An International Analysis of Earnings, Stock Prices and Bond Yields

Journal of Business Finance & Accounting, 34(3) & (4), 613–641, April/May 2007, 0306-686X
doi: 10.1111/j.1468-5957.2007.02010.x
An International Analysis of Earnings,

Stock Prices and Bond Yields
Alain Durré and Pierre Giot∗
Abstract: This paper assesses the contemporaneous relationship between stock prices, earnings
and long-term government bond yields for a large number of countries. The time period of our
data spans several decades. In a time series framework our analysis first tests the presence of a long-
term contemporaneous relationship between these three variables (the so-called Fed model).
Next, we assess if government bond yields play a significant role in the long-run relationship. Our
empirical results question the validity of the Fed model in the sense that we show that long-term
market movements are mainly driven by the earnings yield and not the differential between bond
and earnings yields. As such, our analysis validates the results of Asness (2003) for a much larger
collection of countries while using a dynamic time series (cointegration) framework. Finally, we
also show that changes in long-term government bond yields have a short-term impact on stock
prices.
Keywords: stock prices, earnings, long-run relationships, interest rates, inflation, market
valuation
1. INTRODUCTION
Although neither endorsed nor suggested by the US Fed, the name ‘Fed model’ was
coined by market practitioners in the late 1990s. According to this valuation model,
there is an equilibrium relationship between the earnings yield of a stock index and the
10-year government bond yield. In a nutshell, when the earnings yield is below (above)
the 10-year government bond yield, the stock market is supposed to be overvalued
(undervalued). Thus the ‘fair value’ for the stock index should be equal to the earnings
index divided by the prevailing 10-year government bond yield. Strictly speaking, the
∗ The first author is from the European Central Bank, IESEG-Catholic University of Lille (France) and
member of Labores (CNRS-U.R.A. 362). The second author is Professor of Finance at the Department of
Business Administration & CEREFIM, University of Namur, Belgium and CORE at Université catholique de
Louvain. They would like to thank discussants at the National Bank of Belgium and the European Central
Bank for insightful comments. The opinions expressed in this paper are those of the authors and do not
reflect the views of the European Central Bank or other institutions. The authors also thank the editor,
an anonymous referee and participants at the 2006 JBFA Capital Markets Conference for very insightful
comments which helped to improve the paper. The usual disclaimer applies.
Address for correspondence: Pierre Giot, Professor of Finance, Department of Bussiness Administration &
CEREFIM, Universtiy of Namur, Rempart de la Vierge, 8,5000 Namur, Belgium.
e-mail: pierre.giot@fundp.ac.be

C 2007 The Authors
Journal compilation
C 2007 Blackwell Publishing Ltd, 9600 Garsington Road, Oxford OX4 2DQ, UK
and 350 Main Street, Malden, MA 02148, USA. 613
614 DURRÉ AND GIOT
expected earnings yield should be taken into account and equated to the prevailing
bond yield (we come back to this issue later). The main rationale of this model is the
use of a discounted cash-flow model. In a simplified setting, decreasing (increasing)
government bond yields imply a smaller (larger) discount factor, hence a smaller
(larger) denominator in the valuation formula. This should lead to higher (lower)
stock prices. Note that this supposes that the other variables in the valuation formula
are not affected by the modifications of the discount factor. A closely connected model
is the Stock Valuation Model of Yardeni (2003).
For the past five years, this simplified valuation model has been severely criticized.
Critics argue that the valuation argument is flawed, in the sense that an element is
missing (the risk premium, which is known to be time-varying) and that the concept
of ‘inflation illusion’ is not taken into account. Indeed, lower bond yields suggest
lower anticipated inflation. Hence, firms should witness smaller earnings growth rates
because of a likely decrease in corporate pricing power. Therefore, when the discount
factor decreases, the EPS growth rate should also decrease. This implies that higher
stock prices are not necessarily warranted. As summarized in Lansing (2004):
Investors and homebuyers appear to be adjusting their discount rates to match the
prevailing nominal interest rate. However, for some unexplained reason, they do
not simultaneously adjust their forecasts of future nominal cash flows, i.e., earnings
distributions or imputed rents.
Thus, these critics stress that the growth rate and discount factor variables are
interrelated in the valuation formula. Consequently, the impact of inflation on stock
prices is difficult to quantify as it affects both the numerator and the denominator
of a discounted cash-flow model. Note that it also implies that rising interest rates
are not necessarily a negative factor for stock prices, which was already suggested by
Modigliani and Cohan (1979). Among others, Asness (2000), Ritter and Warr (2002),
O’Hanlon and Peasnell (2004), Asness (2003), Campbell and Vuolteenaho (2004) and
Cohan, Polk and Vuolteenaho (2005) provide a treatment of these issues. In the same
vein, many academic papers stress the role of valuation ratios (such as the P/E ratio)
for fundamental stock market valuation, see e.g. Philips (1999), Campbell and Shiller
(1998 and 2001) or Asness (2003). In contrast to most papers published in this field
however, Thomas (2005) presents some recent evidence that earnings yield do vary
with expected inflation. His analysis tends to validate the rationale underlying the Fed
model. To set the stage for our empirical analysis, we provide a literature review in
Section 2.
Given these recent developments, the goal of this paper is to empirically assess
the contemporaneous relationship between stock prices, earnings and long-term
government bond yields for a large number of countries (Australia, Austria, Belgium,
Canada, Denmark, France, Germany, Italy, Japan, Switzerland, The Netherlands, the
United Kingdom and the United States). Our analysis involves long-term data on a
quarterly basis. To assess the robustness of our results, we also run the analysis using
expected earnings instead of actual earnings and use a really long-term database for
two countries (the UK and the US) for which this kind of data is available. While
Asness (2003) already conducted a related analysis for the US stock market in an OLS
framework, we use dynamic time series models (cointegrated VAR models, also called
VECM models) which allow a rigorous modeling of the short-term and long-term
dynamics. The latter is important for our study as the presence of a valid long-term
C 2007 The Authors
Journal compilation
C Blackwell Publishing Ltd. 2007
EARNINGS, STOCK PRICES AND BOND YIELDS 615
cointegrating relationship between stock prices, earnings and long-term government

bond yields for many countries would lend credence to the Fed model. 1
Besides Asness (2003), our analysis is also close to Koivu, Pennanen and Ziemba
(2005) who assess a restricted Fed model for three countries. In contrast to the latter
study, we do not constrain the weights in the long-term relationship (i.e. we do not
claim that it is exactly the differential between the earnings and bond yield that should
be modeled) and indeed show that the long-term parameters can deviate substantially
from what is commonly assumed. In other words, we let the empirical analysis choose
the optimal long-term coefficients in the cointegrating relationship. We can then test if
these weights are equal to the Fed model weights (e.g., in the Fed model the coefficient
of the bond yield is exactly equal to −1) and if the long-term government bond yield
plays a significant economic role in the analysis.
While cointegration analysis is harder to implement than OLS, it also offers a much
more rigorous testing framework. In particular, the long-term and short-term effects
can be disentangled and we can separately assess their influences. For several countries
our empirical analysis shows that there indeed exists a long-run relationship between
earnings, stock prices and government bond yields. Our analysis is also conclusive when
we use expected earnings instead of actual earnings and when we run the analysis with
very long-term data for the UK and the US. In contrast to the Fed model however, we
show that the long-term bond yield does not really bear on stock market valuations,
neither from a statistical point of view (the bond yield coefficient is not significant in the
long-run relationship) nor from an economic point of view (the bond yield coefficient
is quite small). In other words, while bond yield variations do impact stock prices in
the short-run, the long-run relationship is made up mostly of a linear combination of
earnings and stock prices. This analysis thus supports the view that earnings, and not
bond yields, are the main determinants of stock prices in the long run. Variations in
bond yields help explain stock returns in the short term however.
The rest of the paper is structured as follows. Section 2 discusses the pros and
cons of the Fed model. We then present our dataset in Section 3. The cointegration
econometric framework is detailed in Section 4 and the empirical application is
discussed in Section 5. Finally, Section 6 concludes.
2. THE EARNINGS YIELD, THE BOND YIELD AND THE FED MODEL
This section describes the Fed model and its inputs. We also discuss present value
models and provide a discussion as to why the Fed model could be meaningful or
meaningless.
(i) From the Dividend Model to the Fed Model

For an investor long one share in a given stock, the expected return from period t to
t + 1, HPRet+1 , can be expressed as the sum of the expected dividend, D et+1 , and the
1 Note that we do not consider time-varying models (for the risk premium) as we focus on the
contemporaneous long-run relationship between stock prices, earnings and long-term bond yields. Hence,
our econometric methodology is closer to Harasty and Roulet (2000) and what some practitioners would
like to test than the time-varying models of Campbell and Shiller (1988 and 1989).

C 2007 The Authors
Journal compilation
expected change in the stock price, P et+1 − P t :

e
Pt+1 − Pt De P e + D t+1
e
HPRet+1 ≡ + t+1 = t+1 − 1. (1)
Pt Pt Pt
Let us assume that the expected return is a constant h, i.e. HPRet+1 = h (we briefly
discuss time-varying models below). Rearranging the previous equation, we have:
e
Pt+1 + D t+1
e
Pt = . (2)
1+h
Solving equation (2) N periods forward, we get the usual specification for P t :

N i N
1 1
Pt = e
D t+i + e
Pt+N . (3)
i=1
1+h 1+h
When N → ∞, the second term on the right hand side of equation (3) tends to zero:
N
i
1
Pt = e
D t+i . (4)
i=1
1+h
If dividends are expected to grow at a constant rate d, equation (4) can be simplified
into:
e
D t+1 (1 + d)D t
Pt = = , (5)
h−d h−d
which is valid if and only if h >d. This is the classical stock valuation model of Gordon
(1962). Equation (5) can also be written as:
δ(1 + d)E t
Pt = , (6)
h−d
where δ is the payout ratio (assumed constant here) and E t are the earnings of the firm
at time t. Finally, the required rate of return is usually expressed as r f + RP, where r f is
for example, the 10-year government bond yield and RP is the risk premium demanded
by investors (in excess of r f ) to hold the stock. This finally yields:
δ(1 + d)E t
Pt = . (7)
r f + RP − d
Such a present value relationship sets the stage for the stock yield - bond yield
relationship used in the Fed model. 2 In this simplified framework, decreasing bond
yields lead to higher stock prices, provided that the growth rate of earnings is not
affected. In the same vein, an upward revision in expected earnings (or their long-
term growth rate) leads to higher stock prices, provided that the discount rate does
not increase when the growth rate of earnings increases. Besides the pure ‘mechanical’
2 Note that we formally characterize present value relationships and their econometric framework in
Section 7.
C 2007 The Authors

