We show that the long-term total market and average investor’s compounded stock returns are determined by GDP growth and are much less than believed because of the infeasible assumption that dividends can be fully reinvested. The long-term stock return closely approximates the return on risk-free debt, thus yielding a zero premium on a compounded per-capita basis. We demonstrate that the market earnings yield ratio (inverse P/E) is akin to a minimum expected return and a direct function of inflation and long-term real GDP per capita growth with marginal regard to risk. Our derived valuation formula is tested against the S&P 500 index and produces a 21% mean percentage tracking error, compared to 32% for the “Fed Model” over the period 1954 – 2002.
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Paper provided by EconWPA in its series Finance with number
0311005.
Length: 34 pages Date of creation: 05 Nov 2003 Date of revision:
17 May 2004 Handle: RePEc:wpa:wuwpfi:0311005
Note: Type of Document - pdf; prepared on Win2000; to print on HP LaserJet 4 plus; pages: 34; figures: Embedded in text. pdf document Contact details of provider: Web page: http://129.3.20.41
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References listed on IDEAS Please report citation or reference errors to , or , if you are the registered author of the cited work, log in to your RePEc Author Service profile, click on "citations" and make appropriate adjustments.:
Ellen R. McGrattan & Edward C. Prescott, 2000.
"Is the stock market overvalued?,"
Quarterly Review,
Federal Reserve Bank of Minneapolis, issue Fall, pages 20-40.
[Downloadable!]
Other versions:
Eugene F. Fama & Kenneth R. French, 2002.
"The Equity Premium,"
Journal of Finance,
American Finance Association, vol. 57(2), pages 637-659, 04.
[Downloadable!] (restricted)
Other versions:
Eugene Fama & F. & Kenneth R. French, .
"The Equity Premium.","
CRSP working papers
522, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
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