Stock Market Duration

Abstract

At the peak of the tech bubble, only 0.57% of market valuation comes from dividends in the next year. Taking the ratio of total market value to the value of one-year dividends, we obtain a duration of 175 years. In contrast, at the height of the global financial crisis, more than 2.2% of market value is from dividends in the next year, implying a duration of 46 years. What drives market duration? We find that market participants have limited information about cash flow beyond one year. Therefore, an increase in market duration is due to a decrease in the discount rate rather than good news about long-term growth. Accordingly, market duration negatively predicts annual market return with out-of-sample R2 of 15%, outperforming other predictors in the literature. While the price-dividend ratio reflects the overall valuation level, market duration captures the slope of the valuation term structure. We show that market duration, as a discount rate proxy, is a critical state variable that augments the price-dividend ratio in spanning the (latent) state space for stock-market dynamics.

Keywords: stock market duration, state space dimension, cash flow expectations, return predictability

JEL Classification: G14