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Estimating the Equity Premium

  • John Y. Campbell

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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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. 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.
  2. John Y. Campbell, 1985. "Stock Returns and the Term Structure," NBER Working Papers 1626, National Bureau of Economic Research, Inc.
  3. 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.
  4. Jacob Boudoukh & Roni Michaely & Matthew Richardson & Michael R. Roberts, 2007. "On the Importance of Measuring Payout Yield: Implications for Empirical Asset Pricing," Journal of Finance, American Finance Association, vol. 62(2), pages 877-915, 04.
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  8. Campbell, John, 1996. "Understanding Risk and Return," Scholarly Articles 3153293, Harvard University Department of Economics.
  9. 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.
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  12. 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.
  13. 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.
  14. 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.
  15. 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.
  16. John Y. Campbell, 1992. "Intertemporal Asset Pricing Without Consumption Data," NBER Working Papers 3989, National Bureau of Economic Research, Inc.
  17. Campbell, John, 2001. "Why Long Horizons? A Study of Power Against Persistent Alternatives," Scholarly Articles 3196341, Harvard University Department of Economics.
  18. Eugene Fama & F. & Kenneth R. French, . "The Equity Premium."," CRSP working papers 522, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  19. 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.
  20. Robert F. Stambaugh, 1999. "Predictive Regressions," NBER Technical Working Papers 0240, National Bureau of Economic Research, Inc.
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