The FED Model and Expected Asset Returns

The FED model and expected asset returns
Abstract
The earnings yield and long-term bond yields have been widely used to predict
asset returns. In this paper, I focus on the predictive role of the stock-bond
"yield gap" - the difference between the earnings yield and the 10 year Treasury
bond yield also know as the FED model, and which can be interpreted as a
long term yield spread of stocks relative to bonds. Conditional on other
forecasting variables, the yield gap forecasts positive excess stock returns,
both at short and long forecasting horizons, although the forecasting power is
greater at the near horizons. On the other hand, the yield gap forecasts
negative excess returns for bonds, at both short and long horizons. A VAR
variance decomposition for stock market returns, shows that shocks in the yield
gap are highly positively correlated with innovations in both future discount-rate
and cash flow news, confirming that the spread conveys information about
future earnings and returns. An investment strategy based on the forecasting
ability of the Yield gap produces higher Sharpe ratios than passive strategies in
both the market index and longterm bond. In the context of an equilibrium
multifactor ICAPM, the yield gap has some explanatory power over the cross
section of stock returns.
Keywords: Asset pricing; FED model; Earnings yield; Predictability of returns;
Stock and bond returns;
JEL classification: G11;G12; G14; E44
1
"The Feds model arrives at its conclusions by comparing the yield on the 10-year Treasury
note to the price-to-earnings ratio of the S&P 500 based on expected operating earnings in
the coming 12 months. To put stock and bonds on the same footing, the model uses the
"earnings yield" on stocks, which is the inverse of the P/E ratio. So while the yield on the
10-year Treasury is now 5.60%, the earnings yield on the S&P 500, based on a P/E ratio of
21, is 4.75%. In essence, the Feds model asks, why would anyone buy stocks with a 4.75%
earnings return, when they could get a bond with a 5.60% yield? "
Barrons online
The earnings yield and smoothed earnings yield have been widely used as predictors of
future stock market excess returns (Fama and French (1988), Campbell and Shiller (1988a,
2001)). In addition, yield spreads related to Treasury and corporate bond yields have also
been used for some time, to forecast asset returns (Fama and French (1989)).
In this paper, I focus instead on the yield gap, which corresponds to the difference between
the earnings yield on a stock market index, and the long term yield on Treasury bonds, which
is also known as the FED model. Despite the fact that this variable is widely referred in the
financial press, it is used by practioneers to forecast returns, and it is even referred in FED
publications, and has been used in official testimonies by FEDs chairman Alan Greenspan in
the recent years (to argue for the overvaluation of the stock market), little attention has be
devoted to it in academics, with the exception of Asness (2003).
This variable might be viewed as a simple measure of the yield spread of stocks versus
bonds, or a relative long-term rate of return of stocks against bonds. In fact, the earnings
yield, being the inverse of the price-earnings ratio can be interpreted as a equivalent long term
yield on stocks, analogous to the yield on long term bonds: If the earnings level were
constant, the price-earnings ratio would represent the number of years (earnings yield is
2
calculated based on annual earnings) needed for a very long term investor - who receives all
the earnings in the form of dividends or other forms of cash flow distributions - to recover its
investment (which corresponds to the price paid for the stock or the index level), by
accumulating annual earnings. Thus, the greater the price-earnings ratio is, the worst off the
investor is, since he will recover its investment (in terms of earnings), in a longer period of
time, and this corresponds to a lower earnings yield - the average long term yield for investing
in stocks. Naturally, this constitutes a simplification, since nominal and real earnings growth
over time, and the earnings growth rate is time-varying, and the investor receives only a
fraction of earnings as pay-out distributions. Nevertheless, it represents a simple
straightforward measure of the long term return on stocks.
By using the definition of returns, I derive a dynamic accounting decomposition for the yield
gap, as a function of future stock and bond returns, future dividend to earnings payout ratios
and future earnings growth, which provides the rationale for the predictive role of the yield gap
over asset returns.
The reminder of this paper is organized as follows. Section I presents the theoretical
motivation. Section II describes the data and variables. Section III presents the results for the
long-horizon regressions. Section IV produces an alternative short-term VAR estimation.
Section V analyzes non-linearities in the predictive role of the yield gap. Section VI evaluates
the economic significance associated with the predictive role of yield gap, and Section VII
explores the explanatory power for the cross section of average stock returns. Finally, Section
VIII concludes.
I. Theoretical framework
The Yield gap (YG) by representing the difference between the earnings yield and the long
term bond yield, it conveys information about both future expected stock and bond returns,
3
future dividends and future earnings. In the Appendix, I derive the following dynamic
accounting identity for YG,
YG
t
ln1
Et
Pt
y
nt
k

k
1
1
E
t
j0
j
r
t1j
1 de
t1j
e
t1j
1
b
1
b
n
E
t
j0
n1
b
j
r
b,nj,t1j
1
where k, k
, ,
and
b
are parameters of linearization defined in the Appendix, E
t
and P
t
in
the first equality, represent the earnings and price level associated with the stock market
index, respectively, and y
nt
is the log yield at time t of a bond with maturity n. Equation 1
says that high values of the Yield gap (earnings yield is high relative to the bond yield), are
associated with a expected combination of higher future stock returns r
t1j
, lower dividend to
earnings payout ratios de
t1j
, lower growth rate on future equity earnings e
t1j
and lower
future bond returns r
b,nj,t1j
. Thus, YG forecasts higher expected stock market returns and
lower expected bond returns, although with different weights as shown by equation 1. This
equation will be used to interpret the predictive regressions in the next sections, and does not
assume any behavior for asset prices, rather being based on the definition of returns and a
terminal condition that the log earnings to price ratio does not growth slower or faster than the
linearization parameter .
II. Variables and data
A. Data
Monthly data on prices, earnings and dividends associated with the Standard & Poors
(S&P) Composite Index is obtained from the website of Professor Robert Shiller. p is the log of
the S&P Composite Index, e is the log of the annual moving average of earnings, and d is the
log annual dividend. Return data on both the value-weighted R
vw
and equally-weighted R
ew
market index, and the 10 year Treasury bond R

b
is obtained from CRSP. Macroeconomic
4
and interest rate data, including the Federal funds rate, 10 year and 1 year Treasury bond
yields and the 3 month Treasury bill rate, are all obtained from the FRED II database,
available from the website of the St. Louis FED. The 1 month Treasury bill rate R
f,t1
is
obtained from the website of Prof. Kenneth French.
B. Construction of variables and summary statistics
The k horizon continuously compounded excess return is calculated as r
t1,tk
r
t1
. . . r
tk
,
where r
tj
lnR
tj
lnR
f,tj
is the 1 month log excess return, between dates t j 1 and
t j, R
tj
is the simple (not log) gross market return, and R
f,tj
is the gross risk-free rate (1
month treasury bill) at the beginning of period t j. The "Yield gap" is calculated as shown in
the last section, YG
t
EY
t
y
t
, with EY
t
ln1
Et
Pt
, representing the earnings yield, and
y
t
ln1 Y
t
is the log 10 year Treasury bond yield. The other forecasting state variables
known in period t, used to predict future excess returns, are the FED funds premium
(FFPREM), the term-structure spread (TERM), and the log market dividend yield (DY).
FFPREM is calculated as the difference between the FED funds rate and the 3-month
Treasury bill rate. TERM is the difference between the 10-year and 1-year Treasury bond
yields. The log dividend yield is calculated as DY
t
d
t
p
t
.
Table I reports descriptive statistics for excess returns, the forecasting state variables, and
the two components of YG, EY and y. By analyzing the correlation coefficients, one can see
that the two proxies for stock market excess returns are highly contemporaneously correlated
among themselves, but not significantly correlated with bond returns. The contemporaneous
correlation between YG and excess returns is negligible, and YG is positively correlated with
the earnings yield and negatively correlated with the bond yield, at similar magnitudes. The
first order autocorrelation coefficients show that the yield gap being a difference of two highly
persistent variables, has a slightly lower autocorrelation coefficient than both EY and y, but
5
nevertheless it is a very persistent variable. Nevertheless, all three variables - YG, EY and y -
are less persistent than the log dividend yield.
III. Long-horizon regressions
In this section I use Fama and French (1989) multivariate long-horizon regressions, to
access the explanatory power of the Yield gap spread (YG) over future excess returns. The
typical specification used is,
r
t1,tk
a
k
b
k
x
t
u
t1,tk
2
where r
t1,tk
is the continuously compounded market excess return over k periods, and x
t
is
a column vector of forecasting state variables known in time t. I use forecasting horizons of 1,
3, 12, 24, 36 and 48 months ahead. The compounded return r
t1,tk
is multiplied by 12/k,
where k is the forecasting horizon, in order for the slope coefficients b
k
to measure the
annualized effect of the state variable on excess returns.
For each regression, I conduct statistical inference based on both Newey-West and Hansen
and Hodrick (1980) asymptotic t-statistics, and also on a Bootstrap experiment. The
Newey-West standard errors are calculated using 5 lags. Whenever the variance-covariance
matrix associated with Hansen and Hodrick (1980) standard errors is not positive definite, I
substitute by the Newey-West standard errors calculated under the number of lags employed
by the Hansen-Hodrick estimator. The Bootstrap consists of 10,000 simulations for each
equation. Following Goyal and Santa-Clara (2003), I bootstrap the t-statistics instead of the
regression coefficients, applying the procedure for the Newey-West t-statistics. I bootstrap the
original regression residuals 10.000 times, and in each simulation, I draw the endogenous
variable (compounded excess returns) imposing the null of no predictability, i.e. the slope
coefficients in the regression are constrained to zero, and then run the regression and obtain
the associated Newey-West t-statistics. By this process, a empirical distribution of
6
Newey-West t-statistics is generated - as opposed to an asymptotic theoretical distribution -
which is then compared with the Newey-West t-statistic obtained from the data, calculating the
proportion of distribution t-statistics larger (in absolute value) than the original t-statistic, to
finally obtain the corresponding p-value for the null of no predictability of returns.
A. Predicting stock market returns
I conduct long horizon regressions with Yield gap as the sole forecasting variable (results
displayed in Table II, Panel A). The coefficient estimates with YG are positive at all horizons,
and the t-statistics indicate statistical significance, although for long horizons only
Newey-West t-statistics and bootstrapped p-values show significance, whereas at the 48
month horizon there is no significance. Thus, it seems that on a preliminary analysis, the yield
gap forecasts positive equity excess returns. On the other hand, the forecasting power of the
yield gap on excess returns declines gradually with the forecasting horizon: YG has a
coefficient estimate of 2.965 at the 1 month horizon comparing to 0.363 at the 4 year horizon.
The adjusted R
2
achieve the maximum values at the 12 month horizon regression, declining
thereafter. This estimates show that forecasting power of the yield gap is greater, and with
higher statistical significance, on the near horizons, being less relevant for forecasting more
distant ahead returns.
In Panels B and C, I add three forecasting state variables usually used in the predictability
of returns literature: The term structure spread (TERM), the spread between the Fed funds
rate and the treasury bill rate (FFPREM), which is a measure for both monetary policy actions
and short term interest rates, and the log market dividend yield (DY). Panel C includes the 3
variables, whereas Panel B includes only FFPREM and TERM, along with YG. It is important
to control for these variables, since YG is correlated with them, in particular both TERM and
YG depend on the 10 year bond yield, and both the log dividend yield and log earnings yield
7
are correlated. Hence, one needs to check if the predictive power of YG is maintained after
the inclusion of those variables.
This will be my benchmark regression throughout the paper,
r
t1,tk
a
k
b
k1
FFPREM
t
b
k2
TERM
t
b
k3
DY
t
b
k4
YG
t
u
t1,tk
3
The results in Panel B show that when one controls for both FFPREM and TERM, the
magnitude of the yield gap estimates (and the associated t-statistics), actually increases
relative to the single variable forecasting regression, especially on the short-term horizons
(until 1 year): At k1, the YG coefficient is 3.889 and at k48, the corresponding estimate is
0.778. In addition the YG estimates are strongly significant (1% level) for all horizons, as
indicated by the Newey-West t-statistics and p-values from the bootstrap experiment. The
pattern of coefficients magnitudes is the same as in Panel A, with the estimates declining in a
monotonic way with the forecasting horizon.
In Panel C, by adding the log dividend yield (DY), the YG coefficient estimates decline in
magnitude relative to Panels A and B. Nevertheless YG is significant at the 5% level for
horizons until 12 months. In fact, the dividend yield being a very persistent variable, has a
forecasting power over returns which increases with horizon, which is in part due to the mean
reversion of stock prices (the denominator) in the medium and long term. Since in addition DY
is correlated with the earnings yield (EY) and hence YG, the predictive power of the variables
is overlapped, and the higher persistence of DY makes it a better forecaster for long-horizon
returns, than YG.
In Table III, I replicate the long-horizon regressions for the equally-weighted market return
r
ew
as the variable to be forecasted. The results for the univariate case in Panel A, show that
compared to the corresponding regression for the value-weighted market index r
vw
, the
forecasting power of YG is greater at all horizons: At k1 the estimate is 4.763, and at k48
8
we have an estimate of 1.647. The t-statistics are also higher than the corresponding ones for
r
vw
, showing statistical significance at the 1% level, at all forecasting horizons. The adjusted
R
2
s are also higher than the corresponding values in the equation for r
vw
, at all horizons: At
k1, the R
2
is 0.022 (0.013 for r
vw
), and at k48, we get a value of 0.163 compared with only
0.013 for r
vw
. Similarly, to the case of value-weighted returns, the forecasting power of YG is
stronger on the short horizon, with the coefficient estimates declining monotonically with
horizon. The results in Panels B and C, show that by adding the control variables, YG remains
strongly significant (1% level) at all forecasting horizons, whereas the log dividend to price
ratio (DY) has no predictive power over the return on the equally-weighted index.
These results showing that the yield gap has greater forecasting power for the
equally-weighted relative to the value-weighted market excess returns, combined with the fact
that the equally weighted index is more tilted towards small caps relative to big caps, suggests
that YG has greater forecasting power for small caps excess returns, relative to large
capitalization stocks.
B. Predicting bond returns
Equation 1 above suggests that current values of Yield gap are negatively correlated with
expected future bond returns. I investigate this hypothesis, by running the long-horizon
regressions with the 10 year Treasury bond excess return as the variable to be forecasted,
which results are presented in table IV. The results in Panel A, confirm that the yield gap is
negatively correlated with future bond excess returns, at all forecasting horizons. The
coefficient estimates exhibit a hump-shaped pattern, with the magnitudes peaking at k12,
and then declining gradually. The forecasting power as measured by the coefficient
magnitudes associated with YG, is lower when compared with the regressions for the
value-weighted market return r
vw
for horizons until 1 year, being nevertheless higher for
9
longer horizons. In terms of statistical significance the coefficients are very significant (at the
1% significance level), even for long horizons, which didnt happen in the long-horizon
regressions for r
vw
. The adjusted R
2
s increase with the horizon and are higher than the
corresponding values in the regressions for the value-weighted market return. Panels B and
C, present the results for the regressions including the control forecasting variables. In Panel
C, DY is significant for the longer horizons, which confirms Fama and French (1988) that the
dividend yield helps to predict long-horizon returns on both stocks and bonds. On the other
hand, the effect of the term structure spread (TERM) on future bond returns is not significant
in both Panels B and C, a fact that should be related with the presence of YG, which overlaps
the forecasting role of TERM, since the two variables are correlated. After accounting for the
control variables, the YG coefficients maintain the statistically significance, and even increase
in magnitudes at all horizons, relative to the estimates in Panel A. Overall these results
suggest that conditional on other forecasting variables, YG is negatively correlated with future
bond excess returns.
Common to the predictive regressions of both stock market and bond returns is that the
forecasting power of Yield Gap is greater in the near horizons (horizons until 1 year), than for
long horizons. In order to analyze this issue, I estimate long horizon regressions for the
components of the Yield Gap - the earnings yield (EY) and the log bond yield (y) - which
results presented in Table V. In the case of the value-weighted market return (Panels A and
B) , the estimates associated with the Earnings yield, have a hump-shaped pattern, peaking at
k12, and declining thereafter, which leads to a similar pattern in the forecasting ability of the
Yield gap. In the case of the bond return (Panels C and D), the responsible for the lower
forecasting power of YG at long horizons, is the slightly lower coefficient estimates associated
with the log bond yield, at more distant horizons, compared with the short-term forecasts.
10
IV. A short-term VAR analysis
A. A short-horizon VAR alternative to long-horizon regressions
Following the work of Campbell and Shiller (1988a,b), Campbell (1991) and Hodrick (1992),
an alternative to long-horizon regressions is to estimate a short-horizon VAR, and obtain
implied long-horizon coefficient estimates and implied statistics which are a non-linear
function of the VAR parameters. This approach is likely to have better finite sample properties
than the long-horizon regressions, given the more data used in the estimation. I estimate the
VAR-analogue to the benchmark long-horizon regression in specification 3.
Let Z
t
represents a vector of the variables contained in the VAR, with
Z
t
FFPREM
t
, TERM
t
, DY
t
, YG
t
, r
m,t
where r
m,t
is the 1 period log excess return for the market
index. All the variables in the VAR are demeaned. I estimate a first order VAR, nevertheless
irrespective of the number of lags in the VAR, one can always write it in companion form as a
first-order VAR,
Z
t1
AZ
t

