The Shape of the Expected Equity Risk Premium

Abstract

While there is significant evidence of a positive historical realized equity risk premium (ERP), it is less clear how equity returns have varied in different bond yield environments (the expected ERP). This paper explores historical expected ERPs across 16 countries from 1870 to 2015 leveraging the Jordà-Schularick-Taylor Macrohistory database. We find evidence that while future equity returns have been lower during periods of lower bond yields, the decline is less than would be implied by a constant expected ERP. The predictive significance of bond yields varies significantly depending on the future return metric considered (nominal return versus real return, as well as total return versus price return), as well as whether dividend yields and recent inflation are considered. Overall, these results suggest that while equity returns are likely to be lower in a low bond yield environment, they are not likely to be as low as a constant ERP would suggest, and that the overall relation is relatively noisy.