Financial Econom

Assignment 1

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Table of Contents
1. Introduction to Equity Premium .................................................................................................2
2. Literature Rrview..........................................................................................................................3
3. Data and Methodology ...............................................................................................................3
Methodology……………………………………………………………………………………………………...…………...3
4. Empirical Analysis..............................................................................................................................6
5. Discussion..........................................................................................................................................9
6. Conclusion........................................................................................................................................10
7. References........................................................................................................................................10

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1. Introduction to Equity Premium

One of the central challenges in finance lies in accurately predicting the equity risk premium, the
additional return investors expect for taking on the risk of stocks compared to safer fixed-income options. As
Lettau and Ludvigson (2001) succinctly state, "predictable excess returns by variables such as dividend-price
ratios, earnings-price ratios, and other financial indicators" are now widely accepted. Yet, despite this
acceptance, determining the precise and reliable predictors of this premium remains elusive.

Refining our understanding of predictive models, this study replicates and evaluates the work of Goyal
and Welch (2008), focusing on their use of dividend-price ratio, dividend yield, and earnings-price ratio.
Leveraging historical data and employing their established methodology, we will explore whether these
indicators possess the power to forecast future stock market returns.

This replication study holds two crucial objectives. Firstly, validating the findings of Goyal and Welch
(2008) through replication of their analysis is vital. This process ensures the robustness of their conclusions,
contributing to the body of knowledge on equity premium prediction. Secondly, by diligently replicating their
work, we open the door to uncover new insights that may have been obscured in the original study. Through
this exploration, we aim to contribute to a deeper understanding of the factors influencing market behavior
and equip investors with more informed decision-making tools.

Our analysis will specifically focus on the equity premium and its relationship with the aforementioned
indicators through the lens of the following model:

Equity Premium(t) = γ0 + γ1 * x(t-1) + ϵ(t)

Here, γ1 serves as a crucial element, quantifying the significance of the past period's predictor x in
forecasting the equity premium. Predicting this premium is both challenging and vital for financial planning.
Key predictors extend beyond our chosen indicators, encompassing diverse financial ratios like book-to-
market ratios, market volatility measures, and even inflation rates. Understanding these factors' influence
equips investors and firms with the knowledge to navigate the delicate balance between pursuing potentially
higher returns and managing inherent risks.

This paper is structured to provide a comprehensive exploration of the research question. Section 2
presents a thorough literature review, contextualizing the study within the wider landscape of equity
premium prediction research. In Section 3, we delve into the data and methodology employed. Section 4
unveils the results obtained from our analysis, paving the way for a thoughtful discussion of their implications
in Section 5. Finally, we conclude with a concise summary of our findings in Section 6.

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2. Literature Review

Some earlier studies, like Campbell and Shiller (1988) and Fama and French (1989), have found evidence
supporting the predictability of equity returns using variables like dividend yields, earnings yields, and the
term structure of interest rates. These studies suggest that certain financial and economic indicators can help
forecast long-term returns.

Opposed to those views, the main scope of Goyal and Welch (2008) article is to critically assess the
empirical performance of various models proposed to predict the equity premium. The article mainly focuses
on the dividend-price ratio (dp), dividend yield (dy), and earnings-price ratio (ep) as predictors, revisiting the
performance in both in-sample and out-of-sample contexts while underscoring a stark skepticism towards the
prevailing methods of forecasting the equity premium.

Goyal and Welch's findings suggest that regardless of the intuitive temptation to use financial ratios in
order to predict future equity premiums, the empirical evidence over the past 30 years does not robustly
support their predictive power. This skepticism is rooted in the statistical methodologies employed and the
historical data analyzed, leading them to conclude that most predictors fail to outperform a simple historical
average model, especially out-of-sample. The authors highlight the instability of these predictions and caution
against overreliance on these models for forecasting the equity premium, emphasizing the need for more
robust approaches in financial econometrics.

Out of all the available models, only one model (eqis) is singled out as potentially deserving further
investigation, particularly for very-long-term frequencies (5 years). Most other models did not show good
performance, based on a comprehensive analysis including modified data definitions, frequencies, time
periods, and econometric specifications.