Journal compilation
relationship implied by equation (7), market participants also constantly arbitrage the
stock and bond markets. When new money has to be invested and interest rates are
low, it is expected that this money inflow will mostly find its way in the stock market
(this is especially true if dividend yields are high). 3 The opposite should be true when
interest rates are high. As such, there exists a substitution effect between stocks and
bonds which is strongly shaped by the relationship of the dividend yield to the bond
yield. Another example is the so-called ‘carry trade’, where market participants take
advantage of low interest rates to buy stocks on margin: stock markets indirectly benefit
from a low-rate environment as portfolio managers incur low borrowing costs when
buying shares. When interest rates rise, these portfolio managers sell their shares to
put a cap on their rising borrowing costs.
Besides practitioners’ discussions, many academic studies have also focused on these
contemporaneous relationships. For example, the relationship between stock prices,
dividends and government bond yields has been keenly studied by British academics.
As indicated in Mills (1991):
the relationship between equity prices, dividends and gilt edged stocks was once felt
by market practitioners in the UK to be of primary importance for forecasting future
movements in prices . . . .
Mills (1991) also uses a cointegration framework to model the stock price index
(P t ), the associated dividend index (D t ) and 20-year government bond yields (R t ). 4
Although not set in the cointegrating framework, the so-called GEYR ratio is very
similar. Indeed, the GEYR ratio, or gilt-equity yield ratio, is defined as the ratio of
the coupon yield on long-term government bonds to the dividend yield on the stock
index. Proponents of the GEYR ratio argue that it fluctuates around a central value
and that any deviation from this ‘equilibrium’ state indicates that the stock market
is under- or over-priced. Therefore the current GEYR ratio, i.e. GEYR t , should have
predictive power for forecasting future stock index returns. See Clare, Thomas and
Wickens (1994), Levin and Wright (1998), Harris and Sanchez-Valle (2000a) or Harris
and Sanchez-Valle (2000b) for some recent discussions and empirical applications. 5
In the United States, the differential between bond yields and appropriately defined
‘equity yields’ has recently been highlighted with the growing popularity of the so-
called Fed and SVM models. Widely popularized by market practitioners and finance
journals (e.g. the Wall Street Journal, Barron’s, . . .), the Fed model states that the ratio
of the 10-year government bond yield to the expected earnings yield for the S& P500
index should be relatively stable through time. When this ratio is below (above) its
long-term average, it is believed that the stock market is undervalued (overvalued) as
the earnings yield is particularly high (low). Recent modifications of the Fed model
3 As an illustration, the Wall Street Journal on Monday June 6, 2005, ran a story in its Money and Investing
column ‘Equities shrug off gloom’, quoting a practitioner as saying ‘To see a market that is this cheap
compared to interest rates, you have to go back 30 to 40 years . . . There’s never been a better moment to buy
equities compared to bonds and that’s a very strong support to the market’.
4 Using data from the UK, Mills (1991) concludes that these three series expressed in logs, i.e. p t = ln(P t ),
d t = ln(D t ) and r t = In(R t ), are cointegrated (with 1 cointegrating vector). We come back to the issue of
cointegration in Section 4 as we detail our econometric methodology.
5 Switching to logs, we have that ln(GEYR)= In(R) − In(D ) + In(P ), or ln(GEYR) = r − d + p. Readers
familiar with the cointegration framework will immediately recognize that proponents of the GEYR ratio
indeed state that r , d and p are cointegrated with ‘constrained’ weights for the long-term relationship set
equal to (1, −1, 1).

C 2007 The Authors
Journal compilation
include the SVM-1 and SVM-2 models introduced by Yardeni (2003). These models
forecast a ‘fair value’ for the S&P500 based on the 10-year bond yield and earnings.
They also motivate asset allocation decisions based on the perceived degree of over and
undervaluation of the S&P500 with respect to its ‘fair value’. 6 To complete the review
of the literature, it is worth noting that Lander, Orphanides and Douvogiannis (1997)
present the Fed model as:
E te
= a + Rt , (8)
Pt
where a is an intercept (or a constant risk premium), E te is the expected earnings and R t
is a nominal bond yield. As underlined by Vila-Wetherilt dnd Weeken (2002), equations
(6) and (8) are strongly related if we assume δ = 1 and d = 0. This discussion shows
that the Fed model approach is very similar to the GEYR framework, with (anticipated)
earnings instead of dividends and 10-year government bonds instead of gilts. Next we
look at the pros and cons of this simplified approach.
(ii) Why the Fed Model Could or Could Not be Relevant?

The rationale underlying the Fed model has been discussed in the academic literature
for the last five years. For example, Lander, Orphanides and Douvogiannis (1997),
Asness (2003) or Campbell and Vuolteenaho (2004) highlight the pros of this model,
although they disagree regarding the way the model should be interpreted. First,
portfolio managers do arbitrage the equity and bond markets and carry trades are much
used. Secondly, this model is more or less in agreement with present value models.
Thirdly, the recent empirical evidence supports the rationale of the Fed model: the
equity yield has somewhat tracked the government bond yield over the last thirty years.
As indicated in Campbell and Vuolteenaho (2004):
the Fed model has been quite successful as an empirical description of stock prices. Most
notably, the model describes the rise in stock yields, along with inflation, during the
1970s and early 1980s, and the decline in stock yields during the past 20 years.
Despite the recent empirical evidence the Fed model has also been severely criticized.
Indeed, there is some confusion regarding the role of inflation as the earnings
yield (expressed in real terms) is set equal to a nominal bond yield. This is neatly
summarized in Lansing (2004) who echoes Asness (2000) and Modigliani and Cohan
(1979) and shows that this leads to ‘expectational errors’. This is also at odds with the
empirical evidence that shows that equities could be a good hedge against inflation,
see e.g., Marshall (1992), Boudoukh and Richardson (1993), Anari and Kolari (2001)
and Spyrou (2004). More recently, the money illusion argument has also been studied
by Campbell and Vuolteenaho (2004) and Cohan, Polk and Vuolteenaho (2005). They
show that, although the Fed model tends to fit the recent data quite well, this model is
on very shaky grounds with few theoretical justifications for its relevance. In the same
vein, Ritter and Warr (2002) highlight two possible problems regarding the Fed model.
6 Note that the Yardeni (2003) SVM-1 model is exactly the model specified by equation (7) when RP = d
and δ = 1. Yardeni (2003) recently introduced the so-called SVM-2 model to alleviate concerns regarding
the RP = d and δ = 1 constraints and discuss the risk premium problem. This second model still hinges on
the differential between the 10-year government bond yield and the earnings yield.
C 2007 The Authors

Journal compilation
On the one hand, the discount rate is not adjusted for risk, which yields capitalization
rate errors (as defined by Ritter and Warr, 2002). On the other hand, when focusing
solely on the earnings growth without any adjustment for the firms’ wealth given specific
cases (e.g., due to changing inflation environment), a debt capital gain error is made.
Therefore the potential capital gain that may result from the reduction of the real
value of the firm’s debt in presence of inflation is not taken into account. Without
questioning the problems raised by Ritter and Warr (2002), O’Hanlon and Peasnell
(2004) show however, that none of the three types of adjustments advocated by Ritter
and Warr (2002) have any theoretical impact on the value estimates generated by
the residual income-based valuation procedure. In particular, they find no theoretical
basis for the argument that residual income valuation needs to be carried out on
the basis of inflation-adjusted residual incomes. More recently, Thomas (2005) argues
quite convincingly that forward earnings yield should vary with expected inflation.
His analysis is thus at odds with most of the recent literature on this topic and is
based on descriptive analysis and accounting simulations. In a nutshell, Thomas (2005)
contends that accounting earnings include inflation holding gains, which introduces
a link between expected earnings and inflation.
Another potential problem stems from the fact that the risk premium is not really
taken into account in the simplified Fed model framework. More precisely, possibly
time-varying risk premia à la Campbell and Shiller (1988 and 1989) are not taken into
account as the relationship focuses solely on the contemporaneous links between the
variables. Finally, there is also some confusion regarding the role of interest rates in
the determination of stock prices and anticipated returns. For example, Philips (1999),
Campbell and Shiller (1998 and 2001) or Jones, Wilson and Lundstrum (2002) show
that valuation ratios are the main determinants of future stock price performance;
prevailing bond yields do not enter the relationships. In contrast, the Fed model takes
as input the nominal bond yield to set the ‘right’ stock index price (if the nominal
bond rate would decrease to 1% for instance, the ‘right’ P/E ratio would be at 100).
Besides, in the recent 2001–2003 period, fears of deflation have depressed the stock
markets, while decreasing interest rates should have spurred the markets according to
the Fed model. Actually, there is a growing consensus that valuation ratios (such as the
price earnings ratio) strongly matter for the future long-term stock market outlook.
In this framework, the long-run equilibrium relationship should only involve earnings
and stock prices, interest rates should not be an input in the model. We focus on this
research agenda in Sections 4 and 5.
3. THE DATASET
The empirical part of the paper focuses on thirteen countries: Australia, Austria,
Belgium, Canada, Denmark, France, Germany, Italy, Japan, Switzerland, The Nether-
lands, the United Kingdom and the United States. As far as stock prices, earnings
and long-term interest rates are concerned, reliable data has been available for this
group of 13 countries since the early seventies. Therefore, the sample period of our
analysis ranges from January 1973 to December 2004 (quarterly data). Taking into
account the international and historical perspectives of this paper, we rely on data
vendors that ensure that the data is harmonized across countries. For the equity
variables (stock indexes and corresponding earnings), the primary source is Thomson
Financial Datastream (TFD). More precisely, we use the stock and earnings harmonized

C 2007 The Authors
Journal compilation
indexes (as computed by Datastream) to facilitate the comparison between countries.

For example, the stock indexes are the so-called total market indexes of the given
country. The source for the long-term interest rate is the IMF International Financial
Statistics. The selected long-term interest rate is equivalent to the yield-to-maturity of
long-term government bonds, i.e. a 10-year yield. To switch from nominal stock prices
and earnings to real stock prices and real earnings, we first download the consumer
price index (CPI) series for each country from the harmonized OECD dataset. 7 In a
second step, the stock index and earnings series are deflated accordingly. Therefore,
for each country, we have six quarterly series: the nominal stock index, the real stock
index, the nominal earnings index, the real earnings index, the long-term government
bond yield and the inflation index normalized at 1 in 1973:01.
The global indexes supplied by TFD feature all the stocks of the given country. They
are thus more relevant than the more narrowly-defined (and better-known) S&P500,
CAC-40 or DAX-30 indexes (henceforth called the standard indexes). The correlation
of the global indexes with the standard indexes is very high (typically larger than 0.9). In
contrast to Lander, Orphanides and Douvogiannis (1997), we use the current earnings
and not the expected earnings because the latter are not available for so many countries
and for such a large time frame. Indeed, expected earnings (such as provided by the
I/B/E/S database) have only been available for a much shorter time period (this is
particularly relevant for the European countries). As our paper features data spanning
three decades for a very large number of countries, we thus cannot use the expected
earnings. Note that Koivu, Pennanen and Ziemba (2005) use the same kind of dataset,
i.e. they also focus on current earnings and not expected earnings. In the last part of the
paper, we nevertheless assess the robustness of our results using a proxy for anticipated
earnings. More precisely, we use the actual 1-year ahead earnings as the anticipated
earnings in the models. 8 Regarding the earnings extracted from the TFD database,
it should be noted that the global indexes constructed by TFD do not include losses
(or negative earnings) but only positive earnings. As discussed in Ohlson (2006), more
accurate earnings measures exist while earnings themselves may not appear sufficient to
reflect the equity valuation as discussed in Phlson (1995) or Ohlson and Zhang (1998).
However, given the purpose of our study, the choice of the TFD database is motivated
by several considerations. First, the historical perspective of our analysis requires the
use of very long time series, only provided by TFD. Second, the need of using a long
sample of data is also explained by the application of the cointegration method, which
also requires that time series variables contain a relatively high number of cycles. Third,
the TFD indexes, which include the most representative stocks in each country, ensure
a homogenous sample of equities for all related ratios. The latter point also allows a
fair comparison of ratios between countries. All these elements explain why the TFD
time series are the most used in the financial empirical literature. Finally, the potential
implications of the non inclusion of negative earnings in the indexes should be rather
limited. On the one hand, given the nature of stocks included in the TFD indexes,
the probability of occurrences of losses is pretty low. On the other hand, the empirical
evidence also suggests that firms’ losses are highly transitory. 9
7 As these series are not seasonally adjusted, we compute seasonally adjusted CPI series using the Census
X-12 ARIMA method run by the EViews 4.0 software.
8 We thank the anonymous referee for this suggestion. The 1-year delay to approximate the anticipated
earnings is also supported by empirical evidence. See for instance Capstaff, Paudyal and Rees (2001) and
Ou and Sepe (2002) for further discussion.
C 2007 The Authors

Journal compilation
Finally, we further check the long-term robustness of our results by looking at

two countries for which really long-term data is available, i.e. the UK and the US
This however, necessitates a change of database. For these two countries, we use
the information provided by Global Financial Data, a data vendor of long-term time
series. For the UK and the US, we thus have all series starting from 1958 and 1871
respectively. 10
4. THE FED MODEL IN THE COINTEGRATION FRAMEWORK
(i) Why Cointegration Instead of OLS?

