FED action has distorted capital market, as equity risk premium no longer looks valid

When estimating market risk, finance theory uses the so-called equity market risk premium (EMRP), which refers to the excess return that investing in the stock market provides over a risk-free rate.

The EMRP is used in the Capital Asset Pricing Model, popularly known as CAPM, in which the expected returns of a security is calculated by risk free rate plus its systematic risk calculated by the Beta coefficient multiplied by the EMRP.

The CAPM model sets out the following formula, where (Rm – Rf) is the EMRP.

Ra = Rf + βa (Rm – Rf)

where:

Ra = expected return on investment in “a”

Rf = risk-free rate of return

βa = beta of “a”

Rm = expected return of market

In other words, to get the required rate of return from holding a stock, you would need to choose and calculate risk free rate (typically US treasury yield), expected equity market return, and beta which is a stock’s volatility in relation to the overall market (i.e. if the share price change 1% when the market index changes by 1%, then the beta is 1).

To further explain this formula, two types of risks should be identified:

Systematic Risk: These are market risks—that is, general perils of investing—that cannot be diversified away. Interest rates, recessions, and wars are examples of systematic risks.

Unsystematic Risk: Also known as “specific risk,” this risk relates to individual stocks. In more technical terms, it represents the component of a stock’s return that is not correlated with general market moves.

Source: Investopedia

Hence, this CAPM model is saying that holding an equity should give a rate of return that is equal to the sum of risk-free rate and equity market risk premium that is only attributable to systematic risk (by beta amount). This is because specific risk relating to individual stocks can be diversified by holding a diversified portfolio, while the systematic risk from the market cannot be diversified.

With this finance theory in mind, let us have a look at what is happening to the current stock market.

The stock market is inherently risky, but since 2008 Global Financial Crisis the US stock market has consistently moved upward, marking the longest bull market in history. The recent bear market caused by COVID-19 in February and March 2020 was very short-lived as the bear market ended with another bull market in April 2020 (technical definition of bull market is when the major stock market indexes rise by at least 20 percent).

This was largely due to the intervention by the FED (Federal Reserve Board) with unlimited quantitative easing, basically meaning that FED will buy everything. The amount and magnitude of FED’s buying assets are evidenced in the chart below, with FED’s balance sheet now exceeding 7 trillion USD.

Source: Federal Bank of St. Louis Economic Research

What does all of this tell us? It seems that the inherent market risk premium—the additional compensation required to hold risky stock security—is no longer true because while the upside of holding stocks remains intact, the downside is mitigated by the US government and the FED doing whatever they can to save the financial market when correction is due.

Hence, the stock investors are now faced with the task of analyzing what the FED is going to do, rather than calculating equity risk premium and analyzing stock market risks. In other words, because all that matters is what the FED’s intention is with the stock market, investors now have incentives to care more about what the FED is going to do.

Is this a good thing for investors? Most likely yes in the short run, because investors are enjoying the upside potential with limited downside by holding stocks in their portfolio.

Is this a healthy financial system? Probably not in the long run because this is going to distort everything we have learned about finance market, and we never know what will happen when the buying spree of the FED ends.

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Joon Young Kwon holds a Master's in International Economics and Finance and currently works as an economics and finance consultant in Singapore.