The risk premium and stock market performance.

Here we examine the equity risk premium as a key component of the asset allocation decision. Our purpose is to test the predictive value of various equity market risk premium proxies. To do this we conduct statistical tests to determine if the risk premium proxy, measured in any month, is directly correlated with subsequent market returns in the following month. The results are encouraging, suggesting the following: 1) Earnings yield and dividend yield are very effective tools for asset allocation. 2) The earnings yield approach can be improved substantially with appropriate attention given to some of the quirks of the earnings stream. 3) By combining various techniques, we can produce an "equity excess return predictor," which turned bearish three months before the October 1987 crash.