Working Paper: NBER ID: w13423
Authors: John Y. Campbell
Abstract: To estimate the equity premium, it is helpful to use finance theory: not the old-fashioned theory that efficient markets imply a constant equity premium, but theory that restricts the time-series behavior of valuation ratios, and that links the cross-section of stock prices to the level of the equity premium. Under plausible conditions, valuation ratios such as the dividend-price ratio should not have trends or explosive behavior. This fact can be used to strengthen the evidence for predictability in stock returns. Steady-state valuation models are also useful predictors of stock returns given the high degree of persistence in valuation ratios and the difficulty of estimating free parameters in regression models for stock returns. A steady-state approach suggests that the world geometric average equity premium was almost 4% at the end of March 2007, implying a world arithmetic average equity premium somewhat above 5%. Both valuation ratios and the cross-section of stock prices imply that the equity premium fell considerably in the late 20th Century, but has risen modestly in the early years of the 21st Century.
Keywords: equity premium; valuation ratios; stock returns; finance theory
JEL Codes: G12
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| equity premium (G12) | market conditions (P42) |
| valuation ratios (G32) | expected stock returns (G17) |
| valuation ratios (G32) | equity premium (G12) |
| high valuation ratios (G32) | high subsequent stock returns (G17) |
| valuation ratios (G32) | stock returns (G12) |