Duration-Based Stock Valuation

Abstract

Interest rates across maturities have dropped to all-time low levels around the world. These unexpected shocks to discount rates have an important effect on the valuation of long duration assets. To quantify this effect, I construct a number of counterfactual fixed income portfolios that match the duration of the dividend strips of the aggregate stock market. I show that such fixed income portfolios have performed as well, if not better, than the U.S. stock market in the past five decades, while exhibiting similar (or higher) levels of volatility. Therefore, investors have received little to no compensation for taking long duration nominal dividend risk in the past half century. Further, if anything, stocks seem to have too little volatility (not excess volatility) compared to these fixed income counterfactuals. I discuss several explanations for these findings, including a secular decline in economic growth rates, dividends' potential to hedge against inflation, as well as the diversification of dividend risk across maturities. These results also have important implications for research on the cross-section of stock returns and capital structure.

Keywords: Stock Market Performance, Dividend Risk Premium, COVID-19