t1
4
where A is the VAR coefficient matrix 5X5, and
t1
is the vector of errors 5X1.
Following Hodrick (1992), an alternative to the slope coefficients in the long horizon
regression are the estimators implied by the VAR,
b
l
k
e1
C1...Ckel
el
C0el
5
where the unconditional variance of Z
t
is given by
C0

j0
A
j
VA
j
whith V E
t1
t1
representing the variance-covariance of the VAR errors. Cj, the

jth-order autocovariance of Z
t
, is given by Cj A
j
C0. e1 and el are indicator vectors that
take a value of one in the cell corresponding to the position in the VAR, of the excess returns
11
and any of the forecasting variables we are analyzing, respectively, e.g., e1 0, 0, 0, 0, 1
.
The implied long horizon R
2
from the VAR is given
R
2
k 1
e1
W
k
e1
e1
V
k
e1
6
where
V
k
kC0
j1
k1
k jCj Cj
represents the variance of the sum of k consecutive Z

t
s, and e1
W
k
e1 is the innovation
variance (variance not explained by the VAR variables) of the sum of k consecutive returns,
with
W
k

j1
k
I A
1
I A
j
VI A
j
I A
1
The implied variance ratio statistic which compares with Lo and Mackinlay (1988) and
Poterba and Summers (1988) variance ratio statistics, is derived as
VRk
e1
V
k
e1
ke1
C0e1
7
The variance ratio should be equal to 1 if returns were i.i.d., since in that case, with zero
covariances, the variance of the sum of k consecutive returns is equal to k times the variance
of one return. If the ratio is above 1, this is a sign of positive autocorrelation in returns
(momentum), whereas a ratio below 1, is evidence of negative autocorrelation in realized
returns (mean reversion in returns).
In order to compute the asymptotic standard errors associated with the long-horizon
coefficients b
l
k, I use the non-linear GMM distribution theory, as in Hodrick (1992),
T
T
0
~N0,
T Hp
T
Hp
0
~N0,
Hp
T
p
T

Hp
T
p
T
8
where Hp
0
and Hp
T
represent b
l
k as a function of the population and sample
estimation values of the parameters from the VAR, respectively. includes the slope
12
coefficients A and the variance-covariance of the VAR errors V.
H
T
T
denotes the gradient of
H evaluated at
T
, which is estimated numerically. The first 25 moment orthogonality
conditions from the vector of moments, deliver the OLS estimates of A, and the remaining
ones correspond to the distinct elements of E
t1
t1
V 0. I compute Newey-West
standard errors associated with this GMM system, thus allowing for serial correlation between
the different moments.
Table VI presents the results for the implied long-horizon coefficients, implied long horizon
R
2
and variance-ratio statistics derived from the VAR, corresponding to the excess returns on
the value weighted market index (Panel A) and equally weighted market index (Panel B).
Comparing the results in panel As VAR concerning r
vw
, with the corresponding
long-horizon regressions in Table II, Panel C, the implied YG estimates are of lower
magnitude in the very short term horizons (1 and 3 months), but higher in the remaining
forecasting horizons, and both the t-statistics and bootstrapped p-values indicate higher
statistical significance for horizons beyond 12 months. The implied t-statistics associated with
YG are higher than the t-statistics for DY at all horizons, contrary to what happened in the
long-horizon regressions, where for horizons bigger than 24 months, DY was more significant
than YG. The implied slopes on lagged excess returns are positive at all horizons, indicating
the existence of momentum in stock prices. The implied R
2
associated with the excess return
equation in the VAR, are also higher than the corresponding values in the long-horizon
regressions, at all horizons. The implied variance ratio statistics are higher than 1 for horizons
beyond 3 months, thereby indicating the existence of momentum in value-weighted market
excess returns, as implied by the VAR, and confirming the coefficient estimates associated
with lagged market returns.
The VAR estimation results for r
ew
presented in Panel B, show that the implied long-horizon
13
coefficients for YG are lower than the corresponding long-horizon coefficients, at the near
forecasting horizon (1 and 3 months), but for the remaining horizons, the implied VAR
estimates have higher magnitudes, similarly to the VAR for r
vw
. In terms of statistical
significance, the YG estimates are strongly significant as shown by both t-statistics and
p-values from Bootstrap simulation, whereas the estimates associated with DY are not
significant in what concerns the bootstrap experiment. Following the results obtained for the
long-horizon regressions, the implied estimates for YG confirm that this variable has bigger
forecasting power for equally-weighted compared to value-weighted market returns. The
implied R
2
are also higher than the corresponding values for the long-horizon regressions, as
for the case of r
vw
. The implied variance ratio statistic achieves 1.828 at k48, indicating a
higher degree of momentum in r
ew
as compared to r
vw
, which suggests that small caps have
higher momentum than big caps.
Overall, the implied estimates from the first-order VAR confirm and even strengthen the
forecasting power of YG over returns associated with the long-horizon regressions.
B. Variance decomposition: The impact of discount rate news and cash-flow news
Following the work of Campbell and Shiller (1988a,b) and Campbell (1991), I employ a
log-linear approximate decomposition for unexpected excess returns:
r
t1
E
t
r
t1
E
t1
E
t
j0
j
d
t1j
E
t1
E
t
j1
j
r
t1j
N
CF,t1
N
DR,t1
9
where N
CF,t1
and N
DR,t1
represent news about future cash flows, and news about future
discount rates, respectively. This dynamic accounting identity which results from the definition
of market return, states that positive innovations in current returns are associated with
expectations of rising future dividends/cash flows and/or expectations of declining future stock
market returns. Thus, this identity makes clear the negative correlation between realized
returns and expected returns.
14
The unobserved components of market returns, N
CF,t1
and N
DR,t1
can be derived in the
context of the VAR in equation 4, as functions of the VAR residuals,
N
CF,t1
E
t1
E
t
j0
j
d
t1j
e1
e1
AI A
1
t1
10
N
DR,t1
E
t1
E
t
j1
j
r
t1j
e1
AI A
1
t1
11
Using equation 9, the variance of unexpected excess returns can be decomposed as
varr
t1
E
t
r
t1
varN
CF,t1
varN
DR,t1
2covN
DR,t1
, N
CF,t1
12
and we can compute each of the three components in proportion of varr
t1
E
t
r
t1
, to
produce a variance decomposition for stock market returns.
The results for this variance decomposition analysis are presented in Table VII. The results
for the value-weighted index (Panel A), show that the variance of discount-rate news
represents 0.986 of the total market variance, whereas cash-flow news have a weight of
0.378, thus confirming previous evidence that discount rate news is the main driver of stock
market volatility (Campbell (1991), Campbell and Ammer (1993), Campbell and Vuolteenaho
(2004)). The two variances sum up to more than 1, since the covariance between the two
components has a negative contribution (-0.364) for the overall market variance.
By analyzing the correlations of shocks in the individual VAR state variables with both
discount rate and cash flow news, we can see that innovations on the market return are
strongly negatively correlated with discount-rate news and weakly positively correlated with
cash-flow news, thus confirming the predictions of the dynamic identity in equation 9.
Shocks in the log dividend yield are highly positively correlated with discount rate news and
almost uncorrelated with cash flow news, which is consistent with the following decomposition
for innovations in the log dividend to price ratio, derived in the Appendix,
E
t1
E
t
d
t1
p
t1

