Equities (Still) for the Long Run: A New Look at the Future Equity Premium

Abstract

The equity premium is a well-known and well-explored artifact of financial economics. However, relatively poor equity performance over the last decade leaves many investors questioning the persistence of the equity premium into the future. The lack of a relatively simple forward-looking equity premium model with sufficient historical data availability compounds this uncertainty. Such an equity premium model essentially needs to compare a reasonable forward-looking equity earnings yield to real bond return expectations and be fairy predictive of future relative returns. The data necessary to calculate a cyclically adjusted earnings yield has been available for decades, but real bond return expectations, based on Treasury Inflation Protected Securities or a similar measure, are only recently available in the United States.

This article presents a forward-looking equity premium model based on cyclically adjusted S&P 500 earnings yield data and nominal Treasury bond data that has been adjusted utilizing the Cleveland Federal Reserve’s Index of Inflation expectations. The resulting data series, representing forward-looking equity premium expectations across various time horizons for the 1982-2012 period, exhibits statistical significance and reasonable predictive power. Currently this ERP model implies far better returns on stocks than bonds over the balance of the next decade – 6.7%, 6.4%, and 5.8% annualized for the next 2, 5, and 10 years, respectively.

Keywords: Equity risk premium, Asset pricing

JEL Classification: G11, G12