A Required Yield Theory of Stock Market Valuation and Treasury Yield Determination

Stock market valuation and Treasury yield determination are consistent with the Fisher effect (1896) as generalized by Darby (1975) and Feldstein (1976). The U.S. stock market (S&P 500) is priced to yield ex‐ante a real after‐tax return directly related to real long‐term GDP/capita growth (the required yield). Elements of our theory show that: (1) real after‐tax Treasury and S&P 500 forward earnings yields are stationary processes around positive means; (2) the stock market is indeed priced as the present value of expected dividends with the proviso that investors are expecting fast mean reversion of the S&P 500 nominal growth opportunities to zero. Moreover, (3) the equity premium is mostly due to business cycle risk and is a direct function of below trend expected productivity, where productivity is measured by the growth in book value of S&P 500 equity per‐share. Inflation and fear‐based risk premia only have a secondary impact on the premium. The premium is always positive or zero with respect to long‐term Treasuries. It may be negative for short‐term Treasuries when short‐term productivity outpaces medium and long run trends. Consequently: (4) Treasury yields are mostly determined in reference to the required yield and the business cycle risk premium; (5) the yield spread is largely explained by the differential of long‐term book value per share growth vs. near term growth, with possible yield curve inversions. Finally, (6) the Fed model is partially validated since both the S&P 500 forward earnings yield and the ten‐year Treasury yield are determined by a common factor: the required yield.