1
E
t1
E
t
j1
j
d
t1j

1
E
t1
E
t
j1
j
r
t1j
13
Innovations in the Yield gap are highly positively correlated with discount rate news
15
(correlation coefficient is 0.776), and on the other hand, they are also positively correlated
with cash flow news. The fact that YG is positively correlated with discount rate news arises
from the positive correlation of the earnings yield (similarly to the dividend yield) to future
returns, and reflects mean reversion in stock prices. The fact that YG is also positively
correlated with cash flow news might be attributable to a negative correlation between current
shocks in log bond yields and future cash flows.
The variance decomposition for the equally-weighted market return, presented in Panel B,
shows that both discount rate news and cash flow news account for more than 100% of the
total market variance, which is possible since the covariance between the two news
components represents -1.819 of the overall variance. Furthermore, the variance of discount
rate news is only marginally higher than the variance of cash flow news. Since the equally
weighted index assigns an equal weight for all stocks, this result is consistent with
Vuolteenaho (2002), who found that for individual stocks, the variance of cash flow news is
higher than the variance of individual expected return news. In what concerns the correlations
between shocks in the VAR state variables and the news components, we have that
innovations in the dividend yield (market return) are only weakly positively (negatively)
correlated with discount rate news. This confirms the results for the long-horizon regressions,
in that the dividend yield does not help in forecasting the equally-weighted market return, and
it is a consequence of less mean reversion for the equally weighted index. On the other hand,
shocks in market return are weakly positive correlated with cash-flow news, and thus, part of
the rise in current market returns are due to an improvement in future earnings. Finally, YG is
strongly positively correlated with discount rate news (correlation of 0.965) and also correlated
with future cash flows.
The results of this subsection seem to confirm that innovations in the Yield gap are
important to explain the two unobserved components of market returns - Cash flow and
16
discount rate news.
V. Non-linear effect of the Yield gap in expected excess returns
One interesting issue to analyze, is to check whether there is an asymmetric relation in the
predictive role of the yield gap over future excess returns, namely if the magnitude of the
correlation between YG and future excess returns changes with the sign of Yield gap: Is the
forecasting power of future returns greater in periods where the yield gap is positive (earnings
yield higher than the long term bond yield), as opposed to periods where YG is negative (long
term bond yield higher than the earnings yield), or vice-versa?
To answer this question, I construct one indicator variable, DYG, that assumes the value 1
when YG
t
0, and 0 otherwise. Then, I perform the following long-horizon regression, which
corresponds to an augmented version of specification 3:
r
t1,tk
a
k
b
k1
FFPREM
t
b
k2
TERM
t
b
k3
DY
t
b
k4
YG
t
DYG
t
b
k5
YG
t
1 DYG
t
u
t1,tk
14
I estimate this regression for both the value-weighted market return and 10 year bond
return, and the results are presented in table VIII. In what concerns the value weighted market
excess returns (panel A), we can see that at short horizons (1 and 3 months), the effect of YG
on future excess returns is higher when YG is negative: At k1, the estimate associated with
YG
t
1 DYG
t
is 6.056 versus 1.232 for YG
t
DYG
t
and 3.131 for YG in the benchmark
regression 3, although only the p-values from the bootstrap simulation indicate statistical
significance at the 5% level. For horizons beyond 12 months, we get the reverse relation, i.e.,
the coefficients in YG
t
DYG
t
are higher than the ones on YG
t
1 DYG
t
, and also higher than
the corresponding coefficients associated with YG in the benchmark regression 3: At k12,
the estimate on YG
t
DYG
t
is 2.011, and at k48 the coefficient is 1.106, compared to 0.501 and
-1.181 for YG
t
1 DYG
t
. The t-statistics associated with YG
t
DYG
t
, indicate statistical
significance at the 5% level, for horizons between 12 and 48 months ahead. These results
17
constitute evidence in favor of an asymmetric relation between the yield gap and future
market excess returns: At short horizons, the forecasting power is greater when the ratio
assumes negative values, while at longer horizons, the forecasting power is bigger when the
yield gap is positive. In addition, the negative estimates associated with YG
t
1 DYG
t
for
longer horizons, help to interpret the low forecasting power of YG at longer horizons, since the
sum of positive and negative influences zero out, and the overall predictive power of YG is
small.
The estimation for bond excess returns presented in panel B, show somehow different
results. I found that, when the yield gap is negative, the forecasting power over future excess
bond returns, is greater than when YG is positive, at all horizons, as indicated by the
coefficients on YG
t
1 DYG
t
which are of higher magnitude (absolute value) compared with
YG
t
DYG
t
estimates, at all horizons. The higher forecasting power of YG
t
1 DYG
t
is
especially relevant at longer horizons. Thus for bond returns, contrary to stock market returns,
negative values of the yield gap, have greater forecasting power than when the variable is
positive.
Similar to other forecasting state variables like the dividend yield or the default spread, the
Yield gap is negatively correlated with the business cycle. By using a business cycle dummy
(CYCLE), which takes the value 1 in an economic expansion as defined by the NBER, and
takes value 0 in recessions, and performing a monthly regression of YG on CYCLE, I get the
following results (OLS t-statistics in parenthesis),
YG
t
0. 008 0. 010CYCLE
t
Adj. R
2
0. 022
3. 268 3. 825
Given the countercyclical nature of YG, it is possible that its forecasting role over asset
returns, changes with the state of the business cycle, i.e. differs between economic
expansions and recessions. In order to evaluate this hypothesis, I specify the following
18
regression,
r
t1,tk
a
k
b
k1
FFPREM
t
b
k2
TERM
t
b
k3
DY
t
b
k4
YG
t
CYCLE
t
b
k5
YG
t
1 CYCLE
t
u
t1,tk
15
and the estimation results are presented in Table IX. In what concerns the value-weighted
market return (Panel A), the coefficient estimates associated with YG
t
1 CYCLE
t
are higher
relative to the estimates associated with YG
t
CYCLE
t
, at all forecasting horizons. Hence, the
predictive power of YG over stock market returns is greater in recessions than in economic
expansions. The results for the bond return (Panel B), show that the coefficient estimates
associated with YG
t
CYCLE
t
have higher magnitudes compared to YG
t
1 CYCLE
t
, thus in the
case of bond return, the forecasting power of YG is greater in expansions compared to
recessions, in opposition with the result for stock market returns.
Another potentially relevant question to address concerning the forecasting role of the yield
gap, is to measure how much of the forecasting power of YG over returns, comes from
predicting positive versus negative excess returns. In order to analyze this issue, I conduct a
regression similar to specification 14, using a dummy variable DR
t
that assumes the value 1
when future excess returns are positive, and zero otherwise. Thus, the interaction terms
YG
t
DR
t
(YG
t
1 DR
t
) measure the impact of YG on future returns, when future returns are
positive (negative). The regression to be estimated is,
r
t1,tk
a
k
b
k1
FFPREM
t
b
k2
TERM
t
b
k3
DY
t
b
k4
YG
t
DR
t
b
k5
YG
t
1 DR
t
u
t1,tk
16
The results for the value-weighted market r
vw
and bond returns r
b
are presented in Table
X, panels A and B respectively. The regression for r
vw
show that the coefficients on
YG
t
1 DR
t
are higher than the corresponding estimates on YG
t
DR
t
, at all horizons, being
also higher than the comparable YG estimates in Table II, Panel C. The t-statistics associated
with YG
t
1 DR
t
indicate statistical significance at the 5% level for all the horizons, while YG
in the benchmark regression 2 was not significant for longer horizons. The adjusted R
2
s also
19
compare favorably with the ones in the benchmark regression at all horizons. The estimates
associated with YG
t
DR
t
are positive at all horizons, but not statistically significant. Thus, it
seems that the forecasting power of the yield gap over stock returns is more attributable to
predicting negative excess returns into the future, relative to positive excess returns. Another
feature from the results in Panel A, is that the dividend yield is no longer significant at longer
horizons (36 and 48 months).
The results for bond returns, reported in panel B, show a different picture. In terms of
magnitudes, YG
t
DR
t
have higher coefficients and associated t-statistics than YG
t
1 DR
t
at
horizons between 1 and 24 months, and similar estimates for horizons, k36,48.
Nevertheless, YG
t
1 DR
t
is statistically significant for horizons beyond 12 months.
As was the case with the results for the value weighted market return, YG
t
DR
t
coefficients
are higher than the YG estimates for the benchmark regression, at all horizons. Thus, most of
the predictability of the yield gap over future bond returns comes from predicting positive
excess returns. Nevertheless, it must be pointed out that YG
t
1 DR
t
coefficients although
exhibit lower magnitude, are still negative at all horizons, and highly significant for horizons
beyond 12 months. Therefore, the Yield gap also forecasts negative bond returns at longer
horizons.
The combination of these results for both stock index and bond returns, suggest that the
biggest forecasting power of the yield gap is over the return of a portfolio long in bonds and
short in the market index.
VI. Economic Significance
In this section, I try to evaluate the economic significance of the predictive power of Yield
Gap over both stock market and bond returns. Following Goyal and Santa-Clara (2003), I
20
define an "active" trading strategy, based on the out-of-sample 1 month ahead predicting
power of the Yield gap and other state variables, over returns. At each time t, I conduct the 1
month predictive regression,
r
t1
a
k
b
k
x
t
u
t1
17
and the forecasted excess returns are calculated as r
t1

k
b
x
t
, where
k
and b
k
are the
estimated coefficients from the above regression, and r
t1
denotes excess returns on the risky
asset (stock index or bond). Then, the strategy allocates 100% in the risky asset if the
forecasted excess returns r
t1
are positive, and otherwise, it invests 100% in the risk-free
rate. In symbols, the strategy can be written as
S
t

o 1 if r
t1
0
o 0 if r
t1
0
18
At time t 1 the realized return associated with the trading strategy, is given by
r
p,t1
or
t1
1 or
f,t1
19
By iterating this process forward and using an expanding sample for the predictive
regressions, I generate a time-series of realized returns on the trading strategy, which are
compared to a "passive" investment strategy ("buy-and-hold") that invests either in the stock
index or long term bond. I calculate this strategy for the value-weighted market index,
equally-weighted index and bond returns, as proxies for the risky asset. In order to have an
initial sample of 60 months to conduct the first predictive regression, the active strategy starts
at 1959:07.
In addition, I consider the case of an investor who invests simultaneously in stocks and
bonds. His trading strategy is given by
S
t

o
m
o
b
0 if r
m,t1
0, r
b,t1
0
o
m
1, o
b
0 if r
b,t1
r
m,t1
0
o
m
0, o
b
1 if r
m,t1
r
b,t1
0
20
21
and the associated realized returns are given by
r
p,t1
o
m
r
m,t1
o
b
r
b,t1
1 o
m
o
b
r
f,t1
21
If the excess returns on both stocks and bonds are negative, the investor allocates 100% in
the risk-free rate; if the excess returns on the stock index are higher than the bond excess
return, he invests 100% in the stock index, and otherwise he allocates 100% to bonds. This
trading strategy is compared with a passive "buy-and-hold" investment strategy that allocates
equal weights to both the stock index and long term Treasury bond.
The results for the trading strategy simulation are presented in Table XI. Panels A, B and C
offer the results for the "one risky-asset strategy", where the investor allocates either in the
value-weighted index, equally-weighted index or the long term bond, respectively, in addition
to the risk-free rate. Panels D and E contain the results for the "two risky-asset strategy",
where the investor chooses among both the value-weighted index and long maturity bond
(Panel D), or both the equally-weighted index and long maturity bond (Panel E), in addition to
the risk-free rate. The passive strategy "buy-hold" is compared with a trading strategy based
on three sets of conditioning state variables: our benchmark regression which contains
FFPREM, TERM, DY and YG; the "reduced" benchmark regression which excludes DY, and
the single predictive regression, where YG is the sole forecaster of asset returns. In each
panel, are presented the average return, standard deviation and Sharpe ratio (ratio of average
return to standard deviation) for each strategy.
For the value-weighted index, the trading strategies based on the benchmark regression
and reduced benchmark regression, produce higher average returns and lower volatilities
than the passive strategy, and therefore, have higher Sharpe ratios associated. In the case
where the conditioning set is restricted to the Yield Gap, the active strategy has similar
average returns, but lower standard deviation than the passive strategy, and this leads to a
rise in the Sharpe ratio of nearly 0.1% on a monthly basis, which translates to a 1.2% gain
22
annually. For the equally-weighted index, the Sharpe ratios are slightly higher than in Panel A,
as a result of the higher average returns despite the higher volatility associated with the
trading strategies. The trading strategy based on YG produces a larger gain in the Sharpe
ratio relative to the passive strategy, than in Panel A, in consequence of both an increase in
average return and lower volatility. For the long maturity bond, the active strategy exhibits
both higher average returns and lower volatilities - and hence higher Sharpe ratios - when
compared to the passive strategy. Notice that the trading strategy based on YG has a higher
Sharpe ratio than the strategy associated with the bigger conditioning set - FFPREM, TERM,
YG.
In the case where investment opportunities depend of 2 risky assets (Stock index and long
maturity bond), the "active" trading strategies produce higher Sharpe ratios than the passive
"long" strategy which allocates half weights to both the stock index and long maturity bond.
This result is robust for both measures of stock market return, value-weighted and
equally-weighted index. The rise in the Sharpe ratio, arises from higher average returns,
which more than compensates the higher volatility associated with the trading strategies. It is
remarkable, to note that the trading strategy conditioning only on YG has higher Sharpe ratios
than the strategies based on the larger information sets. This is a confirmation, that YG has a
higher forecasting power over both stock and bond returns - both in and out of sample - at
short forecasting horizons, when compared with the other state variables.
The results in the last section show that there is evidence in favor of asymmetries in the
forecasting role of YG over the returns of both the market index and long term bond. More
specifically, the biggest forecasting power of YG is over positive excess bond returns and
negative excess stock returns. Thus, I extend the above strategies to take into account the
possibility of short-selling both stocks and bonds. In the case where the investor chooses
23
among one risky asset and the risk-free rate, the active trading strategy is given by
S
t

o 1 if r
t1
0
o 1 if r
t1
0
22
where the investor allocates 100% to the risky asset if its forecasted excess return is
positive, and otherwise, he sells short the risky asset and invests the proceedings in the
risk-free asset.
In the case where the investor chooses among stocks, bond and the risk-free rate, the
strategy is as follows,
S
t

o
m
1, o
b
0 if r
m,t1
r
b,t1
0
o
m
0, o
b
1 if r
b,t1
r
m,t1
0
o
m
1, o
b
0 if 0 r
b,t1
r
m,t1
o
m
0, o
b
1 if 0 r
m,t1
r
b,t1
o
m
1, o
b
1 if r
m,t1
0, r
b,t1
0
o
m
1, o
b
1 if r
b,t1
0, r
m,t1
0
23
In this strategy, if the predicted excess returns on both stocks and bond are positive, the
investor allocates 100% for the asset with the highest forecasted return and if the forecasted
excess returns are both negative, the strategy consists of selling short the asset with the
lowest predicted return and invest the proceedings in the risk-free rate. Finally, if one asset
has positive - and the other asset negative - forecasted returns, the investor allocates 100% to
the former one, sell-short the last one, and invest the proceedings at the risk-free rate.
The results associated with the strategies involving short-sales are presented in Table XII.
For both the value-weighted and equally-weighted market index, the trading strategies have
higher Sharpe ratios than the passive strategy, in result of higher average returns which
overstates the rise in the associated volatility. Similar to Table XI, the equally weighted index
has higher out of sample predictability, as indicated by the Sharpe ratios, compared to the
value-weighted index. In the case of bond returns, the three trading strategies have also
24
higher Sharpe ratios than the passive strategy. For the augmented scenario with two risky
assets, the trading strategies are more profitable than the passive strategy. The main
difference associated with the strategies that allow short sales, is that the Sharpe ratios are in
general lower, than the corresponding values in Table XI, which is the result of the higher
volatility associated with the trading strategies when short-sales are available, despite the
increase in average returns.
Overall, the results of this simulation indicate that YG has both in and out of sample
predictive power over stock and bond returns and this forecasting power is significantly
relevant in terms of asset allocation/portfolio choice, as showed by the gains in the Sharpe
ratio.
VII. The Yield gap and the cross-section of returns
According to Mertons (1973) ICAPM, state variables that predict future investment
opportunities or market returns, should act as risk factors that price the cross-section of
ex-post average returns. Campbell (1993) derives a discrete-time ICAPM, where the factors
are the market return and news on future market returns (discount-rate news), and Campbell
(1996) derives an equivalent k factor ICAPM, using as factors the innovations on state
variables that help to forecast market returns. Recently, and using the same basic framework
as Campbell (1993, 1996), there has been some new versions of the ICAPM, e.g., Chen
(2003), Campbell and Vuolteenaho (2004) and Maio (2005a,b). Given the evidence in the
previous sections, that the yield gap helps to forecast market returns, then in the ICAPM
context, it must be a factor that explains the cross-section of returns.
Following Campbell (1993, 1996), I use an Epstein and Zin utility function,
U
t
1 oC
t
1,
0
oE
t
U
t1
1,
1
0

