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A General Theory of Stock Market Valuation and Return

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Author Info

  • Christophe Faugere

    (U at Albany)

  • Julian Van Erlach

    (Nexxus Financial Technologies)

Abstract

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 nominal expected return and a direct function of inflation and a real required yield equal to 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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File URL: http://128.118.178.162/eps/fin/papers/0403/0403004.pdf
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Bibliographic Info

Paper provided by EconWPA in its series Finance with number 0403004.

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Length: 32 pages
Date of creation: 22 Mar 2004
Date of revision: 17 May 2004
Handle: RePEc:wpa:wuwpfi:0403004

Note: Type of Document - pdf; pages: 32
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Web page: http://128.118.178.162

Related research

Keywords: Required yield; Earnings yield; Equity Premium; S&P 500 Valuation; Fed Model.;

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References

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  1. Steven A. Sharpe, 2001. "Reexamining stock valuation and inflation: the implications of analysts' earnings forecasts," Finance and Economics Discussion Series 2001-32, Board of Governors of the Federal Reserve System (U.S.).
  2. Robert J. Shiller, 1980. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," NBER Working Papers 0456, National Bureau of Economic Research, Inc.
  3. Eugene F. Fama & Kenneth R. French, . "Forecasting Profitability and Earnings," CRSP working papers 358, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
  4. Ellen R. McGrattan & Edward C. Prescott, 2001. "Is the Stock Market Overvalued?," NBER Working Papers 8077, National Bureau of Economic Research, Inc.
  5. Merton H. Miller & Franco Modigliani, 1961. "Dividend Policy, Growth, and the Valuation of Shares," The Journal of Business, University of Chicago Press, vol. 34, pages 411.
  6. Joel Lander & Athanasios Orphanides & Martha Douvogiannis, 1997. "Earnings forecasts and the predictability of stock returns: evidence from trading the S&P," Finance and Economics Discussion Series 1997-6, Board of Governors of the Federal Reserve System (U.S.).
  7. Pritchett, Lant, 1995. "Divergence, big time," Policy Research Working Paper Series 1522, The World Bank.
  8. Steven A. Sharpe, 1999. "Stock prices, expected returns, and inflation," Finance and Economics Discussion Series 1999-02, Board of Governors of the Federal Reserve System (U.S.).
  9. Christophe Faugère & Julian Van Erlach, 2006. "The Equity Premium: Consistent with GDP Growth and Portfolio Insurance," The Financial Review, Eastern Finance Association, vol. 41(4), pages 547-564, November.
  10. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, 04.
  11. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
  12. Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc.
  13. Arturo Estrella & Jeffrey C. Fuhrer, 1983. "Average Marginal Tax Rates U.S. Household Interest and Dividend Income 1954-80," NBER Working Papers 1201, National Bureau of Economic Research, Inc.
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Cited by:
  1. Christophe Faugere & Julian Van Erlach, 2004. "The Price of Gold: A Global Required Yield Theory," Finance 0403003, EconWPA.

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