The Determinants of the Time-Varying Equity Premium

Abstract

The ex-ante excess return required by investors for taking positions in the stock market is found to be lower when there are greater past dividend growth rates, higher past stock returns, narrower credit spreads, lower unemployment rates, faster past consumption and money growth, higher values for the dollar, more elevated existing/expected interest rates, and less inflation. The findings indicate that the equity risk premium tends to fall (rise) with improving (deteriorating) financial/economic fundamentals. Measures of investor sentiment (stock market volatility) are found to separately have only a minor (insignificant) impact on the equity premium.

Keywords: Equity Premium, Counter-cyclical, Economic Fundamentals, Inflation, Sentiment, Volatility, Ex-ante Sharpe Ratio