In the existing empirical literature, the Fed model is usually tested using ordinary
least squares methodology (OLS). For example, Asness (2003) estimates the following
model:
Pt = α + β1 (EPt − Rt ) + εt (9)
where P t is the ten-year real returns for the Standard&Poors 500 index, α is an
intercept and EP t − R t is the contemporaneous difference between the earnings yield
(EP t ) and the ten-year US Treasury bond yield (R t ). Over the 1881–2001 time period,
Asness (2003) shows that the weak statistical significance of the β 1 coefficient (its
t-statistic is equal to 1.41) is due to the inclusion of the earnings yield in the expression.
When the earnings yield and the ten-year bond yield are included separately, EP t
is strongly significant (with a t-statistic of 4.13) while R t is not significant (with a
t-statistic of 0.06). Besides, the switch from equation (9) to the new model improves
substantially the explanatory power of the regression as the adjusted R 2 increases from
11.9% to 30.1%. In a related OLS framework, other authors predefine the weights for
the variables and then assess the forecasting properties of the combination of variables
(e.g., the forecasting performance of the P/E ratio, as in Campbell and Shiller, 1998
and 2001, or the GEYR ratio as in Harris and Sanchez-Valle, 2000).
From an econometric point of view, an OLS analysis of the Fed model is ‘restrictive’
in the sense that it has a hard time combining the long-term and short-term dynamics if
these are present in the analysis. Indeed, OLS regressions that do not include dynamic
time series effects cannot disentangle and properly assess the short-run and long-run
dynamics. From a finance point of view, it is crucial that both effects be separated.
Indeed, even if bond yields do not impact stock prices in the long run (i.e. what is
argued by those who criticize the Fed model), we cannot rule out the fact that maybe
variations in long term bond yields affect stock prices in the short run. This could
explain the popularity of the Fed model in the financial press.
Regarding the relationship between earnings and stock prices, tests of present value
relationships (as pioneered by Campbell and Shiller, 1987 and 1988) have become very
popular. While the early paper of Campbell and Shiller (1987) did not get meaningful
9 See for instance Ou and Sepe (2002) for a discussion on negative profits.
10 In contrast to dividends, long-term data for earnings are not available for the other countries in our
dataset. Strictly speaking, the earnings series is available from Global Financial Data since 1933, however the
10-year government bond yield has only been available since 1958. Hence we set the starting date at 1958 for
the UK.

C 2007 The Authors
Journal compilation
cointegration results (using stock prices and dividends as input variables), MacDonald
and Power (1995) validate the present value relationship between earnings and stock
prices for the US market. They suggest that earnings, and not dividends, should be
included in the analysis (they argue that both dividends and retained earnings, which
sum to earnings, should be taken into account). However, since dividends, and hence
the pay-out ratio, do not vary considerably over time as shown for instance in Gwilym,
Morgan and Thomas (2000), this discussion on total returns and returns excluding
dividends should not be a big issue.
In this paper, we jointly analyze these short-term and long-term effects within the
cointegration framework (dynamic time series models—VECM models). Originally
developed by Engle and Granger (1987), the cointegration methodology allows an
assessment of possible long-term relationships between economic or financial variables
while explicitly modeling the short-term dynamics. Put simply, a cointegrated model
lets the future time path of a variable be governed by a long-term equilibrium and a
short-term dynamics. To our knowledge, with the exception of Mills (1991) in his study
on the GEYR ratio and recently Koivu, Pennanen and Ziemba (2005), there have been
no cointegration studies of the Fed model. Even Koivu, Pennanen and Ziemba (2005)
do not run a complete cointegration analysis as they constrain the coefficients of the
long-term relationship (see below). 11
(ii) The Cointegrated Model

(a) The Fed Model in the Cointegration Framework
Let us illustrate the methodology by focusing directly on the variables involved in the
Fed model. For each country, the variables are e t = ln(E t ), the log earnings index,
p t = ln(P t ), the log stock index and r t = ln(R t ), the log government bond yield. 12
Provided that there is one cointegration relationship among the three variables, the
cointegration model can be written as: 13
e t = γe + αe (e t−1 + β p pt−1 + βr r t−1 ) + Short-run dynamics for e + e ,t , (10)
pt = γ p + α p (e t−1 + β p pt−1 + βr r t−1 ) + Short-run dynamics for p + p,t , (11)
r t = γr + αr (e t−1 + β p pt−1 + βr r t−1 ) + Short-run dynamics for r + r,t . (12)
These equations illustrate the rationale of a cointegration model. For example, the
change in stock prices ( p t ) is driven both by the past disequilibrium in the long-run
relationship e t−1 + β p p t−1 + β r r t−1 and a short-run dynamics. 14
11 More recently, the international analysis conducted by Harasty and Roulet (2000) also supports the
cointegration hypothesis.
12 An alternative specification would include p t = ln(P t ), e t = ln(E t ) and R t , and not r t = In(R t ), as
inputs. We however, prefer to work with the log government bond yield as taking the log of the supposed
Fed model relationship E t /P t = R t gives e t − p t − r t . As detailed in the equations given below, this is thus
the supposed long-run relationship if the Fed model is valid. The log specification is also suggested in many
papers, see e.g. Campbell and Shiller (1989), Timmermann (1995), Campbell, Lo and MacKinlay (1997) or
Koivu, Pennanen and Ziemva (2005).
13 In theory, there could be up to 2 cointegration relationships. Anticipating on the empirical results, we
always have 0 or 1 cointegration relationship, hence we do not detail the specification which features 2
cointegration relationships.
C 2007 The Authors

Journal compilation
(b) Interpretation of the Coefficients

What should β p and β r be if the Fed model is correct? Taking the log of the supposed
Fed model relationship E t−1 /P t−1 = R t−1 gives e t−1 − p t−1 − r t−1 . Hence, if the Fed
model is valid, we should have β p = −1 and β r = −1. If the Fed model is only partially
valid in the sense that long-term government bond yields do not really matter while the
bulk of the adjustment comes from the earnings and stocks prices, then β p should be
significantly negative (but not necessarily equal to −1) and β r should not be significant.
In the empirical application, we test these hypotheses (in contrast, Coivu, Pennanen
and Ziemba, 2005, impose these constraints, i.e. they suppose that the Fed model is
∗
−1
true). Regarding the short-term dynamics, it can be expressed as kj =1 δe , j e t− j +
∗ ∗
k −1 k −1
j =1 δ p, j pt− j + j =1 δr, j r t− j , i.e. a weighted sum of past changes in the three
variable (k ∗ − 1 being the optimal number of lags to include).
In the cointegration literature, the α e , α p and α r coefficients are called the
adjustment speeds, as they determine how each variable is affected by the disequilibrium
in the lagged long-run relationship e t−1 + β p p t−1 + β r r t−1 . For example, if α p was equal
to 0, the dynamics of p t would solely be governed by the short-run effects. Economic
good sense suggests a positive α p if β p is negative: if stock prices increase more than
warranted by earnings increases, e t−1 + β p p t−1 + β r r t−1 becomes negative and the
system should ‘correct’ by having stock prices decrease.
Given this discussion and the literature review of Section 4, we suggest three testable
hypotheses regarding the validity or partial validity of the Fed model:
H1: There is a cointegration relationship between earnings, stock prices and govern-
ment bond yields.
H2: The cointegrating relationship of hypothesis 1 implies that a deviation from the
long-run equilibrium impacts stock prices such that the equilibrium is restored.
H3: Although there is a cointegration relationship, government bond yields do not play
a significant role in the long-term relationship.
Note that hypothesis 2 is key to the adjustment process. For example, it predicts that,
if stock prices are too high with respect to the equilibrium level fixed by the earnings and
bond yields, they should decrease in the near future. Hypothesis 3 modifies hypothesis
2 in the sense that the bond yield no longer influences the ‘return to equilibrium’
of stock prices. It was also the main focus of Asness (2003) but we test it here within
the error-correction framework. Hypothesis 3 also looks at the validity of constraining
(as in the strictest version of the Fed model and as assumed in Koivu, Pennanen and
Ziemba, 2005) the long-run relationship to be exactly e t−1 − p t−1 − r t−1 .
(c) Unit Root Tests and the Cointegration Test
Prior to estimating this model, we must first test that the log variables are integrated of
order 1. This is done via the usual augmented Dickey-Fuller (ADF) unit root tests with
constant and/or trend included in the specification. Then we must of course test for
the presence of cointegration. Indeed, if the e t , p t and r t variables are not cointegrated,
then it makes no sense to estimate such a VECM model. We use the Johansen trace
14 Note that our specification is not at odds with the evidence in the literature according to which stock
prices anticipate future earnings as shown for instance by O’Hanlon (1998). In particular, the exercise with
the expected earnings in the last part of the paper reinforces the robustness of our specification.

C 2007 The Authors
Journal compilation
and Max Eigenvalues tests. 15 Additional details are presented in Enders (1995), Brooks
(2002) or Harris and Sollis (2003).
(d) Assessing the Possible Contemporaneous Influence of Bond Yields on Stocks Prices
To assess this influence, we estimate the single-equation ECM model for the stock price
adjustments. This model can be written as:
pt = γ p + α p res t−1 + δe ,0 e t + δr,0 r t + Short-run dynamics for p + t , (13)
where res t are the residuals from the previous (and separate) estimation of the long-
∗ ∗
−1 −1
run relationship and the short term dynamics is kj =1 δe , j e t− j + kj =1 δ p, j pt− j +
∗
k −1
j =1 δr, j r t− j . Note that we use the same Greek letters for the coefficients as in the
VECM model, but of course they will take different numerical values.
Regarding the short-term dynamics of the model, coefficient δ r,0 is important as it
shows how contemporaneous changes in the bond yield affect the stock prices (we suspect
that this coefficient will turn out to be significantly negative). In the short-run dynamics,
coefficient δ p,1 highlights the momentum effect in stock prices as it summarizes the
influence of the past returns (it should not be statistically different from zero if the
stock market is weakly efficient).
A key feature of the single-equation ECM is that it features contemporaneous terms
on the right-hand side. As such, this type of model is not much used in forecasting
applications as scenarios for the right-hand side variables must be made prior to
computing the forecasts. In contrast, the VECM only features lagged variables on the
right-hand side. The single-equation approach is often used by financial institutions
which use that kind of model in conjunction with a scenario analysis.
5. EMPIRICAL ANALYSIS
(i) A Long-Run Equilibrium?

