Valuation Duration of the Stock Market

TL;DR

This paper introduces a valuation-based duration measure of the stock market, revealing how market participants' limited long-term cash flow information influences valuation and return predictions.

Contribution

It develops a novel valuation duration metric derived from market value and dividend data, linking it to discount rates and market dynamics.

Findings

Valuation duration varies significantly over market cycles.

Lower discount rates increase valuation duration.

Valuation duration predicts market returns with 15% out-of-sample R2.

Abstract

At the peak of the tech bubble, only 0.57% of market valuation comes from dividends in the next year. Taking the ratio of total market value to the value of one-year dividends, we obtain a valuation-based duration of 175 years. In contrast, at the height of the global financial crisis, more than 2.2% of market value is from dividends in the next year, implying a duration of 46 years. What drives valuation duration? We find that market participants have limited information about cash flow beyond one year. Therefore, an increase in valuation duration is due to a decrease in the discount rate rather than good news about long-term growth. Accordingly, valuation duration negatively predicts annual market return with an out-of-sample R2 of 15%, robustly outperforming other predictors in the literature. While the price-dividend ratio reflects the overall valuation level, our valuation-based measure of duration captures the slope of the valuation term structure. We show that valuation duration, as a discount rate proxy, is a critical state variable that augments the price-dividend ratio in spanning the (latent) state space for stock-market dynamics.