0
1,
24
25
where 0
1,
1
1
, is the elasticity of intertemporal substitution, , is the relative risk aversion

parameter, o is a time discount factor, and C
t
denotes consumption. This utility function has
the advantage of allowing to separate and ,, contrary to the power utility function, where
is the reciprocal of ,. The stochastic discount factor (SDF) associated with the objective
function 24 is equal to
M
t1
o
0
C
t1
Ct

1
R
m,t1
10
25
where R
m,t1
denotes the simple return on market wealth. The corresponding log SDF is
given by,
m
t1
0lno
0
c
t1
1 0r
m,t1
26
By summing and subtracting both
0
E
t
c
t1
and 1 0E
t
r
m,t1
yields,
m
t1
E
t
m
t1

0
c
t1
E
t
c
t1
1 0r
m,t1
E
t
r
m,t1
27
where E
t
m
t1
0lno
0
E
t
c
t1
1 0E
t
r
m,t1
, and making use of the fact that
c
t1
E
t
c
t1
c
t1
E
t
c
t1
. Substituting c
t1
E
t
c
t1
by its expression derived in the
Appendix, it follows
m
t1
E
t
m
t1

0
r
m,t1
E
t
r
m,t1
1 r
t1
H
1 0r
m,t1
E
t
r
m,t1
E
t
m
t1
,r
m,t1
E
t
r
m,t1
1 ,r
t1
H
28
where the last equality follows from substituting the expression for 0. If we substitute news
in future discount rates for its expression in equation 11 above,
r
t1
H
E
t1
E
t
j1
j
r
m,t1j
e1
AI A
1
t1

t1

k1
K
k
c
k,t1
29
we have,
m
t1
E
t
m
t1
,r
m,t1
E
t
r
m,t1
1 ,
k1
K
k
c
k,t1
30
where
k
is the kth element of
e1
AI A
1
and c
k,t1
is the kth element of the VAR
error vector
t1
. By letting the market return be positioned last in the VAR state vector, i.e.,
E
t1
E
t
r
m,t1
c
K,t1
, it follows,
26
m
t1
E
t
m
t1
1 ,
k1
K1
k
c
k,t1
1 ,
K
,c
K,t1
31
Finally, by substituting the VAR error vector
t1
c
FFPREM,t1
, c
TERM,t1
, c
DY,t1
, c
YG,t1
, c
m,t1
corresponding to the state vector in section IV, the log SDF is given by,
m
t1
E
t
m
t1
1 ,
1
c
FFPREM,t1

2
c
TERM,t1

3
c
DY,t1

4
c
YG,t1
1 ,
5
,c
m,t1
32
By Making f
t1
c
FFPREM,t1
, c
TERM,t1
, c
DY,t1
, c
YG,t1
, c
m,t1
and
b b
1
, b
2
, b
3
, b
4
, b
5
1 ,
1
, 1 ,
2
, 1 ,
3
, 1 ,
4
, 1 ,
5
,, and using
Theorem 1 in the Appendix, one has the following asset pricing model,
Er
i,t1
r
f,t1

o
i
2
2
, 1
1
o
i,FFPREM

2
o
i,TERM

3
o
i,DY
4
o
i,YG
, 1
5
,o
i,m
33
where o
i,m
Covr
i,t1
, c
m,t1
represents the covariance of the return of asset i with
innovations in the market return and similarly for the other factors. Equation 33 represents a
5 factor equilibrium asset pricing model, similar to Campbell (1996), where the factors are the
innovations in the state variables used to forecast stock market returns, in the spirit of Merton
(1973). The factor risk prices are theoretically constrained, and variables which have higher
forecasting power over market returns (as measured by the respective elements of ) have
higher risk prices. The risk prices also depend on the coefficient of relative risk aversion ,,
which is the only parameter to be estimated in the cross-section of returns. More specifically,
a factor which has a large positive element of associated, will be highly positively correlated
with future investment opportunities, and will demand a high positive risk price, if investors are
risk averse , 1. In the case of the innovations in market return, for a risk-averse investor,
the risk price will be below the risk aversion parameter, if
5
0 as suggested by the results
in Table VII.
Since most asset pricing models are estimated and evaluated in terms of factor betas risk
prices, we can restate equation 33 in terms of single regression betas, by multiplying and
dividing each covariance by the associated factor variance,
27
Er
i,t1
r
f,t1

o
i
2
2
, 1
1
o
FFPREM
2
[
i,FFPREM

2
o
TERM
2
[
i,TERM

3
o
DY
2
[
i,DY
4
o
YG
2
[
i,YG
, 1
5
,o
m
2
[
i,m
34
where o
m
2
Varc
m,t1
, and similarly for the other factors. The risk prices for betas can be
derived from 33, by z
FFPREM
, z
TERM
, z
DY
, z
YG
, z
m

f
b, where
f
is a diagonal matrix
with the factor variances on its main diagonal.
A natural econometric framework to use in estimating and testing the asset pricing model
33, is first-stage GMM using as weighting matrix the identity matrix, where the N sample
moments correspond to the pricing errors for each of the N test assets at hand,
g
T
b

1
T

t1
T
r
i,t1
r
f,t1

o
i
2
2
, 1
1
o
i,FFPREM

2
o
i,TERM

3
o
i,DY
4
o
i,YG
, 1
5
,o
i,m
0, i 1, . . . , N
The standard errors for the parameter estimates and moments are presented in the
Appendix, and the asymptotic test that the pricing errors are jointly zero, with g
T
b
, is
given by
var
1
~
2
N K, with K being the number of parameters estimated by the
system, and N K denoting the number of overidentifying conditions. For the model above,
we have K 1, since only one parameter is estimated in the cross-section.
Following Cochrane (1996), and given the fact that var is singular in most of the cases, I
perform a eigenvalue decomposition of the moments variance-covariance matrix,
var QQ
, where Q is a matrix containing the eigenvectors of var on its columns, and

is a diagonal matrix of eigenvalues, and then I invert only the non-zero eigenvalues of .
In Table XIII, I present the estimation results for the ICAPM model of equations 33 and
34 above. Following Lo and Mackinlay (1990), who argue against testing asset-pricing
models by using returns on portfolios sorted on some characteristic associated with returns
themselves, I use the returns on 38 industry portfolios (IND38), and the combination of
size/book-to-market and industry portfolios (SBV25IND38), as additional groups of test
assets relative to the 25 size/book-to-market portfolios (SBV25). All the data on portfolio
28
returns is obtained from Prof. Kenneth Frenchs website.
The estimated sensitivities of discount rate news to VAR shocks,
0. 237, 1. 935, 0. 395, 7. 611, 0. 372
, indicate that the yield gap is relatively important at

forecasting future market returns (coefficient of 7.611), confirming the results of Table VII. The
estimates of the relative risk aversion coefficient , indicate that , is clearly above 1, and it is
statistically significant for the three sets of testing portfolios. The covariance risk prices of
innovations in the market return are positive and significant, but also lower than ,, in result of
both
5
being negative and , 1 (for SBV25 we have z
m
7. 417 compared to , 11. 213).
The covariance risk price associated with innovations on the yield gap has the highest
magnitude across all factors, due to the high magnitude of
5
. In terms of beta risk prices, z
YG
is lower compared to both z
DY
and z
m
, in result of the lower variance of the yield gap,
compared with these two factors. On the other hand, the magnitude of z
YG
is higher compared
to both z
FFPREM
and z
TERM
. The p-values associated with the asymptotic
2
test, confirm that
the model is not rejected for the three sets of portfolios.
The factor loading estimates associated with model 34 are presented in Table XIV. The
betas associated with YG are negative, which is mainly due to the positive contemporaneous
correlation between market and individual stock returns. The average betas across quintiles
indicate that both growth and small stocks are more sensitive to innovations in YG, relative to
value and large stocks, respectively - the difference in beta magnitudes between BV1 and
BV5 is 2.327, whereas the spread between S1 and S5 is 2.323. In general, growth stocks
discount their cash flows more distant into the future (have higher "duration risk"), and in many
cases start to distribute cash flows for shareholders, only after some periods. Thus, growth
stocks should be more correlated with future discount rates, and given the fact that
innovations in yield gap are positively correlated with future investment opportunities, growth
29
stocks are more correlated with YG than value stocks.
To measure the pricing ability of each factor, I calculate the factor risk premium (beta times
risk price), and compute the averages across book-to-market quintiles, which results appear
in Table XV. The results show that innovations in YG have a negative risk premium, due to
the respective negative betas, and have the third largest contribution to the total pricing errors,
after the market return and dividend yield factors. Comparing across quintiles, the magnitude
of YGs risk premium is higher for growth stocks than value stocks (-0.440 versus -0.291), in
consequence of identical pattern for the average betas, as shown in Table XIV. The presence
of YG in the factor model, is not enough to price accurately both growth and value stocks,
which have pricing errors of -0.385 and 0.267 respectively, which goes in line with the findings
of Maio (2005a,b), that an ICAPM equivalent to model 33 does not price the value premium.
Nevertheless, the results of this section suggest that innovations in the yield gap have some
explanatory power for the cross section of returns.
VIII. Conclusion
The Yield gap - the difference between the stock market earnings yield and the long term
bond yield - can be interpreted a simple measure of the yield spread of stocks versus bonds,
or a relative long-term rate of return of stocks against bonds.
By using the definition of returns, I derive a dynamic accounting decomposition for the yield
gap, where it is positively correlated with future stock market returns and negatively correlated
with future dividend to earnings payout ratios, growth rate on future equity earnings and future
bond returns. This decomposition provides the rationale for the predictive role of the yield gap
over asset returns.
Conditional on other forecasting variables, the yield gap forecasts positive stock excess
30
returns, at several horizons ahead. The greatest forecasting power is achieved at near
horizons (until one year) declining gradually with the horizon, contrary to the majority of other
forecasting variables, which have forecasting power increasing with horizon. Hence, at short
horizons the yield gap has bigger forecasting power than most other state forecasting
variables. The yield gap has greater predictive power for the equally-weighted relative to the
value-weighted market excess returns, suggesting that the yield gap has greater forecasting
power for small caps excess returns, relative to large capitalization stocks. The yield gap has
also a very significant effect on bonds, forecasting negative excess returns for long-term
bonds, both at short and longer horizons ahead.
Implied estimates from a first-order VAR, confirm the forecasting power of YG over returns
associated with the long-horizon regressions, and in addition, innovations in the Yield gap are
positively correlated with the two unobserved components of market returns - cash flow and
discount rate news.
The observed correlation between the yield gap and future returns on both stocks and
bonds is subject to non-linearities: The bulk of the predictability of stock returns, comes from
predicting negative excess returns ahead, whereas for bonds, the bigger proportion of
forecasting power over bond returns, is associated with predicting positive excess returns in
the future.
The out of sample forecasting power of the yield gap, is economically significant, as
indicated by the significant gains in the Sharpe ratios, associated with dynamic trading
strategies conditional on the predictive ability of YG and other state variables. Thus, the yield
gap can be an important state variable to be used in dynamic portfolio optimization.
Furthermore, in the context of a 5 factor ICAPM, the innovations in the yield gap have some
31
explanatory power for the cross section of average returns.
32
References
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unpublished manuscript, Columbia University.
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Campbell, John Y., 1993, Intertemporal asset pricing without consumption data, American
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Campbell, John Y., and Robert J. Shiller, 1988b, The dividend price ratio and
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model , Journal of Political Economy, 104, 572-621.
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35
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233-264.
36
Appendices
A. A decomposition for the yield gap
Following Cochrane (2001), chapter 20, and using the definition of simple return,
1 R
t1
1
R
t1
R
t1
1
P
t1
D
t1
Pt
A. 1
Dividing by the current dividend D
t
, leads to
Pt
Dt
R
t1
1
1
P
t1
D
t1
D
t1
Dt
A. 2
By taking logs, one has
d
t
p
t
r
t1
ln1 expp
t1
d
t1
d
t1
A. 3
where the lowercase letters denote the logs of variables. By taking a first-order Taylor
expansion around the mean of p
t1
d
t1
, it follows
d
t
p
t
k r
t1
d
t1
p
t1
d
t1
A. 4
where
1
1expEdt1pt1
and k ln1 ln
1
1are parameters of linearization. By

adding log earnings e
t
to both sides of A. 4, and rearranging, we have
e
t
p
t
k r
t1
1 de
t1
e
t1
e
t1
p
t1
A. 5
where de
t1
d
t1
e
t1
denotes the log dividend payout ratio. If we iterate forward A. 5,
impose a "transversality condition" that the log earnings to price ratio cant growth faster
(slower) than rate 1/, lim
j
j
e
tj
p
tj
0, and take conditional expectations, we obtain the
log earnings yield as a function of expected future stock returns, dividend payout ratios and
earnings growth,
e
t
p
t

k
1
E
t
j0
j
r
t1j
1 de
t1j
e
t1j
A. 6
By defining the earnings yield as ln1
Et
Pt
, we have
ln1
Et
Pt
ln1 expe
t
p
t
k
e
t
p
t
A. 7
where

