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A Required Yield Theory of Stock Market Valuation and Treasury Yield Determination

Christophe, Faugere (2003): A Required Yield Theory of Stock Market Valuation and Treasury Yield Determination. Forthcoming in:

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Abstract

Stock market valuation and Treasury yield determination are consistent with the Fisher effect (1896) as generalized by Darby (1975) and Feldstein (1976). The U.S. stock market (S&P 500) is priced to yield ex-ante a real after-tax return directly related to real long-term GDP/capita growth (the required yield). Elements of our theory show that: 1) real after-tax Treasury and S&P 500 forward earnings yields are stationary processes around positive means; 2) the stock market is indeed priced as the present value of expected dividends with the proviso that investors are expecting fast mean reversion of the S&P 500 nominal growth opportunities to zero. Moreover, 3) the equity premium is mostly due to business cycle risk and is a direct function of below trend expected productivity, where productivity is measured by the growth in book value of S&P 500 equity per-share. Inflation and fear-based risk premia only have a secondary impact on the premium. The premium is always positive or zero with respect to long-term Treasuries. It may be negative for short-term Treasuries when short-term productivity outpaces medium and long run trends. Consequently: 4) Treasury yields are mostly determined in reference to the required yield and the business cycle risk premium; 5) the yield spread is largely explained by the differential of long-term book value per share growth vs. near term growth, with possible yield curve inversions. Finally, 7) the Fed model is partially validated since both the S&P 500 forward earnings yield and the ten-year Treasury yield are determined by a common factor: the required yield.

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