We report the cointegration results for all countries in Table 2 (nominal data) and
Table 3 (real data). 16 Prior to the cointegration analysis, we also ran augmented Dickey-
Fuller unit root tests on the nominal and real series (and on their first differences).
These results are displayed in Table 1. The unit root results are similar to those
previously documented in the literature (e.g., Harasty and Roulet, 2000; and Koivu,
Pennanen and Ziemba, 2005). Indeed, all series exhibit a unit root. 17 When a constant
and a trend are both included, a few series fail the test at the 5% level. Nevertheless,
a visual inspection of those cases does not invalidate the analysis and we therefore
proceed similarly for all countries. 18
∗ ∗
15 The number of optimal lags (k ) included in the multivariate model is set such that the last included k
+ 1 lagged variables in the VAR specification are jointly non significant. We also check for autocorrelation
and absence of normality in the residuals and look at the AIC criteria. Because cointegration tests are
∗
known to have relatively low power in small samples and can depend on the chosen k , we also perform the
∗ ∗
cointegration tests for k = k + 1 and k = k − 1.
16 We report the cointegration trace tests. The Max Eigenvalues tests deliver the same results and are not
reported to save some space in the tables.
17 See also Fraser and McKaig (1987) for similar evidence in other financial markets.
18 Unit root tests on the first differences of the series tend to confirm the unit root hypothesis for the
original series.
C 2007 The Authors

Journal compilation
Table 1
Unit Root Tests
e = ln(E ) e r = ln(E r ) p = ln(P ) p r = ln(P r ) r = ln(R)
Country c c+t c c+t c c+t c c+t c
Australia 0.58 0.12 0.23 0.09 0.90 0.06 0.81 0 0.76

Austria 0.96 0.59 0.86 0.60 0.97 0.40 0.90 0.38 0.77
Belgium 0.23 0.04 0.49 0.27 0.95 0.30 0.92 0.13 0.94
Canada 0.61 0 0.04 0.08 0.96 0.07 0.93 0.15 0.85
Denmark 0.42 0.04 0.59 0.02 0.92 0.04 0.95 0.01 0.94
France 0.36 0.30 0.74 0.31 0.89 0.27 0.88 0.07 0.90
Germany 0.82 0.30 0.78 0.48 0.86 0.23 0.78 0.15 0.86
Italy 0.77 0.89 0.83 0.51 0.81 0.80 0.70 0.28 0.87
Japan 0.55 0.59 0.14 0.49 0.59 0.95 0.70 0.85 0.76
Switzerland 0.95 0.05 0.88 0.13 0.95 0.11 0.94 0.07 0.44
The Netherlands 0.77 0 0.74 0 0.91 0.37 0.90 0.15 0.89
United Kingdom 0.27 0.25 0.15 0 0.81 0.65 0.79 0.33 0.93
United States 0.69 0.04 0.75 0.32 0.96 0.10 0.94 0.08 0.68
Notes:
P -values for the ADF unit root tests for the log earnings index, log real earnings index, log stock
index, log real stock index and log government bond yield. The P -values reported in the table refer to the
null hypothesis of a unit root in the given series. The time period is 1973:01 - 2004:04 (quarterly data) for all
countries. The c column indicates that a constant was included in the unit root test, while the c + t column
indicates that both a constant and time trend were included in the ADF test.
Among the group of 13 countries (nominal data), eight countries are character-
ized by exactly one cointegration relationship, while 5 countries (Austria, Belgium,
Germany, Italy and Japan) do not exhibit any cointegration. Regarding the real
stock prices, real earnings and long-term bonds, seven countries feature exactly one
cointegration relationship. In this case, there are thus 6 countries (Australia, Austria,
Belgium, Germany, Italy and Japan) that do not exhibit any cointegration. 19 For the
countries that do exhibit cointegration, we report the coefficients (β p , β r ) that enter
the long-run relationship e t−1 + β p p t−1 + β r r t−1 . Besides, we also give the adjustment
speeds (α e , α p and α r for the nominal data; α e r , α pr and α r for the real data). These
results tend to support hypothesis 1 of Section 4. They are also consistent with previous
results, e.g., MacDonald and Power (1995) for US data, Harasty and Roulet (2000) or
more recently Koivu, Pennanen and Ziemba (2005) for three countries. 20
To illustrate, for two countries that exhibit one cointegration relationship (the UK
and the US), we plot the long-run equilibrium relationship (called cr ) vs time in
the bottom of Figure 1. For each of these figures, the top figure shows the earnings
yield, while the middle figure presents the ratio of the earnings yield to the long-term
government bond yield. A look at the long-run relationships visually confirms that the
cointegrating vector is stationary. Note that the cycles are quite long, which supports
the view that a meaningful cointegration analysis needs a large time sample. These
19 The significance level of the cointegration is reported in the P column, while the number of lags in the
VECM system is given in the Lags column.
20 Regarding Belgium and Italy, they exhibited cointegration on a smaller sample. Note also that Japan is a
very difficult market to model given 15 years of bull market followed by 15 years of bear market, with some
deflation. Indeed, on October 9, 2005, the Financial Times in its ‘Arguments persist over assessing valuations’
story discussed the Fed model and also noted that Japan seemed at odds with other countries.

C 2007 The Authors
Journal compilation
626
Table 2
Cointegration Analysis (VECM): Earnings, Stock Prices and Government Bond Yields
Adjustment Speeds
Coint. Coint. Vector H0:β r = 0
Country Time Period Lags Level (1 β p β r ) αe αp αr (P-value) R2
Australia 1973:03–2004:04 1 0.13 (1 −0.69 −0.14) −0.10 (0.03) 0.16 (0.06) −0.04 (0.04) 0.41 0.06
Australia 1973:03–2004:04 1 0.13 (1 −0.65 0) −0.09 (0.03) 0.13 (0.06) −0.05 (0.03)
Austria 1973:03–2004:04 – – – – – – – –
Belgium 1973:03–2004:04 – – – – – – – –
Canada 1973:04–2004:04 2 0.03 (1 −0.74 −0.05) −0.15 (0.03) 0.03 (0.03) 0.03 (0.03) 0.85 0.05
Canada 1973:04–2004:04 2 0.04 (1 −0.72 0) −0.15 (0.03) 0.03 (0.03) 0.02 (0.02)
Denmark 1973:04–2004:04 2 0.01 (1 −0.72 0.13) −0.17 (0.04) 0.08 (0.02) −0.02 (0.03) 0.74 0.16
Denmark 1973:04–2004:04 2 0.01 (1 −0.77 0) −0.17 (0.04) 0.08 (0.02) −0.02 (0.03)
France 1973:03–2004:04 1 0.06 (1 −0.77 −0.02) −0.12 (0.03) 0.07 (0.04) −0.04 (0.02) 0.94 0.09
France 1973:03–2004:04 1 0.06 (1 −0.77 0) −0.12 (0.03) 0.07 (0.04) −0.04 (0.02)
Germany 1973:03–2004:04 – – – – – – – –
Italy 1973:03–2004:04 – – – – – – – –
Japan 1973:03–2004:04 – – – – – – – –
Switzerland 1973:03–2004:04 1 0.08 (1 −0.68 −0.01) −0.23 (0.05) 0.05 (0.08) −0.11 (0.06) 0.96 0.03
DURRÉ AND GIOT
Switzerland 1973:03–2004:04 1 0.08 (1 −0.68 0) −0.23 (0.05) 0.05 (0.08) −0.12 (0.06)
The Netherlands 1973:03–2004:04 1 0.16 (1 −0.50 0.27) −0.12 (0.04) 0.05 (0.04) −0.09 (0.03) 0.41 0.08
The Netherlands 1973:03–2004:04 1 0.16 (1 −0.57 0) −0.13 (0.04) 0.06 (0.05) −0.08 (0.03)
United Kingdom 1973:01–2004:04 1 0.00 (1 −0.64 0.01) −0.11 (0.02) 0.17 (0.05) −0.07 (0.03) 0.96 0.12
United Kingdom 1973:01–2004:04 1 0.00 (1 −0.64 0) −0.11 (0.02) 0.17 (0.05) −0.07 (0.03)
Journal compilation
United States 1973:03–2004:04 1 0.02 (1 −0.74 −0.40) −0.05 (0.02) 0.17 (0.05) 0.05 (0.05) 0.09 0.13
United States 1973:03–2004:04 1 0.02 (1 −0.62 0) −0.05 (0.02) 0.13 (0.04) −0.02 (0.04)
Notes:

Cointegration analysis for the log earnings index e = ln(E ), log stock index p = ln(P ) and the log government bond yield r = ln(R). The long-run
relationship is e + β p p + β r r , while the adjustment speeds are for e t , p t and r t respectively. As H0:β r = 0 is not rejected, we report the long-run relationship
e + β p p + 0 r , i.e. when β r = 0 is enforced in the estimation (second line of results for each country). The last column gives the R 2 of the regression for the stock
price adjustments in the model. Cointegration tests were done using the Johansen methodology. A - indicates that there is no cointegration for that country, while the
‘Coint. level’ column gives the percentage level at which we reject the absence of cointegration. ‘Lags’ gives the number of lags included in the short-term dynamics.

C 2007 The Authors
C

Table 3
Cointegration Analysis (VECM): Real Earnings, Real Stock Prices and Bond Yields
Adjustment Speeds
2007 The Authors

Country Time Period Lags Level (1 β p β r ) α er α pr αr (P-value) R2
Journal compilation
Australia 1973:03–2004:04 – – – – – – – –
Austria 1973:03–2004:04 – – – – – – – –
Belgium 1973:03–2004:04 – – – – – – – –
Canada 1973:04–2004:04 2 0.04 (1 −0.70 −0.12) −0.12 (0.03) 0.003 (0.03) 0.04 (0.02) 0.81 0.06
Canada 1973:04–2004:04 2 0.04 (1 −0.62 0) −0.12 (0.03) −0.01 (0.03) 0.04 (0.02)
Denmark 1973:04–2004:04 2 0.01 (1 −0.50 0.20) −0.20 (0.05) 0.09 (0.03) −0.03 (0.03) 0.65 0.15
Denmark 1973:04–2004:04 2 0.01 (1 −0.64 0) −0.19 (0.05) 0.09 (0.03) −0.02 (0.03)
France 1973:03–2004:04 1 0.05 (1 −0.61 0.15) −0.15 (0.03) 0.04 (0.05) −0.04 (0.03) 0.59 0.09
France 1973:03–2004:04 1 0.05 (1 −0.68 0) −0.15 (0.03) 0.06 (0.05) −0.03 (0.03)