The evidence suggests that most models appear unstable or spurious. The analysis shines light on
significant periods, such as the 1973–75 Oil Shock, and shows that excluding this period, most models
perform even worse. This suggests that many models' past statistical significance was largely due to their
performance during this unusual period.

For the period after 1975, no model demonstrated superior performance OOS, and few had acceptable
performance IS. This indicates that with 30 years of poor performance, current belief in these models would
require strong priors about their specification and stability.

The paper also notes the difficulty researchers might face in cherry-picking models that show robust
statistical performance IS, underscoring the importance of considering OOS tests as a diagnostic tool for
model stability.

Following Goyal and Welch's skepticism, Cochrane's "The Dog That Did Not Bark: A Defense of Return
Predictability" counters by defending the predictability of returns, focusing on methodological approaches
and the interpretation of empirical evidence. Cochrane argues for the presence of return predictability,
emphasizing the importance of understanding the underlying economic rationale rather than solely relying on
statistical significance. Cochrane suggests that the absence of consistent empirical success does not invalidate

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the concept of return predictability but rather indicates the necessity for refined theoretical frameworks and

empirical approaches. He argues for a nuanced understanding of financial markets, where predictability
might manifest under specific conditions, emphasizing the importance of theoretical underpinnings and
robust empirical evidence.

In conclusion, the debate on the predictability of equity premiums reflects diverse perspectives,
grounded in empirical evidence, economic theory, and methodological considerations. The contrasting views
of Goyal and Welch versus John Cochrane exemplify the ongoing discourse, emphasizing the complexities of
forecasting in an ever-changing market environment. This debate highlights the importance of continuous
research, the application of robust methodological frameworks, and the integration of economic reasoning in
understanding and potentially predicting equity premiums.

3. Data and Methodology

3.1 Data Sources
We use the same data from 1872 to 2005 as what Welch and Goyal used to construct our model. S&P 500
index data are extracted from Robert Shiller’s website, which provides annual and long-term data (Goyal and
Welch, 2008). Treasury-bill rates from 1920 to 2005 are used to be the risk-free rate (Goyal and Welch, 2008).
There is no record for the risk-free rate from 1871 to 1919, to deal with this, the data are estimated through a
regression model which is derived from using Commercial Paper rates and Treasury Bill rate from 1920 to
1971, where the Commercial Paper rate have data from 1871 to 1919 (Goyal and Welch, 2008). Yearly
dividends of S&P 500 from 1871 to 1987 are derived from Robert Shiller’s website, and data from 1988 to
2005 come from S&P Corporation (Goyal and Welch, 2008). Similar to the data source of yearly dividends, the
yearly earnings of S&P 500 from 1871 to 1987 are retrieved from Robert Shiller’s website, and data from
1988 to 2005 are achieved from S&P Corporation (Goyal and Welch, 2008).

3.2 Variables
3.2.1 Dependent Variables
Equity premium is the only dependent variable we use in the models. It is calculated by subtracting the
log of S&P index by the log of risk-free rate.
3.2.2 Independent Variables
We use three independent variables in three models separately to test the predictability of each
independent variable on the equity premium.
Dividend Price Ratio (DP) is the difference between the log of dividends and the log of S&P index.
Dividend Yield (DY) is the difference between the log of dividends and the log of lagged S&P index.
Earnings Price Ratio (EP) is the difference between the log of earnings and log of S&P index.

3.3 Model
3.3.1 Model Construction
The central idea for the result of the model is to test the statistical power of ALTERNATIVE regression
compared to NULL regression. The ALTERNATIVE regression is OLS regression. And NULL model uses historical
mean value. Noting to mention that this study entails both In-Sample (IS) and Out-of-Sample (OOS) tests. The
performance of the model illustrates the comparison between the predictive power of NULL and
ALTERNATIVE. In the IS regressions, performance is measured by subtracting the cumulative squared
regression residual from the cumulative squared demeaned equity premium (Goyal and Welch, 2008). In the
OOS regressions, it is determined by subtracting the cumulative squared prediction errors of the prevailing

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mean with the cumulative squared prediction error of the predictive variable derived from the linear

historical regression (Goyal and Welch, 2008). An upward trend in a line indicates superior predictions by the
ALTERNATIVE model, while a downward trend suggests that the NULL model provided more accurate
predictions, as shown in Figure 1. In order to compare the IS and OOS performance in a straightforward and
efficient way, both IS and OOS lines are shifted to 0 at the time when the first OOS prediction appears.

