• We find that two variables – the long-term risk-free interest rate and, more surprisingly, the “expected” rate of capital gains (proxied by a weighted average of past equity returns) – explain the cyclically adjusted earnings yield of U.S. equities (S&P 500), which has dropped to a record low.
  • The higher the “expected” rate of capital gains, the lower the earnings yield demanded by investors. In the recent episodes of equity repricing, the rise in the “expected” rate of capital appreciation has played a bigger role than the fall in interest rates.
  • To keep the cyclically-adjusted earnings yield stable, a 100-bps fall in the risk-free rate has to offset every 7.5%-fall in the S&P 500: the current level of interest rates provides little cushion against a deflation of the “expected” rate of capital appreciation.