Germany 1973:03–2004:04 – – – – – – – –
Italy 1973:03–2004:04 – – – – – – – –
Japan 1973:03–2004:04 – – – – – – – –
Switzerland 1973:04–2004:04 1 0.12 (1 −0.58 0.12) −0.20 (0.05) −0.06 (0.07) −0.09 (0.05) 0.42 0.03
Switzerland 1973:04–2004:04 1 0.12 (1 −0.61 0) −0.21 (0.05) −0.05 (0.07) −0.07 (0.06)
The Netherlands 1973:04–2004:04 1 0.17 (1 −0.38 0.19) −0.18 (0.05) 0.02 (0.06) −0.09 (0.04) 0.46 0.07
The Netherlands 1973:04–2004:04 1 0.17 (1 −0.44 0) −0.19 (0.05) 0.03 (0.06) −0.08 (0.04)
United Kingdom 1973:01–2004:04 2 0.00 (1 −0.32 0.05) −0.24 (0.03) 0.13 (0.08) −0.02 (0.05) 0.68 0.07
United Kingdom 1973:01–2004:04 2 0.00 (1 −0.35 0) −0.24 (0.03) 0.13 (0.08) −0.02 (0.05)
United States 1973:03–2004:04 2 0.02 (1 −0.45 −0.06) −0.10 (0.03) 0.13 (0.06) 0.06 (0.07) 0.76 0.11
EARNINGS, STOCK PRICES AND BOND YIELDS
United States 1973:03–2004:04 2 0.02 (1 −0.42 0) −0.10 (0.03) 0.12 (0.06) 0.04 (0.07)
Notes:
Cointegration analysis for the log real earnings index e r = ln(E r ), log real stock index p r = ln(P r ) and the log government bond yield r = ln(R). The
long-run relationship is e r + β p p r + β r r , while the adjustment speeds are for e r,t , p r,t and r t respectively. As H0:β r = 0 is not rejected, we report the long-run
relationship e r + β p p r + 0 r , i.e. when β r = 0 is enforced in the estimation (second line of results for each country). The last column gives the R 2 of the regression
for the stock price adjustments in the model. Cointegration tests were done using the Johansen methodology. A - indicates that there is no cointegration for that
country, while the ‘Coint. level’ column gives the percentage level at which we reject the absence of cointegration. ‘Lags’ gives the number of lags included in the
short-term dynamics.
627
Figure 1
United Kingdom and United States
earnyield earnyield
0.14
0.30
0.12
0.25
0.10
0.20
0.08
0.15
0.06
0.10
0.04
0.05
1970 1975 1980 1985 1990 1995 2000 2005 1970 1975 1980 1985 1990 1995 2000 2005
1.6 earnyieldGOVT
earnyieldGOVT
1.8
1.4
1.6
1.4 1.2
1.2
1.0
1.0
0.8
0.8
0.6
0.6
1970 1975 1980 1985 1990 1995 2000 2005 1970 1975 1980 1985 1990 1995 2000 2005
0.50 cr cr
−1.8
0.25 −1.9
−2.0
0.00
−2.1
−0.25 −2.2
−2.3
−0.50
−2.4
−0.75
−2.5
−1.00 −2.6
1970 1975 1980 1985 1990 1995 2000 2005 1970 1975 1980 1985 1990 1995 2000 2005
Notes:
From top to bottom: earnings yield, earnings yield/government bond yield and cointegration relationship
(nominal data). Left figures are for the UK, right figures for the US.
graphs also show that the long-run relationship is not dissimilar to either the ratio
of the earnings yield to the long-term government bond yield (middle figure) or the
earnings yield (top figure), but at the same time it is distinctively different. 21
(ii) Deviations From the Equilibrium

As far as hypothesis 2 is concerned (does a deviation from the equilibrium in the
long-run relationship impact stock prices in such a way that the system reverts to
21 To save space, we present these graphs for only two countries. Graphs for the other countries are
nevertheless similar and are available on request from the authors.
C 2007 The Authors

Journal compilation
equilibrium?), the evidence is mostly conclusive, although some coefficients are not
significant. Indeed, coefficient β p is negative and α p is positive, although not significant
in some cases. To illustrate, this implies that, if stock prices rise more than warranted
by the rise in earnings, the system gets out of equilibrium (e t−1 + β p p t−1 + β r r t−1
becomes negative) and the positive adjustment speed (α p ) channels this effect into
a negative price adjustment at the next period. For example, the UK is characterized
by β p = −0.64 and α p = 0.17, while these coefficients are respectively equal to −0.74
and 0.17 for the US. If β p was exactly equal to −1, then the log earnings yield would
exactly enter the cointegration relationship. This would indicate that high (low) P/E
ratios would lead to poor (good) future stock market performance. Although we do
not have β p = −1, the combination of a negative β p and positive α p indicates that high
stock prices with respect to earnings do lead to poor future stock market performance.
This supports hypothesis 2 and the conventional wisdom prevailing for stock market
performance and high/low stock prices to earnings ratios. It should be stressed that the
set of long-term coefficients is very far from (1 −1 −1), i.e. the set of weights posited by
the Fed model and constrained as such in Koivu, Pennanen and Ziemba (2005) (see
below for an additional discussion).
To further highlight the possible stock index adjustment to the level of the
cointegration relationship, we plot scatter plots of 3-, 12-, 24- and 60-month forward-
looking returns vs the value of the cointegration relationship (at the time the return is
computed). Campbell and Shiller (1998 and 2001) present similar graphs for forward-
looking returns vs P/E ratios. If the valuation argument is correct, we expect that low
(high) values for the cointegration relationship indicate overvalued (undervalued)
markets. Thus these values should lead to negative (positive) forward-looking returns
and hence the scatter plots should trend upwards. We plot these scatter plots for two
selected countries (the United Kingdom and the United States) in Figure 2. The shape
of the scatter plot is as expected. Note however, that these graphs are only illustrative
as it is known that overlapping returns tend to mechanically lead to such patterns.
(iii) Are Bond Yields Relevant?

Let us now focus on hypothesis 3, i.e. whether long-term government bond yields
are economically and/or statistically relevant in the equilibrium relationship. The
P -value for this test (χ 2 (1) LR test) is reported in the H0:β r = 0 column. To better
understand the role of the bond yield, we also report the estimation results from a
constrained cointegration analysis, i.e. the estimation results from the VECM where
the β r coefficient is constrained to be equal to zero. Indeed, if the bond yield does not
really matter in the cointegration analysis, we expect that the exclusion of the bond yield
from the long-run analysis cannot really impact the other coefficients. More formally,
this yields a new cointegrating vector e t−1 + β p p t−1 , which only takes the log earnings
(or real earnings) and stock prices as inputs. In this constrained framework, the bond
yield is absent from the long-run relationship, which is thus shaped by an appropriately
defined linear combination of the stock price and earnings index. Note of course that
bond yields still enter the system through the short-term dynamics.
For all countries that exhibit cointegration, the long-term bond yield coefficient is
not significantly different from zero in the cointegrating space (according to the LR
test). The US is the only country for which the long-term bond yield somewhat matters
(at 9%) in the cointegration relationship. For the real data, the government bond yield

C 2007 The Authors
Journal compilation
Figure 2
United Kingdom and United States (Forward-looking returns vs cointegration
relationship)
y3m × cr y12m × cr
0.50
0.5
0.25
0.0
0.00
−0.5
−0.25
−1.25 −1.00 −0.75 −0.50 −0.25 0.00 −1.25 −1.00 −0.75 −0.50 −0.25 0.00
0.5 1.0
0.0 0.5
−0.5 0.0
−1.0
−1.25 −1.00 −0.75 −0.50 −0.25 0.00 −1.25 −1.00 −0.75 −0.50 −0.25 0.00
0.2 y3m × cr y12m × cr
0.25
0.0 0.00
−0.25
−0.2
−0.50
−2.8 −2.6 −2.4 −2.2 −2.0 −2.8 −2.6 −2.4 −2.2 −2.0
0.50
1.0
0.25
0.00 0.5
−0.25
0.0
−0.50
−2.8 −2.6 −2.4 −2.2 −2.0 −2.8 −2.6 −2.4 −2.2 −2.0
Notes:
From top left to bottom right: 3-month, 12-month, 24-month and 60-month forward-looking returns
on the stock index vs the estimated cointegration relationship (cr ). The top four graphs are for the UK, the
bottom four graphs for the US.
is never significant in the long-run relationship, with large P -values for the H0:β r = 0
test. The results also indicate that the bond yield does not matter much in an economic
sense: the coefficients are not significant and they take low values for all countries
(the United States seems to be the exception, with a coefficient equal to −0.4). This
discussion leads us to accept hypothesis 3. It also invalidates the ‘second’ part of the
C 2007 The Authors
Journal compilation
Figure 3
United Kingdom (Stock index and fair values), 1973:03 - 2004:04
TOTMKUKPI FAIR
5,000 FAIR2
4,000
3,000
2,000
1,000
1970 1975 1980 1985 1990 1995 2000 2005
Notes:
Actual stock index (TOTMKUKPI) and fair values as forecasted by the VECM model: FAIR is the
forecast based on the original VECM model, FAIR2 is the forecast based on the constrained VECM model
(the coefficient of the government bond yield is constrained at zero in the long-run relationship).
Fed model, i.e. the bond yield should not enter the long-run equilibrium relationship
as posited in equation (8). In contrast to E t /P t = a + R t , we thus have that the linear
combination of ln(E t ) and ln(P t ) is stationary (with weights appropriately defined by
the cointegration analysis), and the R t term is not needed. Regarding the literature
discussed in Section 2, our estimation results are similar to Asness (2003). His results
do not however, hinge on the cointegration framework and only focus on US data. Our
results are also in agreement with Siegel (2002) (the equity yield and/or dividend yield
is a strong determinant of future long-run stock market performance). Besides, this
also shows that (1 −1 −1) should not be imposed as the set of long-term weights as this
is clearly rejected by the model.
To illustrate a practical application of the model, let us rewrite the cointegration
relationship such that P becomes the left-side variable and is thus the ‘fair value
predicted by the model’. Indeed, when the system is at equilibrium, the cointegration
relationship should be equal to 0 (e + β p p + β r r + constant = 0) and we can solve for
the ‘right’ p given the prevailing e and r . This can be done with both the unconstrained
and constrained long-run relationships. Let us illustrate with the United States. For
this country, the results in the table indicate that the unconstrained equilibrium
relationship is ln(E ) − 0.74 ln(P ) − 0.4 ln(R) + 2.03. Rewriting this relationship with
respect to P gives P ∗ = exp ((ln(E ) − 0.4 ln(R) + 2.03)/0.74). This P ∗ can thus be
interpreted as the stock market value given the prevailing earnings (E) and long-term
interest rate (R).
When the bond yield is explicitly left out of the cointegration relationship, the
new (constrained) relationship is ln(E ) − 0.62 ln(P ) + 0.57. When the system is

C 2007 The Authors
Journal compilation
Figure 4
United States (Stock index and fair values), 1973:03 - 2004:04
1,500 TOTMKUSPI FAIR

FAIR2
1,250
1,000
750
500
250
1970 1975 1980 1985 1990 1995 2000 2005
Notes:
Actual stock index (TOTMKUSPI) and fair values as forecasted by the VECM model: FAIR is the
forecast based on the original VECM model, FAIR2 is the forecast based on the constrained VECM model
(the coefficient of the government bond yield is constrained at zero in the long-run relationship).
at equilibrium, this should again be equal to 0, which yields P ∗∗ = exp ((ln(E ) +

0.57)/0.62). We plot these P ∗ and P ∗∗ , along with the actual P , for the United States in
Figure 4 and the United Kingdom in Figure 3. An assessment of these figures shows that
the fit is quite good. Moreover, P ∗ and P ∗∗ are quite close, which is in agreement with
our third hypothesis. 22 A look at the R 2 (given in the last column of the two tables) shows
that any stock market forecasting exercise will have a hard time at being economically
(or financially) significant, at least on a quarterly basis. Indeed, the R 2 is between 5%
and 13%, with Denmark being the exception with a higher R 2 of 16% (nominal data).
These R 2 levels are consistent with results previously given in the literature, taking into
account the fact that the left-hand side variable of the VECM is a stock return.
(iv) Short-Term Dynamics

