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New Forecasts of the Equity Premium

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  • Christopher Polk
  • Samuel Thompson
  • Tuomo Vuolteenaho

Abstract

If investors are myopic mean-variance optimizers, a stock's expected return is linearly related to its beta in the cross section. The slope of the relation is the cross-sectional price of risk, which should equal the expected equity premium. We use this simple observation to forecast the equity-premium time series with the cross-sectional price of risk. We also introduce novel statistical methods for testing stock-return predictability based on endogenous variables whose shocks are potentially correlated with return shocks. Our empirical tests show that the cross-sectional price of risk (1) is strongly correlated with the market's yield measures and (2) predicts equity-premium realizations especially in the first half of our 1927-2002 sample.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 10406.

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Date of creation: Apr 2004
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Publication status: published as Polk, Christopher, Samuel Thompson and Tuojmo Vuolteenaho. "Cross-Sectional Forecasts Of The Equity Premium," Journal of Financial Economics, 2006, v81(1,Jul), 101-147.
Handle: RePEc:nbr:nberwo:10406

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  1. Fama, Eugene F & French, Kenneth R, 1992. " The Cross-Section of Expected Stock Returns," Journal of Finance, American Finance Association, vol. 47(2), pages 427-65, June.
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  18. Merton H. Miller & Franco Modigliani, 1961. "Dividend Policy, Growth, and the Valuation of Shares," The Journal of Business, University of Chicago Press, vol. 34, pages 411.
  19. Robert J. Shiller, 1980. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," NBER Working Papers 0456, National Bureau of Economic Research, Inc.
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Cited by:
  1. Stanislav Anatolyev & Nikolay Gospodinov, 2007. "Modeling Financial Return Dynamics by Decomposition," Working Papers w0095, Center for Economic and Financial Research (CEFIR).
  2. Vuolteenaho, Tuomo & Campbell, John, 2004. "Inflation Illusion and Stock Prices," Scholarly Articles 3196090, Harvard University Department of Economics.
  3. John Y. Campbell & Motohiro Yogo, 2002. "Efficient Tests of Stock Return Predictability," Harvard Institute of Economic Research Working Papers 1972, Harvard - Institute of Economic Research.
  4. Hui Guo & Robert Savickas, 2006. "Understanding stock return predictability," Working Papers 2006-019, Federal Reserve Bank of St. Louis.
  5. J. Bradford DeLong & Konstantin Magin, 2009. "The U.S. Equity Return Premium: Past, Present, and Future," Journal of Economic Perspectives, American Economic Association, vol. 23(1), pages 193-208, Winter.

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