Causes of Deviations from a Real Earnings Yield Model of the Equity Premium

Abstract

A market-based forecast of inflation added to equity earnings yields explains much of the variation in stock market returns over multi-year horizons. Return deviations from the prediction are found to be negatively related to the current inflation rate (output gap) over annual (all) horizons. Existing inflation is discovered to be positively (negatively) associated with future higher interest rates (real money supply and long-term profit growth). However, long-term inflationary expectations are positively correlated with long-term real future profit growth and stock returns. These results support the hypothesis of equity returns being positively (negatively) related to inflation (countercyclical anti-inflationary policies).

Keywords: Equity Premium, Real Earnings Yield, Inflation, Interest Rates, Monetary Policy, Money