The discussion above has focused on the long-run relationship and how the system
reacts when it gets out of balance. For market participants, short-term effects are,
however, important and we cannot disregard the fact that bond yields variations maybe
do matter on a short term basis. Fortunately, there are a number of time series tools
that allow an exploration of the short-term dynamics in cointegration models. In
this section, we first focus on the variance decomposition of the log stock index to
22 In an earlier version of the paper still available as a discussion paper, we conducted that exercise for other
countries and we concluded similarly.
C 2007 The Authors

Journal compilation
Table 4
Variance Decompositions for the Log Stock Index and Log Real Stock Index (I)
Australia
ln(P ), explained by innovations in ln(P r ), explained by innovations in}
ln(E ) ln(P ) ln(R) ln(E r ) ln(P r ) ln(R)
Quarters ahead I II I II I II I II I II I II
1 1.8 0.0 95.8 97.6 2.4 2.4
4 6.9 2.4 87.4 91.9 5.7 5.7
20 32.5 22.6 61.7 71.6 5.8 5.8
Canada
ln(P ), explained by innovations in ln(P r ), explained by innovations in
ln(E) ln(P ) ln(R) ln(E r ) ln(P r ) ln(R)
1 1.6 0.0 84.5 86.1 13.9 13.9 1.0 0.0 83.8 84.8 15.2 15.2
4 1.7 0.0 73.7 75.4 24.6 24.6 0.6 0.1 73.1 73.6 26.3 26.3
20 4.8 1.3 69.4 72.9 25.8 25.8 0.3 1.5 69.5 68.3 30.2 30.2
Denmark
ln(E) ln(P ) ln(R) ln(E r ) ln(P r ) ln(R)
1 1.0 0.0 96.6 97.6 2.4 2.4 1.2 0.0 95.8 97 3.0 3.0
4 0.6 1.7 92.4 91.3 7.0 7.0 0.5 1.5 90.7 89.7 8.8 8.8
20 24.4 32.1 68.8 61.1 6.8 6.8 20.8 28.9 71.0 62.9 8.2 8.2
France
ln(E) In(P ) In(R) In(E r ) In(P r ) In(R)
1 3.1 0.0 94.9 98.0 2.0 2.0 2.5 0.0 94.4 96.9 3.1 3.1
4 2.2 0.4 88.4 90.2 9.4 9.4 1.2 0.5 85.5 86.2 13.3 13.3
20 13.9 5.5 79.0 87.4 7.1 7.1 6.8 1.8 81.9 86.9 11.3 11.3
Notes:
Variance decompositions (1, 4 and 20 quarters ahead) for the log stock index (left panel) and for
the log real stock index (right panel) in the VECM models. Each figure gives the proportion of variance
explained by the highlighted variables. There are two variable orderings: I, for in(R), in(E) and in(P ); II,
for in(R), in(P ) and in(E) (and correspondingly for the right panel: I, for in(R), in(E r ) and in(P r ); II, for
in(R), in(P r ) and in(E r )).
ascertain if the bond yield could partially explain the dynamics of ln(P ) in the short-
run. In a second step, we estimate the single-equation ECM (as given by equation (13))
to look at the possible contemporaneous influence of changes in the bond yield
on ln(P ).
The results from the variance decomposition are presented in Tables 4 and 5. In
both tables, the left panel is for the nominal data, while the right panel is for the real
data. 23 The variance of the stock price n quarters ahead (in the table we present results
for n being successively equal to 1, 4 and 20 quarters) is mainly explained by its own
innovations; earnings innovations do not matter much. Regarding the long-term bond
yields, albeit their influence was weak in the long-run relationships, they do impact the
23 Because the results are similar for the nominal and the real data, we focus on the discussion of the
nominal data.

C 2007 The Authors
Journal compilation
Table 5
Variance Decompositions for the Log Stock Index and Log Real Stock Index (II)
Switzerland
in(P ), explained by innovations in in(P r ), explained by innovations in
in(E) in(P ) in(R) in(E r ) in(P r ) in(R)
1 5.8 0.0 93.2 99 1.0 1.0 4.2 0.0 94.0 98.2 1.8 1.8
4 3.7 0.4 93.7 97 2.6 2.6 1.3 1.4 93.1 93.0 5.6 5.6
20 10.3 1.5 87.6 96.4 2.1 2.1 0.6 1.8 91.8 90.6 7.6 7.6
The Netherlands
1 0.0 0.0 99.4 99.4 0.6 0.6 0.0 0.0 98.8 98.8 1.2 1.2
4 0.5 0.3 92.8 93.0 6.7 6.7 0.1 0.1 90.3 90.3 9.6 9.6
20 13.1 12.2 80.0 80.9 6.9 6.9 3.4 3.1 84.7 85 11.9 11.9
United Kingdom
1 0.4 0.0 80.5 80.9 19.1 19.1 0.5 0.0 74.7 75.1 24.8 24.9
4 0.7 1.1 77.8 77.4 21.5 21.5 0.8 0.1 64.1 64.8 35.1 35.1
20 18.4 22.5 63.8 59.7 17.8 17.8 2.7 4.4 62.4 60.7 34.9 34.9
United States
1 1.6 0.0 95.8 97.4 2.6 2.6 3.1 0.0 93 96.1 3.9 3.9
4 1.7 0.3 85.1 86.5 13.2 13.2 3.5 0.6 78.7 81.6 17.8 17.8
20 33.9 26.5 46.8 54.2 19.3 19.3 19.1 9.0 65.2 75.3 15.7 15.7
Notes:
Variance decompositions (1, 4 and 20 quarters ahead) for the log stock index (left panel) and for
the log real stock index (right panel) in the VECM models. Each figure gives the proportion of variance
explained by the highlighted variables. There are two variable orderings: I, for in(R), in(E ) and in(P ); II,
for in(R), in(P ) and in(E) (and correspondingly for the right panel: I, for in(R), in(E r ) and in(P r ); II, for
in(R), in(P r ) and in(E r )).
variance of the stock prices in the short-run, whatever the variable ordering may be.
This result could be consistent with arbitrage effects and/or carry trades that could take
place in the short run. Moreover, even if bond yields do not really matter for long-term
stock market valuation, increasing bond yields tend to raise the cost of borrowing (for
example, for investors who bought stocks on margin), which could lead some investors
to unwind speculative positions. This result is also in line with those obtained in Gwilym,
Seaton, Suddason and Thomas (2005) on smaller sample.
Since most of the long-term bond yield fluctuations are known to be explained by
the inflation rate, the size of the bond yield’s impact on the variance of the stock price
might be related to the country’s history in terms of inflation stabilization. Taking
into account the results of Tables 4 and 5, the countries can be rearranged into three
groups regarding the impact of the bond yield on stock prices: very low but stable
impact, very large but stable impact and a intermediary category with moderately large
C 2007 The Authors
Journal compilation
impact. Switzerland is in the first group. This is consistent with its stable history in
terms of monetary policy objectives. 24 Not surprisingly, the United States, the United
Kingdom and Canada are in the second group. Indeed, these countries were affected by
monetary policy ‘instabilities’ over the sample. This is particularly true for the United
States, as suggested by Favero and Mosca (2001) and Clarida, Gali and Gertler (2000).
By anchoring its exchange rate to the US dollar, Canada imported the same instability.
For the third category of remaining countries, the impact is moderately large.
The estimation results given in Table 6 also contribute to this discussion. This table
pertains to the estimation of the single-equation ECM as expressed in equation (13). For
the short-term analysis, the r t column is particulary interesting, as it gives the impact
of the contemporaneous change in the bond yield on the change in the stock price.
For Switzerland and the Netherlands, the contemporaneous effect is weak and not
significant. For the other countries, the impact is statistically significant, although the
range of the r t coefficient is quite large. Canada and the United Kingdom feature
the largest effect, while Australia and France rank second. The impact is lowest for
Denmark and the United States. This table also shows that there is no ‘momentum’
effect (save for Denmark, in the terminology of Harasty and Roulet, 2000) for the stock
market, i.e. no significant AR(1) effect for the stock returns, which is consistent with
the weak form of the Efficient Market Hypothesis (EMH).
(v) Expected Earnings

The Fed model specifies that the current long-term bond yield should be compared
to the anticipated earnings yield, i.e. the expected earnings yield. This version of the
model is however, hard to assess from an empirical point of view as long-term databases
of anticipated earnings do not exist for many countries. This explains why many tests
of present value models (as discussed in the Introduction) or the Fed model study of
Koivu, Pennanen and Ziemba (2005) rely on current earnings. An anonymous referee
of this paper however, suggested an approximation which may allow us to tackle this
problem. Indeed, for the stock market index, it is not unreasonable to suppose that
actual earnings n-quarter ahead are not systematically out of line with expected earnings
n quarters before. In other words, knowing the actual earnings, one can equal these
on average to the previously anticipated earnings. With this caveat, the Fed model can
E∗
be written as Ptt = a + Rt , where E ∗t are the expected earnings and are set equal to
E t+n where n is the time shift. We implement this variable change in our analysis and
thus test the cointegration hypothesis between anticipated earnings (as equal to future
earnings with n = 4), current stock prices and current long-term government bond
yield. The cointegration results are given in Table 7. All countries (with the exception
of Australia) that exhibited cointegration still do so in this case, while we now accept the
cointegration hypothesis at 10% for Germany and Italy. Note that the long-term bond
yield remains statistically not relevant in the cointegration relationship. Adjustment
weights can be interpreted as indicated above. Hence the switch from actual to expected
earnings actually confirms the hypotheses put forth in the paper and our analysis is still
conclusive.
24 Note also that Switzerland is the country with the lowest (among our sample of 13 countries) real long-
term interest rate over the sample period.

C 2007 The Authors
Journal compilation
636
Table 6
Cointegration Analysis (Single-equation ECM): Nominal and Real Data
Nominal Data Real Data
Country Time Period res t−1 r t p t−1 Time Period res r,t−1 r t p r,t−1
Australia 1973:03–2004:04 0.20 (0.07) −0.27 (0.14) 0.06 (0.09) – – – –

Canada 1973:04–2004:04 0.04 (0.03) −0.45 (0.10) 0.15 (0.09) 1973:04–2004:04 0.02 (0.03) −0.48 (0.11) 0.16 (0.09)
Denmark 1973:04–2004:04 0.05 (0.02) −0.16 (0.08) 0.25 (0.09) 1973:04–2004:04 0.04 (0.03) −0.18 (0.08) 0.23 (0.09)
France 1973:03–2004:04 0.13 (0.05) −0.29 (0.16) 0.07 (0.09) 1973:03–2004:04 0.10 (0.06) −0.33 (0.16) 0.06 (0.09)
Switzerland 1973:03–2004:04 0.13 (0.09) −0.14 (0.11) 0.03 (0.10) 1973:03–2004:04 0.02 (0.08) −0.07 (0.11) −0.01 (0.10)
The Netherlands 1973:03–2004:04 0.06 (0.05) −0.10 (0.13) 0.06 (0.09) 1973:03–2004:04 0.01 (0.06) −0.15 (0.13) 0.07 (0.09)
United Kingdom 1973:01–2004:04 0.11 (0.04) −0.71 (0.12) 0.11 (0.09) 1973:01–2004:04 0.02 (0.07) −0.75 (0.12) 0.04 (0.09)
DURRÉ AND GIOT
United States 1973:03–2004:04 0.19 (0.05) −0.17 (0.08) 0.11 (0.09) 1973:03–2004:04 0.17 (0.05) −0.18 (0.09) 0.12 (0.09)
Notes:
Results from the single-equation ECM analysis (quarterly nominal and real data). We report relevant results for the single-equation ECM: pt = γ p + α p r e s t−1 +
δe ,0 e t + δr,0 r t + Short-run dynamics for p + t . The res t−1 column gives the adjustment speed to the long-run disequilibrium; the r t column reports the
contemporaneous influence of the log government bond yield; the p t−1 column gives the momentum effect (i.e. impact of lagged stock price changes). All numbers
Journal compilation
in parenthesis are standard errors.

