Stock Market Valuation : the Role of the Macroeconomic Risk Premium

Using annual and quarterly data since 1952, we estimate a fundamentals- based empirical model for the earning-price ratio of US stocks. The key fundamental-variable is a time-varying discount rate, decomposed into a time-varying measure for the real interest rate and the equity risk premium. Applying the Johansen procedure, we implicitly estimate the equity risk premium with cointegration test in an error correction model. This equity risk premium is determined by GDP volatility and price inflation. In a lesser extent, the share of U.S. equities held by institutional investors can explain the risk premium. Demographic variables explain the earning-price ratio but only as a short-run phenomenon. Our results suggest that change in the macroeconomic equity risk premium has driven much of the recent run-up in stock prices.