The Equity Curve and Its Relation to Future Stock Returns

Using option prices, a new method for estimating the term structure of expected stock returns (equity curve) is proposed. We analyse how the equity curve relates to future stock returns and obtain three main results. First, a higher level of the equity curve is associated with higher future stock returns. Second, a positive slope is followed by future realized returns which are lower in the short term (1 month) than in the long term (1 quarter or 1 year). Third, a steeper slope (either positive or negative) is associated with a larger absolute difference between short-term and long-term returns. Therefore, the equity curve is consistent with theoretical predictions. We also analyse an investment strategy that uses the slope of the equity curve to determine the allocation to stocks. This strategy earns an outperformance of up to 200 basis points per annum.