Which Component of Treasury Yields Belongs in Equity Valuation Models? An Application to the S&P 500

Abstract

Given a relaxation of the expectations hypothesis of interest rates and an estimate of the term premium, the remaining assumption that anticipated distant-horizon nominal expected short rates and projected earnings growth are equivalent implies novel cash-flow-based valuation models for shares. For example, an application of a simple dividend-discount framework to the S&P 500, under 600 alternative specifications (to avoid data mining), using a sample from January 1987 through January 2012, fits the data well. It suggests that the model errors correct; it also suggests the argument that estimated forward Treasury term premiums, not yields, belong in the discount factor.