Required Yield Theory (or
Method): A New Approach to Asset Valuation
*Disclaimer Regarding Mr. Van
Erlach*
Required Yield Theory (RYT) or Required Yield Method
(RYM) is an asset pricing theory developed in collaboration with Julian Van
Erlach, CEO of Nexxus Wealth Technology. In the Spring of 2002, Julian phoned
me and spoke about a new model that explained the S&P 500 index extremely
well. He went on to claim that, as far as he could tell, major world indexes
were priced in relation to a 1.5% constant. Obviously, these statements seemed
far-fetched at the time. I suggested that he bring me his evidence and we met.
The evidence was intriguing enough to investigate. Julian and I wrote several articles on the
pricing of the S&P 500, Treasury instruments and Gold. Since then, I
continue developing the theoretical foundations of RYT for these and other asset classes (e.g. currencies and real estate).
1.
The essence of RYT is that all
major asset classes are priced in relation to GDP/capita growth.
2.
The 1.5% constant turns out to be
the long-run average real GDP/capita growth rate in major developed economies.
In the US the historical long-term average GDP/capita growth has been 2.03%
from 1929-2006.
3.
RYT
states that assets are priced to yield a minimum expected real return after-tax
closely related to long-run GDP/capita growth.
4.
Gold is a special case since its minimum expected yield (appropriately
defined P/E) varies inversely from that of other asset classes (Stocks and
Bonds).
It is important to point out that the key ideas
behind RYT (points #1 and #2 above) are not new. In fact, going back to the
roots of the consumption based asset pricing model surveyed in Cochrane’s book
(2001), we know that the representative agent framework of Lucas (1978) and its
extensions are modeling the desire of individual consumers to smooth
consumption over time and that this leads to a general condition (the so-called
pricing kernel) linking the return on all
assets to: consumption/capita growth, the social discount rate and consumer
preference parameters. Obviously, consumption/capita growth is directly linked
to GDP/capita growth. While so far the RYT modeling approach has been in terms
of DCF analysis, RYT appears to be a particular case of the Lucas (1978) model,
with the caveat that our analysis sidesteps consumer preferences. This logical
link is true in spite of the roadblocks that the standard consumption asset
pricing has historically faced regarding its empirical confirmation.
RYT goes one step further by combining the idea of
asset returns determined as a function macroeconomic growth with the
relationship often known as the Fisher effect (1930[f1]). There have not been many
attempts made in that direction mostly because the evidence in favor of the
Fisher effect has been lacking. A key piece of the RYT analysis is to explain
the behavior of the marginal investor as being the highest bidder to obtain a minimum real return after-tax. In the
very first version of RYT used to value the S&P 500, the EP (earnings
yield) ratio played the role of the investor’s “expected return”, similar to
the Fed Valuation Model, without a firm theoretical foundation. Our model also
incorporated an after-tax Fisher type effect in the earnings yield, which
seemed to greatly improve the Fed model. Our papers cited below provide the
theoretical structure that underpins these relationships.
You are welcome to consult:
·
A
General Theory of Stock Market Valuation and Return: the academic paper where
we developed the core of RYT to value the SP 500 index.
·
The Price of
Gold: A Global Required Yield Theory: the academic paper in which RYT is applied
to Gold valuation.
The major claims and conceptual points of RYT:
·
General asset classes (Stock Indexes, T-Bonds) are priced to yield a constant
after-tax real return related to long-term productivity as defined by real
long-term GDP/capita growth, we term the required
yield.
·
The “Fed model” (Lander,
Orphanides et al., 1997) is partially correct, since both the market
P/E and T-bond yield are related to a third factor: our previously defined
required yield.
·
Fisher’s (1930) Hypothesis about
investors wanting to earn a real constant return is true on an after-tax basis
(Feldstein, 1976[f2]), when it is understood
that the right variable to use to test the hypothesis is the earnings yield
(not total return).
·
Investors price the S&P 500 to obtain the required yield ex-ante
after-tax and inflation, while taking into account the fast mean reversion of
growth opportunities.
·
The equity risk premium is mostly related to business cycle risk. In
other words, the risk is that the economy does not mean revert over the
marginal investor’s relevant horizon. In the long-term, mean reversion is
certain and therefore the premium is zero. In the short-term (one-year), the
premium can be negative when for example immediate productivity is abnormally
high compared to the expected one-year productivity.
·
Gold is a global real store of wealth and its real price is inversely
related to the stock market P/E and thus directly related to the Required
Yield.
·
Foreign exchange rates fluctuations affect the