Required Yield Theory (or Method): A New Approach to Asset Valuation
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:
· : the academic paper where we developed the core of RYT to value the SP 500 index.
· : 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” is partially correct, since both the market P/E and T-bond yield are related to a third factor: our previously defined required yield.
· ’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