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The equity premium has been high in the past century. However, is it a good indicator for investors to invest in the stock market? Economists have suggested a wide rage of variables to estimate the equity premium, mostly before 2002. Some indicate that equity premium is higher than expected, while others argue that equity premium is not predictable. This paper provides insights into this debate, summarizes explanations on equity premium puzzles, and explores determinants of equity premium. After digging out the possible factors affecting equity premium, I check the predictability of equity premium by performing time series test and Granger causality test, and provide practical explanation for the result. The result shows that the current equity premium is predictable and is significantly affected the dividend yield, the momentum, the Federal Reserve balances, and the government deficit (each represents fundamentals, behavioral finance, monetary policy, and fiscal policy accordingly). Comparatively, fundamental variables have more significant impacts on equity premium than macroeconomic variables and behavioral components do. Especially, monetary policy and fiscal policy all display significant powers during special events. For example, Federal Reserve balances have significant causal impact on equity premium during times of QE series. It is interesting to note that while the average equity premium for the last century was around 7%, the average equity premium since the 21th century has been slightly below zero. This finding indicates that the equity premium puzzle might have not existed for the recent ten years.
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Quan, Minghang, "Equity Premiums: Have they been Predictable since the 21th Century?" (2013). Senior Projects Spring 2013. 130.
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