Stocks vs Bonds

Stocks versus Bonds: Explaining the Equity Risk Premium
Clifford S. Asness
From the 19th century through the mid-20th century, the dividend yield (dividends/price) and earnings yield (earnings/price) on stocks generally exceeded the yield on long-term U.S. government bonds, usually by a substantial margin. Since the mid-20th century, however, the situation has radically changed. In addressing this situation, I argue that the difference between stock yields and bond yields is driven by the long-run difference in volatility between stocks and bonds. This model fits 1871–1998 data extremely well. Moreover, it explains the currently low stock market dividend and earnings yields. Many authors have found that although both stock yields forecast stock returns, they generally have more forecasting power for long horizons. I found, using data up to May 1998, that the portion of dividend and earnings yields explained by the model presented here has predictive power only over the long term whereas the portion not explained by the model has power largely over the short term.

T

he dividend yield on the S&P 500 Index has long been examined as a measure of stock market value. For instance, the wellknown Gordon growth model expresses a stock price (or a stock market’s price) as the discounted value of a perpetually growing dividend stream:
D P = ------------- . R–G (1)

price dividends in Year 0 expected return annual growth rate of dividends in perpetuity Now, solving this equation for the expected return on stocks produces
D R = --- + G. P (2)

where P = D= R = G=

Thus, if growth is constant, changes in dividends to price, D/P, are exactly changes in expected (or required) return. Empirically, studies by Fama and French (1988, 1989), Campbell and Shiller (1998), and others, have found that the dividend yield on the market portfolio of stocks has forecasting power for aggregate stock market returns and that this power increases as forecasting horizon lengthens.

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