Equity risk premium

In theory, stocks should provide a greater return than safer investments like Treasury bonds. The difference is called the equity risk premium: it is the additional return that you can expect from the overall market above a risk-free return. The historical value of this risk premium is about 4%. Currently, TIPs yields are about 2%, so one would expect real equity returns of about 6% going forward.

A paradoxical aspect of this risk premium is the following: once people realize that equity returns dominate bond returns, why should they continue to demand a premium for owning equities (assuming they have long time horizons)? Over the last 20 years, it has become conventional wisdom that one should own stocks, rather than bonds, for the long run ("stocks for the long run","buy and hold", even "buy on the dips"). Nothing wrong with this conclusion, as the data certainly support it. But as more investors accept this wisdom, the more the price of equities gets bid up, leading to large P/E ratios and, eventually, a smaller risk premium. To me, this is the most plausible explanation for recent secular increases in P/E ratios. However, it also implies that equity returns in the near future should lag the historical average.

The equity risk premium plays an important role in discussions of social security privatization - the particular value assumed makes all the difference in future projections. But we should remember that equities are like any other scarce resource subject to supply and demand. If demand for shares increases, their prices will also increase, even if there is no change in the "intrinsic value" = sum of future dividend payments. Eventually the supply of shares can increase, as perhaps the rate of business formation speeds up. But, it seems obvious that the growth in capitalization of the broadest index of equities cannot exceed GDP growth for any length of time, so it would be surprising if this rate of value creation could accelerate drastically.

From this perspective, it seems that social security privatization is likely to bid up equity prices and depress their future returns. Imagine the following analogy: one day, foreign investors wake up and decide to increase their portfolio allocation to US equities. The result may be a buoyant stock market, but to what extent does this increase real value creation in our economy? Does it create enough value (i.e. future earnings and dividend growth) to justify the amount by which prices are bid up? (An even simpler analogy: I have a chicken, which produces eggs at a fixed rate. Demand for egg-laying chickens increases, driving up the price of my chicken. Will it lay eggs any faster as a result of its increased price?)