The Equity Risk Premium and the Low Frequency of the Term Spread
50 Pages Posted: 6 Sep 2017 Last revised: 16 Nov 2017
Date Written: November 14, 2017
The term spread has long been of interest to policymakers and financial markets participants. Despite being a strong business cycle leading indicator, it is known to be a poor out-of-sample predictor of the equity risk premium. In this paper we show that its low-frequency component, when properly extracted from the data, is the best out-of-sample equity risk premium predictor to the date. Concretely, it obtains out-of-sample R-squares (versus the historical mean benchmark) of 2.03% and 21.9% for monthly and annual data, respectively, and generates utility gains of 585 basis points per annum for a mean-variance investor. Its outperformance is consistently stable throughout an out-of-sample period comprising more than 20 years of monthly data. Remarkably, it also forecasts well in expansions and outperforms several variables that have recently been proposed as good equity risk premium predictors.
Keywords: equity risk premium, term spread, predictability, frequency domain
JEL Classification: C58, G11, G12, G17
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