Jeremy J. Siegel

The Shrinking Equity Premium

The author argues that the equity premium or the historical spread between expected equity returns and government bond yields is probably far below the approximately 6% figure estimated in much of the finance literature. This, the author contends, is due both to an underestimate of the expected real return on the risk-free asset and an overestimate of the realized returns on equities. Correction of these biases reduces the equity premium to 1% to 2% per year. Furthermore, given the current high level of equity prices relative to earnings and high yield on government price-indexed bonds, it is extremely unlikely that the future premium will exceed the 1% to 2% range without an unprecedented increase in earnings growth.

Risk, Interest Rates and the Forward Exchange

I. Relationship of foreign exchange prices and interest rates under risk neutrality, 303. — II. An application of the model to fixed spot rates, 305. — III. Conclusion, 309.

The real rate of interest from 1800–1990: A study of the U.S. and the U.K.☆

Abstract Spurred by the work of Mehra and Prescott (M-P), economists have been attempting to explain the surprisingly low levels of real interest rates in light of the behavior of aggregate consumption. This paper constructs a continuous ‘risk-free’ interest rate series for the United States and the United Kingdom from the beginning of the nineteenth century, extending the period analyzed by M-P, 1889–1978, both backward and forward. It is found that the real rate of return on both long- and short-term bonds was over 400 basis points lower during the M-P period than outside that period and that this result holds for the U.K. as well as the U.S. In contrast, equities show almost identical real returns over the whole sample so that the equity premium is only about one-third as large outside the M-P period as within the period. These new data help reconcile the behavior of consumption and the real rate and suggest that the data from 1889–1978 may not be characteristic of returns on fixed income investments in the future.

What Is an Asset Price Bubble? An Operational Definition

This paper reviews and analyses the current definitions of bubbles in asset prices. It makes the case that one cannot identify a bubble immediately, but one has to wait a sufficient amount of time to determine whether the previous prices can be justified by subsequent cash flows. The paper proposes an operational definition of a bubble as any time the realised asset return over given future period is more than two standard deviations from its expected return. Using this framework, the paper shows how the great crash of 1929 and 1987—both periods generally characterised as bubbles—prove not to be bubbles but the low point in stock prices in 1932 is a ‘negative bubble.’ The paper then extends this analysis to the internet stocks and concludes that it is virtually certain that it is a bubble.

Are money growth and inflation related to government deficits? evidence from ten industrialized economies

Abstract We present empirical evidence on the relation between the government debt growth, money growth and inflation for ten industrialized countries over the post World War II period. Non-parametric and parametric tests reveal little evidence that government debt growth is either related to money growth or permanently related to inflation over periods of a decade or less. But the level of debt is significantly associated with subsequent inflation from 1974 to 1983. These results are consistent with the hypothesis that central banks in developed economies can conduct independent monetary policy over long periods, notwithstanding government deficits.

Money supply announcements and interest rates: Does monetary policy matter?

Abstract Most current explanations of the effect of money supply announcements on the rate of interest center on central bank policy. This paper analyzes a flexible price macroeconomic model where present and future monetary policy have no influence on either interest rates or real output, but monetary data signal information about real economic activity which influences both short- and long-term real rates of interest. The magnitude of the interest rate response is shown to depend on the difference in the income elasticities of currency and deposit demand and the relative size of monetary and real disturbances to the economy.

The Shiller CAPE Ratio: A New Look

Robert Shiller’s cyclically adjusted price–earnings ratio, or CAPE ratio, has served as one of the best forecasting models for long-term future stock returns. But recent forecasts of future equity returns using the CAPE ratio may be overpessimistic because of changes in the computation of GAAP earnings (e.g., “mark-to-market” accounting) that are used in the Shiller CAPE model. When consistent earnings data, such as NIPA (national income and product account) after-tax corporate profits, are substituted for GAAP earnings, the forecasting ability of the CAPE model improves and forecasts of US equity returns increase significantly. The summary was prepared by Mark K. Bhasin, CFA, Basis Investment Group LLC. How Did the Author Conduct This Research? The author performs regressions on the CAPE ratio using three measures of earnings. He plots the CAPE ratio from 1881 through 2014, which shows that the model explains about one-third of the movement in future 10-year real stock returns. He also plots after-tax per share earnings for S&P reported earnings, S&P operating earnings, and NIPA real after-tax corporate profits as published in the NIPAs. The latter plot shows that sharp declines of S&P reported earnings have increased significantly since 1991. To show that the volatility of S&P reported earnings has increased significantly in the last three business cycles, the author reports earnings declines in recessions from 1929 to 2014. In the last three recessions (1990, 2001, and 2008–2009), S&P reported earnings decreased by more than twice as much as NIPA corporate profits. The author points out that the change in the computation of S&P reported earnings has resulted in a shift from understating earnings declines during economic downturns to significantly overstating them. The author concludes that using NIPA corporate profits instead of the S&P reported earnings produces higher projected stock market returns. Abstractor’s Viewpoint The CAPE ratio is used by finance practitioners in an attempt to gauge the S&P 500’s level of valuation. The author convincingly argues that changes in US accounting standards have led to an overstatement of earnings declines in recessions and an artificially high CAPE ratio. Given the current popularity of the CAPE ratio by finance practitioners and the media, the author’s research demonstrates that further analysis is required to successfully use this ratio for investment purposes. Editor’s note: The article was reviewed and accepted by Executive Editor Robert Litterman.

Monetary Stabilization and the Informational Value of Monetary Aggregates

A simple stochastic model is developed which demonstrates that information on the nominal value of money conveys sufficient information about the disturbance to currency and deposit demand so that monetary prices, such as adjusting the level of bank reserves, have no impact on the dispersion of price level forecast errors. However, if information on monetary aggregates is obtained only with a lag, then reserve requirements can reduce the disturbances to the demand for high-powered money and hence prices. Such a reserve ratio depends critically on the variance-covariance matrix of shocks to the monetary demands.

The effectiveness of monetary reform under rational expectations

Abstract Automatic monetary stabilizers based on interest rate information are analyzed in a rational expectations framework. Their impact on price level variability is studied, and their effectiveness is compared to optimal decentralized monetary instruments.

Techniques for achieving optimal money supply rules in a rational expectations macroeconomic model

Abstract The monetary authority can achieve an optimal ‘combination policy’ in a rational expectations model by following a simple criterion that can be verified without knowledge of the structural parameters or the variance-covariance matrix of disturbances.