C 2007 The Authors
C

Table 7
Cointegration Analysis (VECM): Expected Earnings, Stock Prices and Bond Yields
Adjustment Speeds
Country Time Period Lags Level (1β p β r ) αp αr (P-value) R2
2007 The Authors

αe∗
Journal compilation
Australia 1973:03–2003:04 – – – – – – – –
Austria 1973:03–2003:04 – – – – – – – –
Belgium 1973:03–2003:04 – – – – – – – –
Canada 1973:04–2003:04 2 0.04 (1 −0.75 −0.02) −0.12 (0.03) 0.06 (0.03) 0.05 (0.03) 0.94 0.12
Canada 1973:04–2003:04 2 0.04 (1 −0.74 0) −0.12 (0.03) 0.06 (0.03) 0.05 (0.03)
Denmark 1973:04–2003:04 2 0.01 (1 −0.58 0.26) −0.06 (0.05) 0.10 (0.03) −0.06 (0.03) 0.46 0.21
Denmark 1973:04–2003:04 2 0.01 (1 −0.69 0) −0.07 (0.06) 0.10 (0.03) −0.04 (0.04)
France 1973:03–2003:04 1 0.00 (1 −0.88 −0.36) −0.01 (0.04) 0.28 (0.05) −0.01 (0.03) 0.07 0.25
France 1973:03–2003:04 1 0.00 (1 −0.77 0) −0.04 (0.04) 0.25 (0.05) −0.03 (0.03)

Germany 1973:03–2003:04 1 0.10 (1 −0.63 0.65) −0.16 (0.05) 0.14 (0.06) −0.05 (0.04) 0.07 0.08
Germany 1973:03–2003:04 1 0.10 (1 −0.83 0) −0.09 (0.04) 0.15 (0.05) 0.01 (0.03)
Italy 1973:04–2003:04 2 0.10 (1 −0.79 0.27) −0.04 (0.04) 0.12 (0.05) −0.09 (0.03) 0.18 0.14
Italy 1973:03–2003:04 2 0.10 (1 −0.86 0) −0.06 (0.04) 0.14 (0.05) −0.07 (0.03)
Japan 1973:03–2003:04 – – – – – – – –
Switzerland 1973:04–2003:04 1 0.00 (1 −0.69 −0.15) −0.10 (0.05) 0.39 (0.07) 0.03 (0.06) 0.13 0.22
Switzerland 1973:04–2003:04 1 0.00 (1 −0.67 0) −0.11 (0.05) 0.37 (0.07) −0.01 (0.06)
The Netherlands 1974:01–2003:04 3 0.06 (1 −0.24 1.55) −0.09 (0.03) 0.04 (0.03) −0.07 (0.02) 0.04 0.12
The Netherlands 1974:01–2003:04 3 0.06 (1 −0.59 0) −0.16 (0.05) 0.12 (0.06) −0.05 (0.04)
United Kingdom 1973:01–2003:04 1 0.01 (1 −0.59 0.13) −0.09 (0.03) 0.20 (0.06) −0.05 (0.04) 0.56 0.10
United Kingdom 1973:01–2003:04 1 0.01 (1 −0.62 0) −0.10 (0.03) 0.20 (0.06) −0.04 (0.04)
United States 1973:03–2003:04 1 0.01 (1 −0.64 −0.10) −0.06 (0.02) 0.14 (0.05) 0.02 (0.05) 0.71 0.10
United States 1973:03–2003:04 1 0.01 (1 −0.61 0) −0.06 (0.02) 0.13 (0.04) 0.004 (0.05)
Notes:
Cointegration analysis for the log expected earnings index e ∗ = in(E ∗ ), log stock index p = in(P ) and the log government bond yield r = in(R). The long-
run relationship is e ∗ + β p p + β r r , while the adjustment speeds are for e ∗t , p t and r t respectively. As H0:β r = 0 is not rejected, we report the long-run relationship
e ∗ + β p p + 0 r , i.e. when β r = 0 is enforced in the estimation (second line of results for each country). The last column gives the R 2 of the regression for the stock
price adjustments in the model. Cointegration tests were done using the Johansen methodology. A - indicates that there is no cointegration for that country, while the
‘Coint. level’ column gives the percentage level at which we reject the absence of cointegration. ‘Lags’ gives the number of lags included in the short-term dynamics.
637
(vi) A Long-Term Analysis for Two Countries

What cointegration results can we expect if we run a really long-term analysis? The
literature on the Fed model has indeed pointed out that the supposed long-run
relationship between earnings yield and bond yield has only been valid for the last
30 years. Hence it makes sense to run a cointegration analysis on longer term data.
Unfortunately really long-term data for earnings, stock prices and bond yields are
hard to come by (especially for earnings). Using the new long-term database of Global
Financial Data described in Section 3, we can nevertheless retrieve long-term earnings
and 10-year government bond yield data since 1958 for the UK and since 1871 for the
US. We thereafter proceed similarly, i.e. we assess the cointegration and estimate the
VECM models in both nominal and real terms. The results are presented in Table 8.
For the US, the long-term evidence strongly supports the view that a cointegration
relationship exists and that, as noted above, the long-term bond yield is not statistically
significant in this relationship. Hence, for more than one century, earnings and stock
prices have been cointegrated; it would however, be misleading to include long-term
bond yields in the relationship with a −1 weight. For the UK, the cointegration
relationship is still present. In this case the long-term bond yield plays a role in the
long-run relationship in nominal terms. In real terms, we can again accept the fact that
the long-term bond yield can be left out of the picture. To save some space, we do not
report the long-term results with expected earnings (as defined in the preceding sub-
section). We nevertheless conclude similarly, both in nominal and real terms.
6. CONCLUSION
For thirteen countries and a time period spanning more than three decades, this
paper looks at the long-run relationship between earnings, stock prices and long-term
government bond yields. The starting point of our analysis is the popular Fed model
which links the equity yield of a stock index to the prevailing 10-year government bond
yield. The Fed model argues that the ‘fair value’ equity yield for the index should be
equal to the 10-year government bond yield. In the first part of the paper, we provide a
literature review of the pros and cons of the Fed model. Critics argue that the rationale
of the Fed model is flawed from a theoretical point of view. Indeed, the Fed model
relates a real quantity (the stock index earnings yield) to a nominal bond yield. In the
same vein, inflation illusion is not really taken into account as the Fed model would
mechanically drive down stock prices when inflation increases. Correspondingly, very
low inflation would warrant very low earnings yields, hence extremely high P/E ratios.
Recently, Thomas (2005) presents a conflicting view according to which earnings yield
are shaped by expected inflation. In this latter framework, there is however, some
support for the Fed model.
In the second part of the paper, we address these issues from an empirical perspective.
More precisely, we estimate dynamic time series models (cointegration models) for the
thirteen countries in our dataset and ascertain if there exists a long-run relationship
between the earnings index, the stock index and the long-term government bond yield.
Our empirical results show that such a long-run relationship indeed exists for many
countries (including the United States and the United Kingdom). However, in contrast
to the rationale of the Fed model, the long-term bond yield is mostly not statistically
significant in this relationship. Put simply, the long-term bond yield does not really affect
the ‘equilibrium’ stock market valuation. As such, we validate and extend the analysis
C 2007 The Authors
Journal compilation
2007 The Authors C

Journal compilation
Table 8
Cointegration Analysis (VECM) for the United Kingdom and the United Sates (Long-term data): Earnings, Stock Prices and
Bond Yields
Adjustment Speeds
Country Time Period Lags Level (1β p β r ) αe αp αr (P-value) R2
UK Nominal 1958:04–2004:04 2.00 0.10 (1 −0.93 −0.60) −0.04 (0.02) 0.07 (0.03) −0.01 (0.01) 0.04
UK Nominal 1958:04–2004:04 2.00 0.10 (1 −0.87 0) −0.02 (0.01) 0.07 (0.02) −0.03 (0.02)

