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Estimating the Equity Premium

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  • 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.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 13423.

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Date of creation: Sep 2007
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Publication status: published as John Y. Campbell, 2008. "Viewpoint: Estimating the equity premium," Canadian Journal of Economics, Canadian Economics Association, vol. 41(1), pages 1-21, February.
Handle: RePEc:nbr:nberwo:13423

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  1. John Y. Campbell, 1995. "Understanding Risk and Return," Harvard Institute of Economic Research Working Papers 1711, Harvard - Institute of Economic Research.
  2. John Y. Campbell & John H. Cochrane, 1994. "By force of habit: a consumption-based explanation of aggregate stock market behavior," Working Papers 94-17, Federal Reserve Bank of Philadelphia.
  3. Fama, Eugene F. & French, Kenneth R., 1989. "Business conditions and expected returns on stocks and bonds," Journal of Financial Economics, Elsevier, vol. 25(1), pages 23-49, November.
  4. Campbell, John & Shiller, Robert, 1988. "Stock Prices, Earnings, and Expected Dividends," Scholarly Articles 3224293, Harvard University Department of Economics.
  5. Alexander W. Butler & Gustavo Grullon & James P. Weston, 2005. "Can Managers Forecast Aggregate Market Returns?," Journal of Finance, American Finance Association, vol. 60(2), pages 963-986, 04.
  6. John Y. Campbell & Motohiro Yogo, 2003. "Efficient Tests of Stock Return Predictability," NBER Working Papers 10026, National Bureau of Economic Research, Inc.
  7. Jessica A. Wachter & Missaka Warusawitharana, 2007. "Predictable Returns and Asset Allocation: Should a Skeptical Investor Time the Market?," NBER Working Papers 13165, National Bureau of Economic Research, Inc.
  8. Campbell, John, 1987. "Stock Returns and the Term Structure," Scholarly Articles 3207699, Harvard University Department of Economics.
  9. John Y. Campbell, 1993. "Why Long Horizons: A Study of Power Against Persistent Alternatives," NBER Technical Working Papers 0142, National Bureau of Economic Research, Inc.
  10. Jacob Boudoukh & Roni Michaely & Matthew Richardson & Michael Roberts, 2004. "On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing," NBER Working Papers 10651, National Bureau of Economic Research, Inc.
  11. Stambaugh, Robert F., 1999. "Predictive regressions," Journal of Financial Economics, Elsevier, vol. 54(3), pages 375-421, December.
  12. Campbell, John, 1993. "Intertemporal Asset Pricing Without Consumption Data," Scholarly Articles 3221491, Harvard University Department of Economics.
  13. Walter Torous & Rossen Valkanov & Shu Yan, 2004. "On Predicting Stock Returns with Nearly Integrated Explanatory Variables," The Journal of Business, University of Chicago Press, vol. 77(4), pages 937-966, October.
  14. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, 04.
  15. Malcolm Baker & Jeffrey Wurgler, 2000. "The Equity Share in New Issues and Aggregate Stock Returns," Journal of Finance, American Finance Association, vol. 55(5), pages 2219-2257, October.
  16. John Y. Campbell, Robert J. Shiller, 1988. "The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors," Review of Financial Studies, Society for Financial Studies, vol. 1(3), pages 195-228.
  17. Venkat R. Eleswarapu, 2004. "The Predictability of Aggregate Stock Market Returns: Evidence Based on Glamour Stocks," The Journal of Business, University of Chicago Press, vol. 77(2), pages 275-294, April.
  18. Fama, Eugene F. & French, Kenneth R., 1988. "Dividend yields and expected stock returns," Journal of Financial Economics, Elsevier, vol. 22(1), pages 3-25, October.
  19. Cavanagh, Christopher L. & Elliott, Graham & Stock, James H., 1995. "Inference in Models with Nearly Integrated Regressors," Econometric Theory, Cambridge University Press, vol. 11(05), pages 1131-1147, October.
  20. Pontiff, Jeffrey & Schall, Lawrence D., 1998. "Book-to-market ratios as predictors of market returns," Journal of Financial Economics, Elsevier, vol. 49(2), pages 141-160, August.
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Cited by:
  1. Dangl, Thomas & Halling, Michael, 2012. "Predictive regressions with time-varying coefficients," Journal of Financial Economics, Elsevier, vol. 106(1), pages 157-181.
  2. Ferreira, Miguel A. & Santa-Clara, Pedro, 2011. "Forecasting stock market returns: The sum of the parts is more than the whole," Journal of Financial Economics, Elsevier, vol. 100(3), pages 514-537, June.
  3. Sévi, Benoît & Le Pen, Yannick, 2013. "Futures trading and the excess comovement of commodity prices," Economics Papers from University Paris Dauphine 123456789/11382, Paris Dauphine University.
  4. Paulo M.M. Rodrigues & Antonio Rubia, 2011. "A Class of Robust Tests in Augmented Predictive Regressions," Working Papers w201126, Banco de Portugal, Economics and Research Department.
  5. Francesco Menoncin & Paolo Panteghini, 2009. "Retrospective Capital Gains Taxation in the Real World," CESifo Working Paper Series 2674, CESifo Group Munich.
  6. Angelidis, Timotheos & Tessaromatis, Nikolaos, 2010. "The efficiency of Greek public pension fund portfolios," Journal of Banking & Finance, Elsevier, vol. 34(9), pages 2158-2167, September.
  7. Walentin Karl, 2010. "Earnings Inequality and the Equity Premium," The B.E. Journal of Macroeconomics, De Gruyter, vol. 10(1), pages 1-23, November.
  8. Nieto, Belén & Rubio, Gonzalo, 2011. "The volatility of consumption-based stochastic discount factors and economic cycles," Journal of Banking & Finance, Elsevier, vol. 35(9), pages 2197-2216, September.
  9. Jessica A. Wachter & Missaka Warusawitharana, 2011. "What is the Chance that the Equity Premium Varies over Time? Evidence from Regressions on the Dividend-Price Ratio," NBER Working Papers 17334, National Bureau of Economic Research, Inc.
  10. Marcelo Bianconi & Joe A. Yoshino, 2012. "Empirical Estimation of the Cost of Equity: An Application to Selected Brazilian Utilities Companies," Discussion Papers Series, Department of Economics, Tufts University 0765, Department of Economics, Tufts University.
  11. repec:ipg:wpaper:19 is not listed on IDEAS

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