedging becomes more difficult, it’s probably more prudent.

Relevant ETFs: VXX, SPY, SH, IWM, RWM