3.3.2 Estimated Period

There are three period specifications.
1. The first OOS forecast began in 1892, which is 20 years after data of both independent and
dependent variables are available. In this period, we are using an expanding window to forecast OOS.
2. The first OOS forecast appeared in 1965, using the first 93 data to predict the first OOS. In this period,
again, we are using an expanding window to anticipate OOS.
3. Using data from 1927 to 2005 and ignoring all data before 1927.

3.3.3 Key Statistics

Key statistics are used to better evaluate performance of IS and OOS, as shown in Table 1.
IS adjusted R Square: IS adjusted R square is derived from the OLS model in the IS regression.
OOS Mean Squared Error:

OOS adjusted R Square:

T is number of predictions
k is number of estimators
T- k is degree of freedom
Change in RMSE:

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4. Empirical Analysis
4.1 Time Series Performance Analysis

Figure 1 Time Series Performance of Dividend Price Ratio (DP), Dividend Yield(DY) and Equity Premium
(rp_div)

The resulting equity premia are identical to those found in Goyal/Welch (2008, p. 1457). Additionally,
the figure, which is a replication of figure 1 from Goyal/Welch (2003), is intriguing to look at. They state that
the dividend ratios exhibit some nonstationary. The equity premia are nearly identified independent
distribution, whereas the dividend ratios are practically random walks. It should come as no surprise that the
expanded Dickey and Fuller (1979) test shows that we cannot rule out the possibility that the dividend ratios
contain a unit-root for the whole sample period (Stambaugh 1999 and Yan 1999).

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4.2 In Sample and Out of Sample Performance Analysis

The IS and OOS performance of the d/p, d/y, and e/p indicators in Table 1 are plotted in Figure 1. The
ALTERNATIVE predicted more accurately when a line increased, and the NULL forecasted more accurately
when it decreased, which means if the curve goes up, the model is doing better in some way and vice versa.
Although the graphs' units are not very clear, the time series pattern makes it possible to identify which years
performed well or poorly.

We replicate Goyal/Welch (2008, p. 1457) using expanded windows of 20 instead of rolling windows. The
advantage of using the expanding window is that it leads to a larger sample size, which can improve statistical
precision and efficiency. Additionally, expanding windows ensure that all available data, including older
observations, are included in the analysis, which may be advantageous for capturing long-term relationships
or trends.

Figure 2 Annual Performance of IS and OOS with regressor Dividend Price Ratio
Dividend Price Ratio:
Figure 2 illustrates that the d/p model has four unique periods, which are relevant to both IS and OOS
performance. From 1905 through World War II, d/p performed rather poorly; from that time until 1975, it
performed well; from that point on, it performed stationary; and finally, from the mid-1990s onward, it
performed poorly. The mid-1930s to the mid-1980s was the ideal sample period for d/p. Although the Oil
Shock was responsible for more than half of the OOS performance, the OOS ran from 1937 to 1984.
Furthermore, the plot demonstrates that the d/p regression's OOS performance was continuously inferior to
that of it IS counterpart. The performance gap between the IS and OOS grew gradually until the Oil Shock.
Dividend Yield Ratio:
The IS patterns of the d/y model are similar to those of the d/p model. Its OOS trend, however, was
far more erratic: d/y accurately anticipated equity premia during the Great Depression (1930–1933), the
post–World War II era until 1960, the Oil Shock, and the 2000–2002 market downturn. In other years, it
performed unremarkably, but from 1958 to 1965 and from 1995 to 2000, it had significant forecast errors and
decreased dramatically. The optimal OOS sample period spanned from around 1925 until either 1957 or
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1975. For d/y, the Oil Shock had no significant impact.

Figure 3 Annual Performance of IS and OOS with regressor Dividend Yield

Figure 4 Annual Performance of IS and OOS with regressor Earning Price Ratio

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Earning Price Ratio:

Because of the mix of economic upheaval, higher expenses, and unclear government action, the earning-
price ratio experienced a sharp decline during World War One. In addition, it performed well from World War
II through the 1980s. Then it started to perform badly in the middle of the 1990s. It is evident that the best
sample period for e/p occurred between 1950 and 2000. It is evident that the price of oil has a positive
impact on the performance of several indicators, which provides us with further information. For example, it
may indicate that GDP growth and inflation will lead to more income and revenue. The performance of e/p
has been negative IS and OOS for the last 30 years.