UK Real 1958:04–2004:04 2.00 0.08 (1 −0.52 −0.17) −0.07 (0.02) 0.06 (0.03) 0.004 (0.02) 0.52
UK Real 1958:04–2004:04 2.00 0.08 (1 −0.40 0) −0.08 (0.02) 0.05 (0.04) 0.01 (0.03)
US Nominal 1871:04–2004:04 2.00 0.02 (1 −0.88 −0.20) −0.05 (0.02) 0.04 (0.01) 0.02 (0.01) 0.30 0.10
US Nominal 1871:04–2004:04 2.00 0.02 (1 −0.92 0) −0.05 (0.01) 0.04 (0.01) 0.01 (0.01)
US Real 1871:04–2004:04 2.00 0.02 (1 −0.70 −0.21) −0.07 (0.02) 0.02 (0.014) 0.02 (0.01) 0.21 0.10
US Real 1871:04–2004:04 2.00 0.02 (1 −0.77 0) −0.06 (0.02) 0.02 (0.01) 0.02 (0.01)
Notes:
Cointegration analysis (long-term data) for the log earnings index e = in(E ), log stock index p = in(P ) and the log government bond yield r = in(R). The
long-run relationship is e + β p p + β r r , while the adjustment speeds are for e t , p t and r t respectively. As H0:β r = 0 is not rejected, we report the long-run
relationship e + β p p + 0 r , i.e. when β r = 0 is enforced in the estimation (second line of results for each country). The last column gives the R 2 of the regression for
the stock price adjustments in the model. Cointegration tests were done using the Johansen methodology. A - indicates that there is no cointegration for that country,
while the ‘Coint. level’ column gives the percentage level at which we reject the absence of cointegration. ‘Lags’ gives the number of lags included in the short-term
dynamics.
639
of Asness (2003) who ran a related analysis (OLS framework, no dynamic models) on
US data. From a methodological point of view, the dynamic time series approach used
in this paper offers a compelling and rigorous testing environment. It also allows us
to disentangle the short-term and long-term effects of the variables involved in the
model. Regarding the possible short-term effects, we show that rising/decreasing bond
yields do impact contemporaneous stock market returns and thus have an important
short-term impact on the stock market. To assess the robustness of our results, we
conduct the analysis in both nominal and real terms. Furthermore, we also estimate
the models using a proxy for the expected earnings and run a really long-term analysis
for the UK and the US, two countries for which longer term data exist. These additional
estimations corroborate our earlier results.
REFERENCES
Anari, A. and J. Kolari (2001), ‘Stock Prices and Inflation’, Journal of Financial Research,
Vol. 24, pp. 587–602.
Asness, C. (2000), ‘Stocks vs. Bonds: Explaining the Equity Risk Premium’, Financial Analysts
Journal, Vol. 56, pp. 96–113.
——— (2003), ‘Fight the Fed Model’, Journal of Portfolio Management, Vol. 30, pp. 11–24.
Boudoukh, J. and M. Richardson (1993), ‘Stock Returns and Inflation: A Long-horizon
Perspective’, American Economic Review, Vol. 83, pp. 1346–55.
Brooks, C. (2002), Introductory Econometrics for Finance (Cambridge University Press).
Campbell, J. and R. Shiller (1987), ‘Cointegration and Tests of Present Value Models’, Journal
of Political Economy, Vol. 95, pp. 1062–88.
——— ——— (1988), ‘Stock Prices, Earnings and Expected Dividends’, Journal of Finance,
Vol. 43, pp. 661–76.
——— ——— (1989), ‘The Dividend-price Ratio and Expectations of Future Dividends and
Discount Factors’, Review of Financial Studies, Vol. 1, pp. 195–228.
——— ——— (1998), ‘Valuation Ratios and the Long-run Stock Market Outlook’, Journal of
Portfolio Management, Vol. 24, pp. 11–26.
——— ——— (2001), ‘Valuation Ratios and the Long-run Stock Market Outlook: An Update’
(Cowles Foundation DP1295).
——— and T. Vuolteenah (2004), ‘Inflation Illusion and Stock Prices’, American Economic
Review Papers and Proceedings.
———, A.W. Lo and A.C. MacKinlay (1997), The Econometrics of Financial Markets (Princeton
University Press Princeton).
Capstaff, J., K. Paudyal and W. Rees (2001), ‘A Comparative Analysis of Earnings Forecasts in
Europe’, Journal of Business Finance & Accounting , Vol. 28, pp. 531–62.
Clare, A.D., S.H Thomas and M.R. Wickens (1994), ‘Is the Gilt-Equity Yield Ratio Useful for
Predicting UK Stock Returns?, The Economic Journal, Vol. 104, pp. 303–15.
Clarida, R., J. Gali and M. Gertler (2000), ‘Monetary Policy Rules and Macroeconomic Stability:
Evidence and Some Theory’, Quarterly Journal of Economics, Vol. 115, pp. 147–80.
Cohen, R.B., C. Polk and T. Vuolteenaho (2005), ‘Money Illusion in the Stock Market: The
Modigliani- Cohn Hypothesis’, NBER Working Paper 11018.
Enders, W. (1995), Applied Econometric Time Series (Wiley).
Engle, R.F. and C.W.J. Granger (1987), Co-integration, and Error Correction: Representation,
Estimation and Testing, Econometrica, Vol. 55, pp. 251–76.
Favero, C. and F. Mosca (2001), ‘Uncertainty on Monetary Policy and the Expectations Model
of the Term Structure of Interest Rates’, Economics Letters, Vol. 71, pp. 369–75.
Fraser, P. and A.J. McKaig (1987), ‘Do Investors Expect Mean Reversion in Asset Prices?, Journal
of Business Finance & Accounting , Vol. 26, pp. 57–81.
Gordon, M.J. (1962), The Investment, Financing and Valuation of a Corporation (Irwin).
Gwilym, O.A, G. Morgan and S. Thomas (2000), ‘Dividend Stability, Dividend Yield and Stock
Returns: UK Evidence’, Journal of Business Finance & Accounting , Vol. 27, pp. 261–81.
C 2007 The Authors

Journal compilation
Gwilym, O.A., J. Seaton, K. Suddason and S. Thomas (2005), ‘Does the Fed Model Travel
Well?, Journal of Portfolio Management (forthcoming).
Harasty, H. and J. Roulet (2000), ‘Modeling Stock Market Returns’, Journal of Portfolio
Management, Vol. 26, pp. 33–46.
Harris, R.D.F. and R. Sanchez-Valle (2000a), ‘The Gilt-equity Yield Ratio and the Predictability
of UK and US Equity Returns’, Journal of Business Finance & Accounting , Vol. 27, pp. 333–57.
——— ——— (2000b), ‘The Information Content of Lagged Equity and Bond Yields’,
Economics Letters, Vol. 68, pp. 179–84.
Harris, R. and R. Sollis (2003), Applied Time Series Modelling and Forecasting (Wiley).
Jones, C.P., J.W. Wilson and L.L. Lundstrum (2002), ‘Estimating Stock Returns’, Journal of
Koivu, M., T. Pennanen and W.T. Ziemba (2005), ‘Cointegration Analysis of the Fed Model’,
Finance Research Letters, Vol. 2, pp. 249–50.
Lander, J., A. Orphanides and M. Douvogiannis (1997), ‘Earnings Forecasts and the
Predictability of Stock Returns: Evidence from Trading the S&P’, Journal of Portfolio
Management, Vol. 23, pp. 24–35.
Lansing, K.J. (2004), ‘Inflation-induced Valuation Errors in the Stock Market’, FRBSF
Economic Letter 2004–30.
Levin, E.J. and R.E. Wright (1998), ‘The Information Content of the Gilt-equity Yield Ratio’,
The Manchester School Supplement, Vol. 25, pp. 89–101.
MacDonald, R. and D. Power (1995), ‘Stock Prices, Dividends and Retention: Long-run
Relationships and Short-run Dynamics’, Journal of Empirical Finance, Vol. 2, pp. 135–51.
Marshall, D.A. (1992), ‘Inflation and Asset Returns in a Monetary Economy’, Journal of Finance,
Vol. 47, pp. 1315–42.
Mills, T.C. (1991), ‘Equity Prices, Dividends and Gilt Yields in the UK: Cointegration, Error
Correction and Confidence’, Scottish Journal of Political Economy, Vol. 38, pp. 242–55.
Modigliani, F. and R. Cohn (1979), ‘Inflation, Rational Valuation and the Market’, Financial
Analysts Journal, Vol. 35, pp. 24–44.
O’Hanlon, J. (1998), ‘The Articulation of Returns and Accounting-related Variables when
Returns Lead Earnings: UK Evidence’, Journal of Business Finance & Accounting , Vol. 10,
pp. 1163–201.
——— and K. Peasnell (2004), ‘Residual Income Valuation: Are Inflation Adjustments
Necessary?’, Review of Accounting Studies, Vol. 9, pp. 375–98.
Ohlson, J.A. (1995), ‘Earnings, Book Values, and Dividends in Equity Valuation’, Contemporary
Accounting Research, Vol. 11, pp. 661–87.
——— (2006), ‘A Practical Model of Earnings Measurement’, The Accounting Review, Vol. 81,
pp. 271–79.
——— and X.J. Zhang (1998), ‘Accrual Accounting and Equity Valuation’, Journal of Accounting
Research, Vol. 36, pp. 85–111.
Ou, J.A. and J. F. Sepe (2002), ‘Analysts Earnings Forecasts and the Roles of Earnings and Book
Value in Equity Valuation’, Journal of Business Finance & Accounting , Vol. 29, pp. 287–316.
Philips, T.K. (1999), ‘Why Do Valuation Ratios Forecast Long-run Equity Returns?’, Journal of
Ritter, J.R. and R.S. Warr (2002), ‘The Decline of Inflation and the Bull Market of 1982–1999’,
Journal of Financial and Quantitative Analysis, Vol. 37, pp. 29–61.
Siegel, J.J. (2002), Stocks for the Long Run (McGraw-Hill).
Spyrou, S.I. (2004), ‘Are Stocks a Good Hedge Against Inflation? Evidence from Emerging
Markets’, Applied Economics, Vol. 36, pp. 41–48.
Thomas, J. (2005), ‘Understanding the Fed Model and the Implications of this Remarkable
Empirical Regularity (Mimeo, Yale University School of Management).
Timmermann, A. (1995), ‘Cointegration Tests of Present Value Models with a Time-varying
Discount Factor’, Journal of Applied Econometrics, Vol. 10, pp. 17–31.
Vila-Wetherilt, A. and O. Weeken (2002), ‘Equity Valuation Measures: What Can They Tell
Us?’, Bank of England Quarterly Bulletin, Vol. 42, pp. 391–403.
Yardeni, E. (2003), ‘Stock Valuation Models 4.1’ (Mimeo, Prudential Financial Research).

C 2007 The Authors
Journal compilation

An International Analysis of Earnings, Stock Prices and Bond Yields

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

An International Analysis of Earnings, Stock Prices and Bond Yields

Uploaded by

Copyright:

Available Formats

Journal of Business Finance & Accounting, 34(3) & (4), 613–641, April/May 2007, 0306-686X

An International Analysis of Earnings,

Alain Durré and Pierre Giot∗

cointegrating relationship between stock prices, earnings and long-term government

(i) From the Dividend Model to the Fed Model

expected change in the stock price, P et+1 − P t :

C 2007 The Authors

(ii) Why the Fed Model Could or Could Not be Relevant?

C 2007 The Authors

indexes (as computed by Datastream) to facilitate the comparison between countries.

C 2007 The Authors

Finally, we further check the long-term robustness of our results by looking at

4. THE FED MODEL IN THE COINTEGRATION FRAMEWORK

(i) Why Cointegration Instead of OLS?

Pt = α + β1 (EPt − Rt ) + εt (9)

(ii) The Cointegrated Model

e t = γe + αe (e t−1 + β p pt−1 + βr r t−1 ) + Short-run dynamics for e + e ,t , (10)

pt = γ p + α p (e t−1 + β p pt−1 + βr r t−1 ) + Short-run dynamics for p +  p,t , (11)

r t = γr + αr (e t−1 + β p pt−1 + βr r t−1 ) + Short-run dynamics for r + r,t . (12)

C 2007 The Authors

(b) Interpretation of the Coefficients

pt = γ p + α p res t−1 + δe ,0 e t + δr,0 r t + Short-run dynamics for p + t , (13)

(i) A Long-Run Equilibrium?

C 2007 The Authors

Australia 0.58 0.12 0.23 0.09 0.90 0.06 0.81 0 0.76

C Blackwell Publishing Ltd. 2007

2007 The Authors

C Blackwell Publishing Ltd. 2007

(ii) Deviations From the Equilibrium

C 2007 The Authors

(iii) Are Bond Yields Relevant?

0.2 y3m × cr y12m × cr

1970 1975 1980 1985 1990 1995 2000 2005

1,500 TOTMKUSPI FAIR

1970 1975 1980 1985 1990 1995 2000 2005

at equilibrium, this should again be equal to 0, which yields P ∗∗ = exp ((ln(E ) +

(iv) Short-Term Dynamics

C 2007 The Authors

(v) Expected Earnings

Australia 1973:03–2004:04 0.20 (0.07) −0.27 (0.14) 0.06 (0.09) – – – –

2007 The Authors

C Blackwell Publishing Ltd. 2007

(vi) A Long-Term Analysis for Two Countries

C Blackwell Publishing Ltd. 2007

C 2007 The Authors

You might also like

e t = γe + αe (e t−1 + β p pt−1 + βr r t−1 ) + Short-run dynamics for e + e ,t , (10)

pt = γ p + α p (e t−1 + β p pt−1 + βr r t−1 ) + Short-run dynamics for p + p,t , (11)

r t = γr + αr (e t−1 + β p pt−1 + βr r t−1 ) + Short-run dynamics for r + r,t . (12)

pt = γ p + α p res t−1 + δe ,0 e t + δr,0 r t + Short-run dynamics for p + t , (13)