Predicting the equity premium with a high‐threshold risk level and the price of risk

Abstract Over 1990 to 2023, we show that time variation in the U.S. equity premium is captured well by a parsimonious model with the CBOE's implied‐volatility index VIX and the sentiment index of Baker and Wurgler (2006, Journal of Finance , 61 , 1645–1680). The equity premium declines linearly with sentiment but increases nonlinearly with VIX, stepping up appreciably when VIX exceeds a threshold around its 80th to 85th percentile. For 6‐ and 12‐month forecasting horizons, the predictive adjusted R 2 values are about 19% and 29%, respectively. Our predictive findings are robustly evident for 1‐, 3‐, 6‐, and 12‐month horizons, in subperiods, for in‐sample and out‐of‐sample evaluations, and when adding control variables. Our interpretation is that a high‐VIX threshold identifies episodes of market stress that generally have both a sharply higher level of risk and an elevated price of risk. Sentiment complements VIX and seems particularly effective in identifying times with a low price of risk.