4.3 Key Statistics Analysis Summary for In Sample and Out of Sample In three period Specifications
The statistics for forecast errors for log equity premium projections at annual frequency are shown in this
table, both in-sample (IS) and out-of-sample (OOS). Except for R2 and power, which are straightforward
percentages, all figures are expressed as percentages per year. The IS-R2 for the OOS period is shown in the
column labeled "IS for OOS." The difference between the conditional and unconditional forecasts for the
same sample/forecast period is known as the root mean square error, or RMSE. A positive value indicates an
improved conditional forecast outside of the sample.

Table 1 Key Statistics Summary for IS and OOS in three different period specifications.

There is strong evidence these three price ratios are not statistically significant at the 90% level during
1872 to 2005. However, some divergence in the literature can be explained by differences in the estimated
period. For example, the last column reveals if all data prior to 1927 are ignored, d/y and e/p are positive at a
90% confidence level and statistically significant IS performance, but Table 1 also shows that the OOS-R2
performance is still negative for both. We also discover that these three price models only lost statistical
significance in the full sample in the 1990s. This IS not because RMSE declined further in the 1990s, but
because forecast errors were more volatile from 1991 to 2005, raising the standard error of the estimates.

5. Discussion

Based on the results acquired through the analysis we can deduce that the dividend-price ratio, dividend
yield, and earnings-price ratio are not very good predictors of the equity premium. Although the IS had a
predictive power when taking all years into account (1927-2005), when looking into the last 30 years of the IS
(1976-2005), it loses all predictive power as it has a negative R squared in all three regressors (d/p, d/y, e/p).
This is the case for the OOS as well, but magnified which makes the predictive power of the models even
worse as the R squared is very high on the negative side. This might mean that models lose accuracy when
covering a large sample of years, therefore financial models need to update and evolve through the years to
consider new parameters that might come into play. As we can deduct from the results the last 30 years had
no predictive power for both IS and OOS whatsoever, meaning that creating models that have predictive
power for such a long term becomes incredibly challenging, therefore this model is better when only used in
a shorter horizon. Investors and policymakers should be cautious when using models that use historical data
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to predict the equity risk premium as in this case, they are not stable and their predictive

power is very weak; therefore, it could be better not to use them at all. It’s also important for investors to
adapt their investment strategies, as the models’ ability to predict deteriorates over time and might not be
considering new economic conditions. One example is the Oil Shock in 1974 which caused the IS and OOS
results to drive further apart in most variables.

6. Conclusion

This study set out to replicate and challenge the claims of Goyal and Welch (2008) work on predicting
equity premiums with classic indicators like dp, dy and ep. While our analysis largely aligns with their
skepticism, revealing limited overall predictive power, intriguing whispers emerged.

Specific timeframes hinted at a different story. The dividend-price ratio shone during the mid-1930s to
mid-1980s, while the dividend yield navigated the Great Depression and other periods with surprising
accuracy. Additionally, excluding pre-1927 data yielded statistically significant in-sample results for these
indicators, although their accuracy in forecasting future trends remained unconfirmed outside the sample
period. These findings urge us to reconsider a complete dismissal, suggesting their predictive power might be
context-dependent rather than universally applicable. While these indicators may exhibit limited overall
predictive power, their effectiveness could be contingent upon specific economic and historical settings.

While accurately predicting equity premiums with these indicators remains a formidable challenge, our
study unlocks contextual understanding. Delving into specific timeframes and economic conditions might
unveil previously hidden patterns, offering valuable insights into the potential predictive power of these and
other indicators. Future research, armed with this newfound perspective, can explore these nuances and
venture beyond traditional models.

7. References

Goyal, A., & Welch, I. (2008). A Comprehensive Look at The Empirical Performance of Equity Premium
Prediction. Review of Financial Studies, 21(4), 1455-1508.

Cochrane, J. H. (2008). The Dog That Did Not Bark: A Defense of Return Predictability. Review of Financial
Studies, 21(4), 1533-1575.

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