Predicting the Equity Risk Premium

Posted in Equity Premium

 

Does a simple model based on the gap between the stock market earnings yield and an inflation-adjusted Treasury yield usefully predict the equity risk premium (ERP)? In their June 2012 paper entitled “Equities (Still) for the Long Run: A New Look at the Future Equity Premium”, Michael Crook and Brian Nick construct and test a model that compares an estimate of the future stock market earnings yield to real bond return expectations. They use the S&P 500 as a proxy for the stock market. They estimate the future stock market earnings yield as the inverse of Shiller’s cyclically adjust price-earnings ratio (P/E10). They use nominal Treasury yields with duration matched to forecast horizon and adjust this yield with inflation expectations from the Federal Reserve Bank of Cleveland. They apply simple inception-to-date linear regression to relate forecasted ERP to actual ERP. Using monthly S&P 500 Index total returns, Shiller’s P/E10 data, Treasury yields (10-year, 5-year and 2-year notes and bills) and the Cleveland Federal Reserve’s Index of Inflation (limiting the start of the sample period) during 1982 through April 2012, they find that: (more…)

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