1
1expEet pt
and k
ln
ln
1
1 are parameters of
37
linearization from a first-order Taylor expansion around the mean of e
t
p
t
.
Following Campbell et al (1997), the log 1 period return on a n maturity coupon bond, can
be represented as
r
b,n,t1
k
b

b
p
n1,t1
1
b
c p
nt
A. 8
where c is the log coupon, and
b

1
1expEcpn1,t1
, k
b
ln
b
1
b
ln
1
b
1define
linearization parameters from a first-order Taylor expansion around the mean of c p
n1,t1
.
From A. 8 it follows that the log bond yield can be represented as the discounted sum of
future 1 period log bond returns.
y
nt

1
b
1
b
n
E
t
j0
n1
b
j
r
b,nj,t1j
A. 9
By combining equations A. 6, A. 7 and A. 9, we have the decomposition for the yield
gap,
YG
t
ln1
Et
Pt
y
nt
k

k
1
1
E
t
j0
j
r
t1j
1 de
t1j
e
t1j

1
b
1
b
n
E
t
j0
n1
b
j
r
b,nj,t1j
A. 10
B. A decomposition for innovations in the log dividend to price ratio
Following Campbell and Shiller (1988b), the log stock market return can be approximated
as,
r
t1
k p
t1
1 d
t1
p
t
A. 11
where and k are parameters of linearization. By combining A. 11 with the decomposition
for innovations in market returns 9, and by noting that E
t1
E
t
k E
t1
E
t
p
t
0, we
have,
E
t1
E
t
d
t1
p
t1
E
t1
E
t
d
t1
E
t1
E
t
j0
j
d
t1j
E
t1
E
t
j1
j
r
t1j
A. 12
In addition by noting that E
t1
E
t
d
t
0, it follows
E
t1
E
t
d
t1
p
t1

1
E
t1
E
t
j1
j
d
t1j
38
E
t1
E
t
j1
j
r
t1j
A. 13
C. Theorem 1
Given the asset pricing model
1 E
t
M
t1
R
i,t1
A. 14
and with the assumption that the log SDF, m
t1
lnM
t1
, is a linear function of K risk
factors f
t1
,
m
t1
a b
f
t1
A. 15
the unconditional model in discount factor form for log returns, r
i,t1
lnR
i,t1
, can be
represented as,
Er
i,t1
r
f,t1
0. 5o
i
2
b
Covr
i,t1
, f
t1
A. 16
Proof:
Taking logs of A. 14, one gets the pricing equation in the log form,
0 lnE
t
expm
t1
r
i,t1
A. 17
Since the log is a non-linear function, one can use a second-order Taylor expansion to the
right hand side of A. 17, leading to the following approximation
0 E
t
m
t1
r
i,t1
0. 5Var
t
m
t1
r
i,t1
A. 18
By expanding A. 18 and rearranging, one obtains,
E
t
r
i,t1
0. 5Var
t
r
i,t1
E
t
m
t1
0. 5Var
t
m
t1
Cov
t
m
t1
, r
i,t1
A. 19
Applying the pricing equation A. 19 to the risk-free rate, r
f,t1
, and noting that
Var
t
r
f,t1
Cov
t
m
t1
, r
f,t1
0, since r
f,t1
is known in period t, one has,
r
f,t1
E
t
m
t1
0. 5Var
t
m
t1
A. 20
Subtracting A. 20 from A. 19, we obtain,
E
t
r
i,t1
r
f,t1
0. 5Var
t
r
i,t1
Cov
t
m
t1
, r
i,t1
A. 21
Given the assumption that the log SDF is linear in the risk factors, m
t1
a b
f
t1
, and
39
substituting in A. 21, we have the following conditional pricing equation for excess returns,
E
t
r
i,t1
r
f,t1
0. 5Var
t
r
i,t1
b
Cov
t
r
i,t1
, f
t1
A. 22
By applying the law of iterated expectations to equation A. 22, one has the unconditional
pricing model
Er
i,t1
r
f,t1
0. 5o
i
2
b
Covr
i,t1
, f
t1

k1
K
b
k
o
i,k
A. 23
where o
i
2
Varr
i,t1
, o
i,k
Covr
i,t1
, f
k,t1
, k 1, . . . , K and f
k,t1
denotes the kth factor.
Theorem 1 represents a straightforward generalization of the theorem in section 6.3 of
Cochrane (2001), for the case in which the SDF is nonlinear, but the log SDF is a linear
function of the factors.
D. Substituting out consumption as in Campbell (1993) model
Using an Epstein and Zin utility function,
U
t
1 oC
t
1,
0
oE
t
U
t1
1,
1
0

0
1,
A. 24
where 0
1,
1
1
, is the elasticity of intertemporal substitution, and , is the RRA coefficient.

The corresponding SDF is given by
M
t1
o
0
C
t1
Ct

1
R
m,t1
10
A. 25
and the corresponding log SDF is equal to
m
t1
0lno
0
E
t
c
t1
1 0E
t
r
m,t1
c
t1
E
t
c
t1
1 0r
m,t1
E
t
r
m,t1
A. 26
Applying the conditional log pricing equation A. 19 to the market return, r
m,t1
, leads to
E
t
r
m,t1
0. 5Var
t
r
m,t1
E
t
m
t1
0. 5Var
t
m
t1
Cov
t
m
t1
, r
m,t1
A. 27
substituting the expressions for E
t
m
t1
, Var
t
m
t1
and Cov
t
m
t1
, r
m,t1
, and using the fact
that Cov
t
m
t1
, r
m,t1
Cov
t
m
t1
, r
m,t1
E
t
r
m,t1
and Var
t
r
m,t1
Var
t
r
m,t1
E
t
r
m,t1
, we
have
40
E
t
r
m,t1
0. 5o
mt
2
0lno
0
E
t
c
t1
1 0E
t
r
m,t1
0. 5
0

2
o
ct
2
1 0
2
o
mt
2
2
0
1 0o
c,mt

0
o
c,mt
1 0o
mt
2
A. 28
where o
ct
2
Var
t
c
t1
E
t
c
t1
, o
mt
2
Var
t
r
m,t1
E
t
r
m,t1
and
o
c,mt
Cov
t
c
t1
E
t
c
t1
, r
m,t1
E
t
r
m,t1
Solving for E
t
c
t1
, and imposing joint conditional homoskedasticity for log consumption
growth and log market returns, it follows,
E
t
c
t1
lno 0. 50
1
o
ct
2
o
mt
2
2o
c,mt
E
t
r
m,t1
lno 0. 50
1
o
c
2
o
m
2
2o
c,m
E
t
r
m,t1
A. 29
where o
c
2
Varc
t1
E
t
c
t1
, o
m
2
Varr
m,t1
E
t
r
m,t1
and
o
c,m
Covc
t1
E
t
c
t1
, r
m,t1
E
t
r
m,t1
.
Equation A. 29 can be restated as
E
t
c
t1
j
m
E
t
r
m,t1
A. 30
with j
m
lno 0. 50
1
o
c
2
o
m
2
2o
c,m
.
Giving a relation similar to equation A. 30, Campbell (1993) shows that innovations in log
consumption and log market returns are related by the following expression,
c
t1
E
t
c
t1
r
m,t1
E
t
r
m,t1
1 E
t1
E
t
j1
j
r
m,t1j
A. 31
E. GMM standard errors formulas for parameter estimates and moments
The parameter estimates b
associated with GMM system in section VII, have variance

