The expected risk premium for the Global Market Index (GMI) continued to fall in November. GMI, an unmanaged, market-value weighted mix of the major asset classes, is currently expected to earn an annualized 3.9% over the “risk-free” rate for the long term (for details on the methodology, see summary below). Today’s forecast is slightly below last month’s 4.0% estimate and moderately under the recent peak of 4.7% in August

Adjusting for short-term momentum and longer-term mean-reversion factors (defined below) further reduces the current ex ante risk premium to 3.7% for GMI. The current adjusted estimate is below last month’s adjusted 3.8% projection.

The current risk premia forecasts remain substantially below the realized return in recent history. GMI’s risk premium is an annualized 10.2% for the trailing 3-year period through November 2014 – a performance that’s near the best levels in the past two years.

Here’s a summary of the current risk premia projections for GMI and the major asset classes:

For additional perspective on recent history, here’s a recap of rolling three-year annualized risk premia for GMI, US stocks (Russell 3000) and US Bonds (Barclays Aggregate Bond Index) in recent history through last month.

Finally, here’s a brief summary of the methodology and rationale for the estimates above. The basic idea here is to reverse engineer expected return based on assumptions about risk. Rather than trying to predict returns directly, this approach relies on the somewhat more reliable model of using risk metrics to estimate performance of asset classes. The process is relatively robust in the sense that forecasting risk is slightly easier than projecting return. With the necessary data in hand, we can estimate the implied risk premia using the following inputs:

● an estimate of GMI’s expected market price of risk, defined as the Sharpe ratio,
which is the ratio of risk premia to volatility (standard deviation).
● the expected volatility (standard deviation) of each asset
● the expected correlation for each asset with the overall portfolio (GMI)