In The Risk Premium Factor: A New Model for Understanding the Volatile Forces That Drive Stock Prices (Wiley, 2011) Stephen D. Hassett sets out to provide a model for estimating the equity risk premium (and hence the cost of capital) and for solving the equity premium puzzle.
Hassett begins with the CAPM equation for the cost of equity: risk-free rate + beta x equity risk premium (ERP). For the market as a whole, the cost of equity is the risk-free rate + ERP. The problem is how to calculate ERP. Enter Hassett’s risk premium factor (RPF) model, which proposes that “the equity risk premium (ERP) is a simple function of the risk-free rate.”
“Conventional theory would hold that if the equity risk premium (ERP) were 6.0 percent and 10-year Treasury yield were 4.0 percent, then investors would expect equities to yield 10 percent, but if the 10-year Treasury were 10 percent, then investors would require a 16 percent return—a proportionately smaller premium.” By contrast, Hassett argues that ERP is not fixed but “varies directly with the level of the risk-free rate in accordance with a risk premium factor (RPF).” For example, “with an RPF of 1.48, equities are expected to yield 9.9 percent when Treasury yields are 4.0 percent and 24.8 percent (10 + 1.48 x 10 = 24.8) when they are at 10 percent to provide investors with the same proportional compensation for risk.” (p. 19)
To calculate the RPF Hassett ran regressions on annual data between 1960 and 2008 and quarterly data from Q4 1986 to Q4 2008. He found two shifts in the RPF—in 1981 and September 2002. (The causes of these shifts, the author admits, are still not fully explained.) The RPF values for the annual data sets were 1.24 between 1960 and 1980, 0.90 from 1981 through 2001, and 1.51 for 2002 through 2008.
Hassett acknowledges that the RPF can be discerned only in hindsight and cannot be projected, but he still considers his method superior to other methods for determining risk premiums. For instance, “if the RPF changed just two times over 50 years, one might argue that in any year there is a 96 percent chance … that the RPF will remain constant over the next year.” (p. 28)
The RPF model is also brought to bear on the equity premium puzzle, the inability to reconcile the observed ERP with financial models. The authors of a 1985 paper found that on average short-term Treasuries produced a real return of about 1% over the long term and equities yielded 7%. This, the authors maintained, would require a puzzling coefficient of risk aversion on the order of 40 or 50 to justify the 7% ERP. Haslett invokes his model in conjunction with the notion of loss aversion to tackle the puzzle.
Hassett uses his model to explain major market gyrations. He also explains how it can be used to value an acquisition or project.
For most investors the model is most applicable in valuing the overall stock market. Hassett argues that when trying to decide whether the market is over- or undervalued the analyst should focus on the two drivers of valuation—earnings and interest rates (interpreted through the lens of the RPF model).
I am not equipped to pass judgment on Hassett’s model. It’s certainly a simple model, not one of those complex quant models that have come under attack of late. It also seems plausible. Is it useful? Perhaps.