formulas given by,
Varb

1
T
d
I
N
d
1
d
I
N
I
N
dd
I
N
d
1
A. 32
where I
N
is a N order Identity matrix, d
gTb
represents the matrix of moments

sensitivities to the parameters, and is a estimator for the spectral density matrix S, derived
under the Newey-West procedure with 5 lags. The variance-covariance matrix for the
moments is given by,
41
Var
1
T
I
N
dd
I
N
d
1
d
I
N
I
N
I
N
dd
I
N
d
1
d
A. 33
42
Table I
Descriptive statistics of returns and forecasting state variables
This table reports descriptive statistics for asset excess returns and forecasting
state variables. The excess returns data is on the value-weighted market index
(r
vw
), equally-weighted market index (r
ew
) and 10 year Treasury bond (r
b
). The
forecasting variables are the earnings yield (EY), the log 10 year Treasury bond
yield (y), the yield gap (YG), the FED funds premium (FFPREM), the term
structure spread (TERM), and the log market dividend yield (DY). The original
sample is 1954:07- 2003:12. Autocorr designates the first order autocorrelation.
For details on the variables construction refer to Section II.
Panel A
Mean Stdev. Min Max Autocorr
r
vw
0.005 0.044 -0.261 0.148 0.073
r
ew
0.007 0.055 -0.324 0.256 0.218
r
b
0.001 0.022 -0.078 0.089 0.066
EY 0.064 0.024 0.025 0.133 0.995
y 0.065 0.025 0.023 0.143 0.993
YG -0.001 0.021 -0.044 0.059 0.982
FFPREM 0.005 0.008 -0.011 0.054 0.878
TERM 0.008 0.011 -0.031 0.033 0.967
DY -3.488 0.371 -4.495 -2.796 0.997
Panel B
r
vw
r
ew
r
b
EY y YG FFPREM TERM DY
r
vw
1.000 0.860 0.159 -0.012 -0.075 0.075 -0.129 0.137 0.009
r
ew
1.000 0.065 -0.005 -0.089 0.099 -0.157 0.167 -0.003
r
b
1.000 0.000 0.023 -0.027 0.028 0.115 0.005
EY 1.000 0.622 0.400 0.480 -0.364 0.840
y 1.000 -0.469 0.561 -0.082 0.433
YG 1.000 -0.115 -0.314 0.441
FFPREM 1.000 -0.441 0.269
TERM 1.000 -0.192
DY 1.000
43
Table II
Yield gap predicting the value-weighted market return
Long horizon regressions for the monthly continuously compounded excess
returns on the value-weighted market index, at horizons of 1, 3, 12, 24, 36 and
48 months ahead. The forecasting variables are the current values of the yield
gap (YG), FED funds premium (FFPREM), term structure spread (TERM), and
log market dividend yield (DY). The original sample is 1954:07- 2003:12, and k
observations are lost in each of the respective k-horizon regressions for
k1,3,12,24,36,48. For each equation, in line 1 are reported the coefficient
estimates, and in lines 2 and 3 respectively, are reported the asymptotic
Newey-West (with 5 lags) and Hansen-Hodrick t-statistics. In line 4, are
presented the p-values from a bootstrap experiment, consisting of 10,000
simulations to the Newey-West t-statistics, under the null of no predictability of
returns. The t-statistics and p-values at bold denote significance at the 1%
level, while the underlined ones indicate significance at the 5% level. Adj. R
2
denotes the adjusted R
2
.
Panel A
Const. YG Adj. R
2
Const. YG Adj. R
2
K=1 0.055 2.965 0.013 K=24 0.046 0.853 0.030
2.470 2.815 5.101 2.238
2.564 2.701 2.520 1.255
0.473 0.003 0.920 0.024
K=3 0.054 2.662 0.031 K=36 0.047 0.606 0.026
2.673 2.961 6.658 1.963
2.449 2.679 2.583 0.907
0.603 0.005 0.972 0.041
K=12 0.049 1.730 0.053 K=48 0.050 0.363 0.013
3.685 3.170 8.394 1.564
2.286 2.084 2.780 0.601
0.821 0.003 0.997 0.077
44
Panel B
Const. FFPREM TERM YG Adj. R
2
2
K=1 0.017 -2.912 6.764 3.889 0.033 K=24 0.023 0.856 2.670 1.256 0.075
0.457 -0.628 2.908 3.336 1.467 0.802 2.829 2.842
0.437 -0.681 2.656 3.091 0.904 0.660 2.002 1.800
0.808 0.263 0.003 0.001 0.990 0.248 0.006 0.009
K=3 0.019 -2.178 5.987 3.486 0.075 K=36 0.020 1.233 2.920 1.050 0.120
0.617 -0.597 2.940 3.628 1.831 1.929 4.818 3.163
0.567 -0.555 2.712 3.298 0.898 1.111 3.035 1.645
0.844 0.279 0.005 0.001 0.998 0.050 0.000 0.004
K=12 0.014 0.157 4.577 2.416 0.126 K=48 0.027 0.680 2.623 0.778 0.136
0.714 0.081 3.313 4.299 3.108 1.177 5.240 3.235
0.486 0.074 2.356 2.803 1.551 0.947 3.114 1.630
0.969 0.474 0.002 0.000 0.999 0.151 0.000 0.003
Panel C
Const. FFPREM TERM DY YG Adj. R
2
2
K=1 0.311 -4.482 6.310 0.081 3.131 0.033 K=24 0.381 -1.163 1.644 0.098 0.324 0.150
1.086 -0.904 2.696 1.026 2.339 3.496 -1.006 2.167 3.120 0.815
1.043 -0.963 2.441 0.991 2.148 1.928 -0.950 1.820 1.643 0.753
0.190 0.188 0.006 0.149 0.013 0.005 0.178 0.026 0.002 0.235
K=3 0.347 -3.944 5.435 0.090 2.637 0.081 K=36 0.294 -0.368 2.012 0.075 0.350 0.185
1.405 -1.039 2.720 1.308 2.448 3.441 -0.554 3.935 3.047 1.323
1.274 -0.962 2.502 1.187 2.219 2.368 -0.601 3.603 1.975 0.983
0.151 0.174 0.008 0.118 0.012 0.010 0.307 0.000 0.004 0.118
K=12 0.387 -1.915 3.749 0.103 1.432 0.162 K=48 0.263 -0.562 2.024 0.066 0.257 0.201
2.275 -0.920 2.873 2.141 2.187 3.775 -0.914 4.632 3.281 1.185
1.441 -0.940 2.212 1.308 1.676 2.560 -0.892 2.923 2.167 0.734
0.048 0.211 0.006 0.028 0.031 0.008 0.214 0.000 0.003 0.150
45
Table III
Yield gap predicting the equally-weighted market return
returns on the equally-weighted market index, at horizons of 1, 3, 12, 24, 36
and 48 months ahead. The forecasting variables are the current values of the
yield gap (YG), FED funds premium (FFPREM), term structure spread (TERM),
and log market dividend yield (DY). The original sample is 1954:07- 2003:12,
and k observations are lost in each of the respective k-horizon regressions for
2
2
.
Panel A
Const. YG Adj. R
2
Const. YG Adj. R
2
K=1 0.082 4.763 0.022 K=24 0.069 2.056 0.106
2.709 3.418 6.093 4.848
3.082 3.584 3.180 2.517
0.483 0.000 0.922 0.000
K=3 0.081 4.565 0.049 K=36 0.069 1.819 0.144
2.932 3.811 7.855 5.636
2.664 3.429 3.129 2.391
0.603 0.000 0.960 0.000
K=12 0.073 3.130 0.101 K=48 0.069 1.647 0.163
4.290 4.754 9.264 6.582
2.751 3.043 3.325 2.420
0.831 0.000 0.986 0.000
46
Panel B
2
2
K=1 0.014 -3.481 11.102 6.333 0.055 K=24 0.051 0.940 1.902 2.358 0.117
0.270 -0.642 3.397 4.054 2.844 0.743 1.691 5.261
0.283 -0.734 3.451 4.157 1.750 0.710 0.992 2.758
0.886 0.264 0.001 0.000 0.942 0.265 0.063 0.000
K=3 0.010 -1.478 10.207 6.064 0.107 K=36 0.053 0.972 1.465 2.058 0.155
0.237 -0.322 3.579 4.677 4.046 0.999 1.717 5.965
0.217 -0.298 3.249 4.217 2.214 0.790 0.952 2.768
0.934 0.380 0.001 0.000 0.957 0.191 0.061 0.000
K=12 0.021 0.993 6.339 4.113 0.174 K=48 0.053 0.751 1.731 1.937 0.187
0.784 0.375 3.803 6.350 4.675 0.726 2.281 6.721
0.537 0.329 2.883 4.060 2.223 0.565 1.483 2.816
0.984 0.373 0.001 0.000 0.980 0.266 0.023 0.000
Panel C
2
2
K=1 0.148 -4.197 10.895 0.037 5.988 0.054 K=24 0.211 0.039 1.444 0.044 1.943 0.124
0.413 -0.726 3.313 0.374 3.440 1.973 0.027 1.207 1.554 3.457
0.407 -0.807 3.361 0.368 3.516 1.949 0.028 0.764 1.435 2.144
0.423 0.244 0.001 0.356 0.001 0.120 0.499 0.145 0.082 0.002
K=3 0.162 -2.297 9.951 0.042 5.670 0.106 K=36 0.082 0.802 1.368 0.008 1.984 0.154
0.519 -0.478 3.480 0.482 3.975 1.117 0.713 1.539 0.410 4.868
0.463 -0.443 3.167 0.429 3.604 0.976 0.722 0.918 0.357 2.505
0.409 0.333 0.001 0.329 0.001 0.377 0.275 0.091 0.352 0.000
K=12 0.228 -0.156 5.880 0.057 3.568 0.179 K=48 0.023 0.911 1.808 -0.008 2.004 0.186
1.159 -0.056 3.444 1.051 4.405 0.314 0.783 2.314 -0.441 5.875
0.918 -0.053 2.790 0.806 3.171 0.201 0.630 1.449 -0.300 2.588
0.257 0.481 0.002 0.172 0.000 0.688 0.248 0.024 0.349 0.000
47
Table IV
Yield gap predicting the long-term bond return
returns on the 10 year Treasury bond, at horizons of 1, 3, 12, 24, 36 and 48
months ahead. The forecasting variables are the current values of the yield gap
(YG), FED funds premium (FFPREM), term structure spread (TERM), and log
market dividend yield (DY). The original sample is 1954:07- 2003:12, and k
2
2
.
Panel A
Const. YG Adj. R
2
Const. YG Adj. R
2
K=1 0.009 -1.245 0.009 K=24 0.009 -1.424 0.319
0.796 -2.474 2.371 -7.353
0.819 -2.634 1.278 -3.640
0.526 0.008 0.644 0.000
K=3 0.009 -1.359 0.033 K=36 0.010 -1.201 0.370
0.875 -3.043 3.175 -8.268
0.794 -2.767 1.485 -3.920
0.580 0.003 0.617 0.000
K=12 0.009 -1.528 0.168 K=48 0.010 -1.103 0.404
1.485 -5.961 3.805 -9.922
0.931 -3.880 1.585 -4.364
0.689 0.000 0.502 0.000
48
Panel B
2
2
K=1 0.008 -1.280 0.882 -1.161 0.009 K=24 0.000 0.773 0.791 -1.281 0.332
0.430 -0.609 0.610 -2.048 -0.033 1.467 1.726 -6.536
0.423 -0.645 0.588 -2.216 -0.017 1.141 1.189 -3.315
0.524 0.276 0.271 0.027 0.060 0.092 0.065 0.000
K=3 0.008 -1.017 0.719 -1.291 0.037 K=36 0.002 1.047 0.332 -1.108 0.395
0.483 -0.568 0.557 -2.562 0.408 3.042 1.068 -7.424
0.454 -0.537 0.516 -2.359 0.182 1.678 0.692 -3.797
0.556 0.309 0.303 0.012 0.931 0.003 0.177 0.000
K=12 -0.001 -0.079 1.500 -1.309 0.200 K=48 0.005 0.974 0.001 -1.053 0.444
-0.161 -0.088 2.206 -4.959 1.174 2.700 0.004 -8.328
-0.118 -0.069 1.594 -3.782 0.555 1.629 0.002 -4.274
0.109 0.471 0.025 0.000 0.841 0.010 0.488 0.000
Panel C
2
2
K=1 0.253 -2.591 0.504 0.068 -1.794 0.014 K=24 0.107 0.169 0.484 0.029 -1.559 0.356
1.648 -1.190 0.352 1.615 -2.426 1.900 0.269 0.998 1.935 -6.015
1.712 -1.251 0.326 1.711 -2.535 1.245 0.194 0.698 1.268 -3.656
0.063 0.127 0.367 0.060 0.011 0.072 0.402 0.181 0.048 0.000
K=3 0.227 -2.195 0.350 0.060 -1.857 0.049 K=36 0.105 0.448 -0.008 0.028 -1.370 0.425
1.622 -1.184 0.272 1.584 -2.782 2.669 1.064 -0.024 2.665 -7.726
1.474 -1.126 0.252 1.438 -2.555 1.565 0.617 -0.017 1.600 -4.234
0.083 0.151 0.398 0.077 0.005 0.021 0.177 0.482 0.013 0.000
K=12 0.163 -0.994 1.134 0.045 -1.743 0.228 K=48 0.134 0.293 -0.328 0.036 -1.339 0.500
1.872 -1.048 1.648 1.910 -4.585 4.704 1.011 -1.201 4.456 -10.167
1.243 -0.869 1.236 1.252 -3.379 2.776 0.622 -0.722 2.593 -5.327
0.072 0.183 0.068 0.051 0.000 0.000 0.187 0.146 0.000 0.000
49
Table V
Yield gap components predicting excess stock and bond returns
returns on the value-weighted market index (Panels A and B) and the 10 year
Treasury bond (Panels C and D), at horizons of 1, 3, 12, 24, 36 and 48 months
ahead. The forecasting variables are the components of Yield Gap - earnings
yield (EY) and the log bond yield (y). The original sample is 1954:07- 2003:12,
and k observations are lost in each of the respective k-horizon regressions for
Newey-West (with 5 lags) and Hansen-Hodrick t-statistics. The t-statistics at
bold denote significance at the 1% level, while the underlined ones indicate
significance at the 5% level. Adj. R
2
2
.
Panel A
Const. EY Adj. R
2
Const. EY Adj. R
2
K=1 -0.021 1.160 0.001 K=24 -0.020 1.006 0.050
-0.316 1.138 -0.661 2.578
-0.308 1.105 -0.306 1.273
K=3 -0.028 1.248 0.007 K=36 -0.003 0.758 0.049
-0.450 1.345 -0.119 2.497
-0.408 1.227 -0.049 1.089
K=12 -0.040 1.357 0.040 K=48 0.015 0.519 0.034
-1.028 2.424 0.779 2.127
-0.652 1.627 0.307 0.944
Panel B
Const. y Adj. R
2
Const. y Adj. R
2
K=1 0.124 -1.089 0.001 K=24 0.030 0.251 0.002
2.091 -1.228 1.338 0.880
2.139 -1.226 0.759 0.603
K=3 0.104 -0.794 0.002 K=36 0.034 0.202 0.002
1.881 -0.958 2.021 0.970
1.740 -0.883 0.848 0.451
K=12 0.051 -0.047 -0.002 K=48 0.039 0.166 0.003
1.255 -0.077 2.676 0.918
0.897 -0.058 1.026 0.401
50
Panel C
Const. EY Adj. R
2
Const. EY Adj. R
2
K=1 0.004 0.091 -0.002 K=24 0.019 -0.150 0.002
0.098 0.151 1.324 -0.603
0.102 0.159 0.667 -0.300
K=3 0.010 -0.014 -0.002 K=36 0.012 -0.041 -0.001
0.303 -0.026 1.081 -0.214
0.273 -0.023 0.478 -0.090
K=12 0.021 -0.164 0.001 K=48 0.004 0.084 0.001
0.901 -0.433 0.333 0.438
0.551 -0.261 0.144 0.190
Panel D
Const. y Adj. R
2
Const. y Adj. R
2
K=1 -0.055 0.993 0.007 K=24 -0.051 0.928 0.181
-1.632 1.736 -4.627 4.848
-1.650 1.778 -2.645 2.805
K=3 -0.054 0.981 0.023 K=36 -0.047 0.861 0.254
-1.783 1.887 -6.740 7.600
-1.606 1.696 -2.874 3.163
K=12 -0.054 0.987 0.094 K=48 -0.048 0.867 0.345
-2.869 3.037 -8.019 9.368
-1.857 1.910 -3.610 4.266
51
Table VI
Estimated implied coeficients from the VAR
This table reports the implied VAR estimates of the long-horizon coefficients
b
l
ks, in a VAR containing the yield gap (YG), FED funds premium (FFPREM),
term structure spread (TERM), log market dividend yield (DY) and the market
excess return (r
m
). The original sample is 1954:07- 2003:12. Panel A presents
the results obtained for the value-weighted market index (r
vw
) and Panel B
shows the results for the equally-weighted market index (r
ew
). For each VAR
and for each forecasting horizon (k), in row 1 are reported the implied
long-horizon coefficient estimates; in row 2 are reported the associated
asymptotic Newey-West (with 5 lags) t-statistics, and in line 3 are reported the
p-values from 5,000 bootstrapping simulations under the null of no predictability
of excess returns, i.e., the excess returns are simulated imposing null
no-constant coefficients, in the excess return equation. R
2
denotes the implied
long-horizon R
2
from the VAR, and VR denotes the implied variance ratio
statistic. The t-statistics and p-values at bold denote significance at the 1%
level, while the underlined ones indicate significance at the 5% level.
Panel A (r
vw
)
FFPREM TERM DY YG r
m
R
2
VR
K=1 -5.431 4.749 0.059 2.338 0.801 0.035 1.000
-32.295 50.393 14.546 39.549 39.007
0.073 0.018 0.399 0.062 0.053
K=3 -4.567 4.472 0.061 2.416 0.416 0.086 1.103
-31.770 48.947 14.645 40.664 44.044
0.069 0.019 0.400 0.055 0.027
K=12 -2.161 3.123 0.064 2.405 0.186 0.217 1.248
-23.937 38.607 14.816 42.931 34.152
0.091 0.040 0.387 0.047 0.024
K=24 -0.659 1.617 0.063 2.225 0.098 0.263 1.320
-8.992 21.642 14.952 44.383 24.137
0.252 0.128 0.400 0.053 0.067
K=36 0.107 0.639 0.061 2.031 0.053 0.271 1.334
1.584 9.142 15.045 45.178 16.602
0.600 0.268 0.412 0.051 0.170
K=48 0.535 0.038 0.059 1.854 0.028 0.277 1.319
8.239 0.589 15.104 45.511 10.578
0.492 0.402 0.407 0.053 0.302
52
Panel B (r
ew
)
FFPREM TERM DY YG r
m
R
2
VR
K=1 -8.748 7.539 0.035 3.726 2.499 0.077 1.000
-48.663 59.215 5.541 48.145 123.354
0.016 0.008 0.520 0.023 0.000
K=3 -7.648 6.862 0.042 4.015 1.207 0.115 1.319
-47.833 56.557 6.312 50.653 97.642
