The Equity Fear Premium and Daily Comovements of the S&P 500 E/P Ratio and Treasury Yields Before and During the 2007 Financial Crisis

Abstract

The daily S&P 500 forward earnings yield (E/P ratio) is strongly negatively correlated with daily Treasury yields of all maturities during the 2007 financial crisis, which is a reversal from the relation that prevailed before the crisis. To explain this pattern reversal, I introduce a new risk measure called the Total Fear Premium that accounts for flight-to-safety and flight-to-liquidity behavior. The Total Fear Premium “mimics” the VIX during the financial crisis. Once the basic GARCH formulation modeling the interaction between the earnings yield and Treasury yields is augmented with the Total Fear Premium, the relation between the earnings yield and short-term Treasury yields becomes significantly positive, in line with Fama’s (1975) view that short-term yields are good proxies for expected inflation. Two by-products of this analysis are: 1) a new risk premium measure associated with flight-to-liquidity and 2) a new way to measure the inflation risk premium on a daily basis.