Equities (Still) for the Long Run: A New Look at the Future Equity Premium

Abstract

The equity premium is a well-known and well-explored artifact of financial economics. Relatively poor equity performance over the last decade, however, has left many investors questioning the persistence of the equity premium into the future. The lack of a relatively simple forward-looking equity premium model with sufficient historical data availability compounds this uncertainty. Such an equity premium model essentially needs to compare a reasonable forward-looking equity earnings yield to real bond return expectations and be fairly predictive of future relative returns. The data necessary to calculate a cyclically adjusted earnings yield have been available for decades, but real bond return expectations, based on Treasury Inflation-Protected Securities or a similar measure, are only recently available in the United States. This article presents a forward-looking equity premium model based on cyclically adjusted S&P 500 Index earnings yield data and nominal Treasury bond data that have been adjusted by using the Cleveland Federal Reserve Index of Inflation Expectations. The resulting data series, representing forward-looking equity premium expectations across various time horizons for the 1982-2012 period, exhibits statistical significance and reasonable predictive power. Currently, this ERP model implies far better returns on stocks than bonds over the balance of the next decade: 6.7%, 6.4%, and 5.8% annualized for the next 2, 5, and 10 years, respectively.

TOPICS: Portfolio theory, fundamental equity analysis, fixed income and structured finance