0.016 0.009 0.501 0.016 0.000
K=12 -4.488 4.596 0.048 3.988 0.440 0.241 1.644
-32.579 42.059 6.772 54.343 58.733
0.041 0.028 0.494 0.017 0.000
K=24 -2.451 2.346 0.047 3.635 0.236 0.272 1.786
-15.950 21.647 6.730 57.548 41.084
0.157 0.124 0.504 0.014 0.000
K=36 -1.393 0.939 0.044 3.283 0.145 0.264 1.830
-8.521 8.876 6.505 60.306 31.146
0.244 0.277 0.508 0.015 0.006
K=48 -0.799 0.097 0.040 2.970 0.095 0.254 1.828
-4.753 0.971 6.194 62.797 24.296
0.309 0.399 0.519 0.009 0.029
53
Table VII
Cash flow and discount rate news: A variance decomposition for stock returns
This table shows the variance decomposition associated with cash-flow (N
CF
)
and discount rate news (N
DR
) implied by the VAR model, of table VI. The VAR
contains the the yield gap (YG), FED funds premium (FFPREM), term structure
spread (TERM), log market dividend yield (DY) and the market excess return
(r
m
). Panel A presents the results obtained for the value-weighted market index
(r
vw
) and Panel B shows the results for the equally-weighted market index (r
ew
).
The original sample is 1954:07- 2003:12. The upper section reports the
variance decomposition of excess returns, in terms of the news components.
The lower section shows the correlations between shocks in each of the
variables used in the VAR, with both N
CF
and N
DR
. s.e. denotes standard errors
computed from 5,000 bootstrapping simulations of the model, under the null of
no predictability of excess returns.
Panel A (r
vw
)
Variance decomposition
Var(N
DR
) 0.986
Var(N
CF
) 0.378
-2Cov(N
DR
,N
CF
) -0.364
Sum 1.000
Shock correlations N
DR
s.e. N
CF
s.e.
FFPREM 0.085 0.217 0.113 0.122
TERM 0.000 0.477 0.242 0.320
DY 0.855 0.611 0.117 0.337
YG 0.776 0.426 0.749 0.264
r
m
-0.810 0.579 0.318 0.282
54
Panel B (r
ew
)
Variance decomposition
Var(N
DR
) 1.434
Var(N
CF
) 1.385
-2Cov(N
DR
,N
CF
) -1.819
Sum 1.000
Shock correlations N
DR
s.e. N
CF
s.e.
FFPREM 0.177 0.219 0.177 0.118
TERM 0.293 0.499 0.444 0.316
DY 0.485 0.589 -0.087 0.326
YG 0.965 0.459 0.701 0.260
r
m
-0.438 0.507 0.404 0.244
55
Table VIII
Yield gap predicting excess returns in a non-linear way: Asymmetries on the yield
gap
returns on the value-weighted market index (Panel A) and the 10 year Treasury
bond (Panel B), at horizons of 1, 3, 12, 24, 36 and 48 months ahead. The
forecasting variables are the current values of the yield gap when it assumes
positive and negative values (YG*DYG and YG*(1-DYG) respectively), FED
funds premium (FFPREM), term structure spread (TERM), and log market
dividend yield (DY). The original sample is 1954:07- 2003:12, and k
2
2
.
56
Panel A (r
vw
)
Const. FFPREM TERM DY YG*DYG YG*(1-DYG) Adj. R
2
K=1 0.358 -4.116 6.997 0.084 1.232 6.056 0.034
1.211 -0.819 2.846 1.055 0.593 1.739
1.178 -0.881 2.641 1.028 0.554 1.771
0.162 0.213 0.004 0.149 0.290 0.038
K=3 0.374 -3.718 5.854 0.092 1.521 4.367 0.082
1.475 -0.959 2.798 1.327 0.897 1.577
1.341 -0.889 2.588 1.207 0.825 1.422
0.128 0.178 0.007 0.112 0.218 0.078
K=12 0.377 -2.067 3.483 0.103 2.011 0.501 0.164
2.194 -0.970 2.491 2.137 1.957 0.328
1.393 -0.977 1.943 1.318 1.307 0.258
0.056 0.185 0.015 0.028 0.046 0.380
K=24 0.365 -1.459 1.134 0.099 1.379 -1.394 0.170
3.209 -1.308 1.440 3.062 2.102 -1.502
1.962 -1.246 1.226 1.837 1.414 -1.207
0.009 0.117 0.097 0.003 0.039 0.101
K=36 0.290 -0.578 1.685 0.077 0.946 -0.656 0.195
3.225 -0.896 2.812 3.019 2.010 -0.803
2.204 -1.376 2.060 1.928 1.090 -0.580
0.015 0.207 0.007 0.004 0.048 0.242
K=48 0.243 -0.844 1.523 0.064 1.106 -1.181 0.236
3.122 -1.406 3.202 2.894 2.813 -1.984
2.056 -1.463 2.283 1.897 1.444 -1.318
0.024 0.107 0.003 0.006 0.008 0.042
57
Panel B (r
b
)
Const. FFPREM TERM DY YG*DYG YG*(1-DYG) Adj. R
2
K=1 0.245 -2.653 0.387 0.067 -1.472 -2.289 0.013
1.591 -1.195 0.252 1.593 -1.463 -1.344
1.692 -1.255 0.235 1.707 -1.636 -1.409
0.070 0.127 0.406 0.062 0.078 0.094
K=3 0.222 -2.239 0.268 0.060 -1.637 -2.198 0.048
1.559 -1.191 0.199 1.565 -1.741 -1.540
1.423 -1.133 0.183 1.424 -1.614 -1.392
0.091 0.145 0.428 0.080 0.061 0.082
K=12 0.155 -1.115 0.923 0.045 -1.283 -2.484 0.234
1.768 -1.137 1.288 1.899 -2.650 -3.151
1.163 -0.941 1.063 1.234 -2.064 -2.762
0.080 0.161 0.123 0.050 0.013 0.003
K=24 0.096 -0.026 0.147 0.030 -0.863 -2.693 0.388
1.761 -0.043 0.308 2.005 -2.830 -5.491
1.208 -0.033 0.243 1.376 -1.792 -4.256
0.089 0.478 0.393 0.043 0.008 0.000
K=36 0.101 0.259 -0.302 0.030 -0.835 -2.272 0.458
2.824 0.638 -0.845 3.136 -3.843 -6.462
1.838 0.453 -0.635 2.061 -2.404 -4.600
0.015 0.286 0.229 0.005 0.001 0.000
K=48 0.122 0.121 -0.632 0.035 -0.824 -2.213 0.539
4.182 0.402 -2.195 4.470 -3.963 -7.559
3.024 0.253 -1.332 3.315 -2.289 -4.379
0.001 0.356 0.026 0.000 0.000 0.000
58
Table IX
Yield gap predicting excess returns in a non-linear way: Business Cycle
forecasting variables are the current values of the yield gap both in economic
expansions and recessions (YG*CYCLE and YG*(1-CYCLE) respectively), FED
2
2
.
59
Panel A (r
vw
)
Const. FFPREM TERM DY YG*CYCLE YG*(1-CYCLE) Adj. R
2
K=1 0.336 -5.197 5.958 0.087 2.652 4.822 0.033
1.173 -1.041 2.475 1.106 1.905 1.690
1.133 -1.159 2.297 1.069 1.780 1.513
0.179 0.154 0.007 0.145 0.034 0.075
K=3 0.383 -4.983 4.917 0.099 1.943 5.074 0.085
1.557 -1.311 2.363 1.446 1.693 2.240
1.410 -1.225 2.182 1.309 1.536 2.065
0.113 0.119 0.016 0.088 0.064 0.042
K=12 0.427 -2.955 3.204 0.112 0.744 3.789 0.182
2.541 -1.442 2.402 2.375 1.051 4.375
1.642 -1.401 1.878 1.478 0.772 3.605
0.031 0.098 0.018 0.017 0.175 0.002
K=24 0.390 -1.389 1.523 0.101 0.175 0.828 0.151
3.599 -1.262 1.986 3.206 0.431 1.098
2.039 -1.200 1.636 1.727 0.449 0.780
0.004 0.134 0.039 0.002 0.350 0.203
K=36 0.310 -0.644 1.850 0.079 0.183 0.850 0.187
3.592 -0.931 3.458 3.189 0.605 2.415
2.562 -0.996 3.078 2.126 0.507 1.874
0.006 0.199 0.002 0.002 0.299 0.037
K=48 0.282 -0.923 1.809 0.071 0.037 0.912 0.210
4.035 -1.468 3.962 3.513 0.157 2.381
2.829 -1.338 2.500 2.387 0.102 1.638
0.003 0.097 0.000 0.001 0.458 0.037
60
Panel B (r
b
)
Const. FFPREM TERM DY YG*CYCLE YG*(1-CYCLE) Adj. R
2
K=1 0.284 -3.468 0.072 0.075 -2.382 0.278 0.018
1.765 -1.637 0.048 1.717 -3.028 0.187
1.897 -1.626 0.046 1.879 -3.212 0.192
0.052 0.063 0.482 0.051 0.002 0.418
K=3 0.243 -2.666 0.115 0.064 -2.172 -0.752 0.052
1.707 -1.482 0.088 1.658 -3.195 -0.555
1.555 -1.421 0.082 1.508 -2.963 -0.513
0.075 0.096 0.466 0.067 0.002 0.325
K=12 0.152 -0.685 1.296 0.042 -1.539 -2.444 0.234
1.809 -0.704 1.957 1.858 -4.166 -3.300
1.210 -0.591 1.442 1.228 -3.067 -2.437
0.081 0.267 0.041 0.056 0.000 0.008
K=24 0.109 0.115 0.455 0.030 -1.595 -1.438 0.355
1.904 0.189 0.951 1.932 -5.827 -2.980
1.236 0.131 0.671 1.254 -3.443 -2.080
0.076 0.423 0.195 0.049 0.000 0.013
K=36 0.124 0.107 -0.209 0.033 -1.576 -0.753 0.445
3.284 0.272 -0.591 3.249 -7.920 -3.027
1.982 0.157 -0.391 1.986 -4.037 -1.889
0.005 0.400 0.301 0.003 0.000 0.012
K=48 0.145 0.100 -0.443 0.039 -1.457 -0.990 0.508
5.198 0.316 -1.513 4.890 -9.225 -4.925
3.252 0.185 -0.859 2.996 -4.791 -2.977
0.000 0.397 0.090 0.000 0.000 0.000
61
Table X
Yield gap predicting excess returns in a non-linear way: Asymmetries on returns
forecasting variables are the current values of the yield gap when future excess
returns are positive and negative (YG*DR and YG*(1-DR) respectively), FED
Newey-West (with 5 lags) and Hansen-Hodrick t-statistics. The t-statistics and
p-values at bold denote significance at the 1% level, while the underlined ones
indicate significance at the 5% level. Adj. R
2
2
.
Panel A (r
vw
)
Const. FFPREM TERM DY YG*DR YG*(1-DR) Adj. R
2
K=1 0.324 -4.553 6.231 0.084 1.710 5.179 0.036
1.159 -0.889 2.649 1.088 0.885 1.651
1.114 -0.953 2.405 1.053 1.073 2.231
K=3 0.357 -3.892 5.569 0.092 1.524 4.673 0.090
1.516 -0.987 2.835 1.407 1.269 1.991
1.374 -0.909 2.613 1.277 1.183 1.888
K=12 0.363 -1.339 3.688 0.095 0.825 3.298 0.182
2.340 -0.637 2.892 2.180 1.245 2.233
1.485 -0.683 2.198 1.326 0.838 1.373
K=24 0.320 -1.174 1.384 0.079 0.007 2.471 0.181
2.943 -0.929 1.749 2.509 0.018 1.702
1.550 -0.888 1.427 1.266 0.014 1.084
K=36 0.134 0.370 2.091 0.028 0.187 3.885 0.276
1.682 0.563 3.890 1.205 0.692 2.975
0.927 0.512 3.037 0.646 0.466 1.841
K=48 0.140 -0.148 1.964 0.029 0.213 3.323 0.258
1.659 -0.229 4.287 1.172 0.960 2.314
0.951 -0.224 2.501 0.663 0.561 1.363
62
Panel B (r
b
)
Const. FFPREM TERM DY YG*DR YG*(1-DR) Adj. R
2
K=1 0.229 -2.305 0.215 0.061 -3.310 -0.316 0.027
1.552 -1.047 0.150 1.534 -2.687 -0.270
1.612 -1.083 0.139 1.630 -3.633 -0.374
K=3 0.218 -2.085 0.079 0.058 -2.943 -0.988 0.065
1.639 -1.071 0.062 1.633 -3.017 -1.173
1.491 -1.017 0.057 1.483 -2.853 -1.111
K=12 0.161 -1.171 0.798 0.045 -2.548 -1.233 0.253
1.969 -1.169 1.163 2.053 -4.322 -2.923
1.303 -0.976 0.880 1.343 -2.923 -1.952
K=24 0.099 0.208 0.466 0.028 -1.755 -1.362 0.360
1.837 0.319 0.951 1.909 -4.462 -5.217
1.228 0.232 0.665 1.284 -2.800 -2.779
K=36 0.105 0.444 -0.003 0.028 -1.352 -1.389 0.424
2.698 1.072 -0.009 2.682 -5.560 -6.404
1.615 0.612 -0.006 1.636 -3.376 -2.996
K=48 0.134 0.286 -0.342 0.036 -1.364 -1.320 0.500
4.676 0.986 -1.205 4.467 -7.733 -6.871
2.774 0.620 -0.742 2.616 -4.411 -4.052
63
Table XI
Trading strategies based on the forecasting ability of yield gap over returns, with no
short-sales
This Table reports descriptive statistics and the associated Sharpe ratios, for
trading strategies based on the "out-of-sample" forecasting power of yield gap
(and other state variables) over stock market and bond returns. Buy-hold
denotes the passive strategy associated with holding the risky asset. The risky
assets used in the portfolio choice, are the value-weighted index (Panel A),
equally-weighted index (Panel B), long term bond (Panel C), value-weighted
index plus long term bond (Panel D) and equally-weighted index plus long term
bond (Panel E). The other asset is the risk free rate, and short-sales are not
allowed. The rolling predictive regressions start at 1959:07 and go until
2003:12.
Panel A (r
vw
)
Mean Std. Dev. Sharpe
Buy-hold 0.881 4.371 0.202
FFPREM, TERM, DY, YG 1.020 2.918 0.350
FFPREM, TERM, YG 1.042 2.771 0.376
YG 0.874 2.902 0.301
Panel B (r
ew
)
Buy-hold 1.103 5.476 0.201
FFPREM, TERM, DY, YG 1.349 3.840 0.351
FFPREM, TERM, YG 1.395 3.616 0.386
YG 1.243 3.845 0.323
Panel C (r
b
)
Buy-hold 0.511 2.181 0.234
FFPREM, TERM, DY, YG 0.731 1.729 0.423
FFPREM, TERM, YG 0.660 1.646 0.401
YG 0.677 1.681 0.403
Panel D (r
vw
, r
b
)
Buy-hold 0.696 2.588 0.269
FFPREM, TERM, DY, YG 1.071 2.944 0.364
FFPREM, TERM, YG 0.964 2.857 0.337
YG 1.096 2.967 0.370
Panel E (r
ew
, r
b
)
Buy-hold 0.807 3.003 0.269
FFPREM, TERM, DY, YG 1.429 3.881 0.368
FFPREM, TERM, YG 1.387 3.685 0.376
YG 1.450 3.830 0.378
64
Table XII
Trading strategies based on the forecasting ability of yield gap over returns, with
short-sales allowed
This Table reports descriptive statistics and the associated Sharpe ratios, for
trading strategies based on the "out-of-sample" forecasting power of yield gap
(and other state variables) over stock market and bond returns. Buy-hold
denotes the passive strategy associated with holding the risky asset. The risky
assets used in the portfolio choice, are the value-weighted index (Panel A),
equally-weighted index (Panel B), long term bond (Panel C), value-weighted
index plus long term bond (Panel D) and equally-weighted index plus long term
bond (Panel E). The other asset is the risk free rate, and short-sales are
allowed. The rolling predictive regressions start at 1959:07 and go until
2003:12.
Panel A (r
vw
)
Buy-hold 0.881 4.371 0.202
FFPREM, TERM, DY, YG 1.223 4.463 0.274
FFPREM, TERM, YG 1.266 4.444 0.285
YG 0.930 4.470 0.208
Panel B (r
ew
)
Buy-hold 1.103 5.476 0.201
FFPREM, TERM, DY, YG 1.650 5.612 0.294
FFPREM, TERM, YG 1.742 5.590 0.312
YG 1.437 5.635 0.255
Panel C (r
b
)
Buy-hold 0.511 2.181 0.234
FFPREM, TERM, DY, YG 0.882 2.196 0.402
FFPREM, TERM, YG 0.741 2.213 0.335
YG 0.775 2.209 0.351
Panel D (r
vw
, r
b
)
Buy-hold 0.696 2.588 0.269
FFPREM, TERM, DY, YG 1.343 4.383 0.306
FFPREM, TERM, YG 1.265 4.440 0.285
YG 1.204 4.238 0.284
Panel E (r
ew
, r
b
)
Buy-hold 0.807 3.003 0.269
FFPREM, TERM, DY, YG 1.808 5.642 0.320
FFPREM, TERM, YG 1.761 5.604 0.314
YG 1.759 5.465 0.322
65
Table XIII
A 5-factor ICAPM: Estimating factor risk prices
This table reports the estimation and evaluation results of the 5 factor ICAPM
presented in Section VII,
E(r
i,t1
-r
f,t1
)
o
i
2
2
(,-1)[
1
o
i,FFPREM
2
o
i,TERM
3
o
i,DY
4
o
i,YG
][(,-1)
5
,]o
i,m
(33)
E(r
i,t1
-r
f,t1
)
o
i
2
2
(,-1)[
1
o
FFPREM
2
[
i,FFPREM
2
o
TERM
2
[
i,TERM
3
o
DY
2
[
i,DY
4
o
YG
2
[
i,YG
]
[(,-1)
5
,]o
m
2
[
i,m
(34)
There are 3 sets of test assets - the 25 size/book-to-market portfolios (SBV25),
38 industry portfolios (IND38), and their combination (SBV25IND38). For each
set of portfolios, are presented the risk prices for single regression betas of
model (34) (row 1), the respective t-statistics (row 2) and the covariance risk
prices of model (33) (row 3), all arising from first stage GMM estimation.
z
FFPREM
, z
TERM
, z
DY
, z
YG
and z
m
denote the risk prices estimates associated with
innovations in the FED funds premium (FFPREM), term structure spread
(TERM), log market dividend yield (DY), yield gap (YG) and the value-weighted
market excess return (r
m
), respectively. , denotes the relative risk aversion
coefficient. Test values (first row) and respective p-values (second row) for the
asymptotic _
2
test are presented for each GMM estimation, in addition to the
square root of the average pricing error (RMSE). The sample is
1954:08-2003:12. Italic, underlined and bold numbers denote statistical
significance at the 10%, 5% and 1% levels respectively. The beta risk prices (z)
are reported in %. For further details, refer to section VII of the paper.
FFPREM

