investment and returns to stockholders and investors in other securities
may tend to become equalized.^16More Stable Economy
There is much literature that attempts to justify the 3 to 3^1 ⁄ 2 percent risk
premium found in the historical data in the context of standard macro-
economic models.^17 Some of these are based on very high aversion by in-
dividuals to lowering their consumption. Others are based on the
myopic behavior of those who dislike taking short-term losses on their
investments even when they have substantial long-run gains.
Even if we assume that the historical level of the equity risk pre-
mium is justified, there is a reason why that premium might narrow in
the future: increasing stability of the real economy.
Examine Figure 8-2, which displays the changes in U.S. industrial
production since 1884. One can see a major reduction in economic
volatility over time, particularly after the Great Depression and again
following 1980. Furthermore, by examining industrial production alone,
one may underestimatethe reduced volatility of the entire economy be-
cause of the increase in the importance of the more stable service sector.
The swings in the GDP have also become more muted. Recessions
have become shorter and milder and expansions longer. The last eco-
nomic expansion in the United States lasted a record 10 years from
March 1991 to March 2001. Economic expansions in Europe have lasted
even longer: the last recession in the United Kingdom ended in 1995 and
much of the Eurozone has been recession free for more than a decade.
Economists call this trend toward greater macroeconomic stability
“The Great Moderation.”^18 The moderation has been attributed to better
monetary policy; a larger service sector, which is inherently more stable
than the goods sectors; and better inventory and production control, en-
abled in part by the information revolution.
Whatever the reasons, greater macroeconomic stability should lead
to greater stability of earnings and a lower equity premium. The lowerCHAPTER 8 The Impact of Economic Growth on Market Valuation and the Coming Age Wave 131
(^16) Chelcie C. Bosland, The Common Stock Theory of Investment, New York: Ronald Press, 1937, p. 132.
(^17) See Jeremy Siegel, “Perspectives on the Equity Risk Premium,” Financial Analysts Journal, vol. 61,
no. 1 (November/December 2005), pp. 61–73. Reprinted in Rodney N. Sullivan, ed., Bold Thinking
on Investment Management, The FAJ 60th Anniversary Anthology, Charlottesville, Va.: CFA Institute,
2005, pp. 202–217.
(^18) James H. Stock and Mark W. Watson, “Has the Business Cycle Changed and Why?” NBER Macro-
economics Annual, 2002, pp. 159–218.