Falkenblog had a post making this argument with more than the usual gusto. Main points:

Arithmetic vs. geometric averages: when an index goes from 100 to 200 and back again, the average annual return on an arithmetic basis is 25% (200/2 + 50/2 = 125). The geometric average, which shows 0% change, would seem to be more relevant to the long-term investor.

Survivorship bias: the U.S. had the best stock market in the 20th century –it’s not a good benchmark for what to expect going forward on average.

After-tax returns: taxes applicable to the equity premium reduce the margin (even in RRSPs since they just defer taxes).

Market timing: dollar-weighted returns, reflecting high inflows at peaks and outflows at troughs, are lower than time-weighted returns.

Transactions costs: “commissions were about 60 cents/share until the 1975 deregulation and are currently about 2 cents a share (about 0.1%) on average. Plus, mutual funds often had 8.5% fees. …. the bid-ask spread will cost you about 0.25% on average….”

Add up all these factors, and the equity premium shrinks to zero or worse for the average investor, says Falkenblog.

Food for thought, as they say. Personally, one issue I am wrestling with is: even if the equity premium does exist, how can it be expected to persist? To rephrase, how can one reconcile a positive equity premium with the efficient market theorem.

The latter says a systemic opportunity to profit doesn’t persist in the stock market because market participants capture such profit opportunities by biding stock prices up or down until the anomaly is eliminated. Yet, the equity premium says there is a systematic opportunity to profit in stocks by buying and holding over the long run.

Ten or fifteen years ago, there weren’t many books or studies alerting investors to the premium, so not many were responding to it. But now everyone knows about it, so we might expect many investors to have incorporated it into their strategies (or be in the process of doing so). Just look, for example, at how much pension funds and other institutional investors have shifted out of bonds toward equities over the past 10 to 15 years.

The end result may be that stock prices have been bid up relative to long-term fundamentals such that the equity premium will turn out to be close to zero or negative (at least more so for investors who buy during the mature  bullish phases).

For example, the growth of mutual funds and pension funds over the 1980s and 1990 is credited with reversing the premium observed on small caps over large caps in previous decades. How so? As investment decisions shifted from individuals to professional managers during the 1980s and 1990s demand went up for large caps owing to their greater liquidity.

Looking ahead, Mauboussin sees Asian and petrodollar countries increasingly becoming sources of funds for U.S. stocks via direct channels (e.g. central banks) and through agents such as sovereign wealth funds (SWF) and hedge funds. Both regions will have ever-growing mountains of U.S. dollar reserves to invest and Mauboussin sees evidence that they are beginning to diversify those reserves away from U.S. government bonds into stocks and alternative assets (e.g. SWFs recent investments in U.S. bank stocks).

“This lower risk aversion, in turn, serves to dampen equity risk premiums and ultimately increase valuation multiples,’ writes Mauboussin. “Note that, if true, this analysis suggests an upward re-pricing to gain a new equilibrium [for stocks].” In short, a flood of liquidity from Asian and petrocurrency countries could buoy the U.S. stock market and perhaps over time help lift it out of the current malaise triggered by the housing and financial crisis. Here is the link to his report.