TERM

DY

YG

M
'
-1
RMSE
SBV25
-0.003 0.015 0.335 0.064 1.369 11.213 21.468 0.274
-2.481 2.481 2.481 2.481 2.868 2.724 0.611
-2.423 19.765 4.033 77.733 7.417
IND38
-0.002 0.012 0.262 0.050 1.111 8.989 24.996 0.178
-2.061 2.061 2.061 2.061 2.471 2.318 0.806
-1.895 15.462 3.155 60.809 6.020
SBV25 + IND38
-0.003 0.013 0.294 0.056 1.224 9.959 62.875 0.236
-2.263 2.263 2.263 2.263 2.665 2.515 0.276
-2.125 17.338 3.538 68.187 6.629
66
Table XIV
A 5-factor ICAPM: Single-regression beta estimates for the 25 size/book-to-market
portfolios
This table reports in Panel A the single regression beta estimates associated
with the 5-factor ICAPM of Table XIII, for the 25 size/book-to-market portfolios
(SBV25). The factors are the innovations in the FED funds premium
(FFPREM), term structure spread (TERM), log market dividend yield (DY), yield
gap (YG) and the value-weighted market excess return (r
m
). SBVij denotes the
portfolio with ith size and jth book-to-market quintiles. Average betas across the
book-to-market and size quintiles are reported in Panels B and C, respectively.
S1 and BV1 denote the lowest size and book-to-market quintiles, respectively.
The sample is 1954:08-2003:12.
Panel A (SBV25) Panel B (BM quintiles)
FFPREM TERM DY YG r
m
FFPREM TERM DY YG r
m
SBV11 -0.191 3.118 -1.647 -8.070 1.397 BV1 -0.180 2.514 -1.480 -6.869 1.279
SBV12 -0.123 3.075 -1.441 -6.747 1.199 BV2 -0.106 2.747 -1.283 -5.192 1.084
SBV13 -0.071 3.160 -1.275 -5.610 1.034 BV3 -0.105 2.780 -1.158 -4.263 0.963
SBV14 -0.137 3.046 -1.193 -5.120 0.963 BV4 -0.119 2.998 -1.111 -3.951 0.910
SBV15 -0.150 3.579 -1.245 -5.554 0.985 BV5 -0.277 3.148 -1.190 -4.542 0.973
SBV21 -0.305 2.666 -1.626 -7.685 1.405
SBV22 -0.202 2.993 -1.365 -5.715 1.143 Panel C (Size quintiles)
SBV23 -0.248 2.932 -1.230 -4.778 1.005 FFPREM TERM DY YG r
m
SBV24 -0.208 3.210 -1.172 -4.301 0.957 S1 -0.134 3.196 -1.361 -6.220 1.116
SBV25 -0.200 3.291 -1.293 -4.983 1.039 S2 -0.232 3.018 -1.337 -5.492 1.110
SBV31 0.037 2.563 -1.534 -7.001 1.328 S3 -0.088 2.899 -1.259 -4.732 1.052
SBV32 0.025 2.701 -1.274 -4.786 1.075 S4 -0.135 2.986 -1.217 -4.475 1.033
SBV33 -0.152 2.861 -1.150 -3.822 0.963 S5 -0.197 2.088 -1.048 -3.897 0.898
SBV34 -0.049 3.183 -1.121 -3.716 0.909
SBV35 -0.304 3.187 -1.216 -4.337 0.986
SBV41 -0.090 2.689 -1.408 -6.280 1.238
SBV42 -0.137 2.844 -1.228 -4.481 1.052
SBV43 -0.019 2.872 -1.153 -3.866 0.966
SBV44 -0.121 3.219 -1.108 -3.426 0.913
SBV45 -0.307 3.305 -1.187 -4.322 0.994
SBV51 -0.351 1.532 -1.183 -5.309 1.027
SBV52 -0.093 2.124 -1.105 -4.231 0.951
SBV53 -0.034 2.077 -0.983 -3.241 0.849
SBV54 -0.083 2.331 -0.963 -3.192 0.806
SBV55 -0.424 2.377 -1.007 -3.514 0.859
67
Table XV
Factor risk premia for book-to-market quintiles
This table reports the risk premium (beta times risk price) associated with each
factor, averaged across the book-to-market quintiles, for the 5-factor ICAPM of
Table XIII. E(r
mt
) denotes the average excess return for the book-to-market
quintiles, and o represents the average pricing models associated with each
quintile. z
FFPREM
, z
TERM
, z
DY
, z
YG
and z
m
denote the risk premiums associated
with the innovations in the FED funds premium (FFPREM), term structure
spread (TERM), log market dividend yield (DY), yield gap (YG) and the
value-weighted market excess return (r
m
), respectively. All the values are
presented in percentage points. BV1 denote the lowest book-to-market quintile.
The sample is 1954:08-2003:12.
E(r
mt
)
FFPREM

TERM

DY

YG

M

BV1 0.469 0.001 0.038 -0.495 -0.440 1.751 -0.385
BV2 0.681 0.000 0.042 -0.429 -0.333 1.485 -0.083
BV3 0.789 0.000 0.042 -0.388 -0.273 1.319 0.088
BV4 0.892 0.000 0.046 -0.372 -0.253 1.245 0.226
BV5 0.958 0.001 0.048 -0.398 -0.291 1.332 0.267
68

The FED Model and Expected Asset Returns

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The FED Model and Expected Asset Returns

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The FED model and expected asset returns

market index, and the 10 year Treasury bond R

representing the variance-covariance of the VAR errors. Cj, the

represents the variance of the sum of k consecutive Z

, is the elasticity of intertemporal substitution, , is the relative risk aversion

, where Q is a matrix containing the eigenvectors of var on its columns, and

, indicate that the yield gap is relatively important at

1are parameters of linearization. By

, is the elasticity of intertemporal substitution, and , is the RRA coefficient.

associated with GMM system in section VII, have variance

represents the matrix of moments

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