The Continued Forecasting Effectiveness of a Real Earnings Model of the Equity Premium

Abstract

This article empirically demonstrates the continued forecasting effectiveness of a simple theory modeling expected stock returns as the sum of the earnings yield on the S&P 500 (measured as the highest past annual earnings on the index divided by the current index value) and a market-based forecast of the inflation rate. Besides having retained its significant one-to-one relationship with subsequent excess annual stock returns, this model’s estimate of the equity premium is discovered to have a correlation of 0.85 with S&P 500 excess returns over subsequent five-year intervals ever since market data for the estimator became available in 1997.