The pattern in the way the equity market values earnings over the cycle documented in the previous section is far from arbitrary. The Nielsen and Oppenheimer study mentioned earlier, shows that the phases in the equity market are linked to the underlying macroeconomy. This allows for a clearer interpretation of the phases and can help to identify when the market is moving from one phase to the next. This section covers these results.

We first look at investors real forward looking return requirements on investment. In the valuation model in equation (5.1), this would be the nominal risk free rate plus the equity risk premium minus expected inflation. This variable is interesting as it measures the real hurdle rate for investment in the stock market.

As mentioned above this is not directly observable, but we measure this Real Required Return (RRR) as the 10-year nominal government bond yield, plus a measure of the Equity Risk Premium that we will discuss further below, minus five-year average historical inflation as a measure of inflation expectations. This measure of the RRR generally increases in the Despair phase, decreases in the Hope and Optimism phases and is somewhat mixed in the Growth phase. Exhibit 5.6 shows the change in the RRR from the beginning to the end of each phase for each of the regions we consider.

EXHIBIT 5.6 Change in the RRR in Each Phase

We interpret the movements in investors' forward-looking ...

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