The Shrinking Equity Premium

Abstract

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.