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The Risk Premium Factor: A New Model for Understanding the Volatile Forces that Drive Stock Prices by Stephen D. Hassett

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Chapter 4

The RPF Model and Major Market Events from 1981 to 2009

The Risk Premium Factor (RPF) Model shows that more than half of the growth in the Standard & Poor's (S&P) 500 Index since 1981 can be attributed to the risk-free rate declining from its peak of 13.7 percent in 1981. The interplay between interest rates, earnings, and valuation is a useful tool for identifying bubbles and diagnosing their cause.

Interest rates are much more important than is generally recognized. Some contend that the only impact of interest rates is the direct cost of borrowing, since higher rates reduce corporate earnings and make it more expensive for consumers to purchase anything on credit. While it is true that the effective cost of anything from a new flat screen to a car to a house becomes more expensive or less expensive (if you borrow to make the purchase) based on rising or falling rates, impact of interest rates is much more far reaching.

If the equity risk premium (ERP) were a constant, cost of capital should change only to the extent that changes in inflation change the risk-free rate. For example, if inflation increased from 3 percent to 5 percent, then the risk-free rate should increase from 5 percent to 7 percent. Since earnings would be expected to increase with inflation by also growing 2 percent faster for the market as a whole, in the constant growth equation, where P = E/(C – G) because C and G increase the same amount, the impact would be zero.

The RPF Model reveals the true ...

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