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Long-Run Stock Returns: Participating in the Real Economy

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  • Roger G. Ibbotson

    ()
    (Yale University, School of Management)

  • Peng Chen

    ()
    (Ibbotson Associates)

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    Abstract

    In the study reported here, we estimated the forward-looking long-term equity risk premium by extrapolating the way it has participated in the real economy. We decomposed the 1926–2000 historical equity returns into supply factors-inflation, earnings, dividends, the P/E, the dividend-payout ratio, book value, return on equity, and GDP per capita. Key findings are the following. First, the growth in corporate productivity measured by earnings is in line with the growth of overall economic productivity. Second, P/E increases account for only a small portion of the total return of equity. The bulk of the return is attributable to dividend payments and nominal earnings growth (including inflation and real earnings growth). Third, the increase in the equity market relative to economic productivity can be more than fully attributed to the increase in the P/E. Fourth, a secular decline has occurred in the dividend yield and payout ratio, rendering dividend growth alone a poor measure of corporate profitability and future growth. Our forecast of the equity risk premium is only slightly lower than the pure historical return estimate. We estimate the expected long-term equity risk premium (relative to the long-term government bond yield) to be about 6 percentage points arithmetically and 4 percentage points geometrically.

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    Bibliographic Info

    Paper provided by Yale School of Management in its series Yale School of Management Working Papers with number ysm354.

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    Date of creation: 04 Apr 2003
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    Handle: RePEc:ysm:somwrk:ysm354

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    Web page: http://icf.som.yale.edu/
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    Keywords: Portfolio Management; Asset Allocation;

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    Cited by:
    1. van Ewijk, Casper & de Groot, Henri L.F. & Santing, A.J. (Coos), 2012. "A meta-analysis of the equity premium," Journal of Empirical Finance, Elsevier, vol. 19(5), pages 819-830.
    2. Claude B. Erb & Campbell R. Harvey, 2013. "The Golden Dilemma," NBER Working Papers 18706, National Bureau of Economic Research, Inc.
    3. Michael Wegener & Göran Kauermann, 2008. "Examining heterogeneity in implied equity risk premium using penalized splines," AStA Advances in Statistical Analysis, Springer, vol. 92(1), pages 35-56, February.
    4. Ferreira, Miguel A. & Santa-Clara, Pedro, 2011. "Forecasting stock market returns: The sum of the parts is more than the whole," Journal of Financial Economics, Elsevier, vol. 100(3), pages 514-537, June.
    5. Fernandez, Pablo, 2004. "Market risk premium: Required, historical and expected," IESE Research Papers D/574, IESE Business School.
    6. Christophe, Faugere, 2003. "A Required Yield Theory of Stock Market Valuation and Treasury Yield Determination," MPRA Paper 15579, University Library of Munich, Germany, revised 04 Jun 2009.
    7. Hachmeister, Dirk & Ruthardt, Frederik & Autenrieth, Matthias, 2014. "Marktrisikoprämien am deutschen Kapitalmarkt: Ermittlung, Simulation und Vergleich historischer und angebotsseitiger Marktrisikoprämien," Hohenheimer Schriften: Rechnungswesen - Steuern - Wirtschaftsprüfung 2014-01, University of Hohenheim, Department of Business Administration.
    8. Fernandez, Pablo & Aguirreamalloa, Javier & Liechtenstein, Heinrich, 2009. "The equity premium puzzle: High required equity premium, undervaluation and self fulfilling prophecy," IESE Research Papers D/821, IESE Business School.
    9. Yacine Aït-Sahalia & Michael W. Brandt, 2008. "Consumption and Portfolio Choice with Option-Implied State Prices," NBER Working Papers 13854, National Bureau of Economic Research, Inc.
    10. Richard W. Kopcke & Matthew S. Rutledge, 2004. "Stock prices and the equity premium during the recent bull and bear markets," New England Economic Review, Federal Reserve Bank of Boston, pages 63-85.
    11. Christophe Faugere & Julian Van Erlach, 2003. "The Equity Premium: Explained by GDP Growth and Consistent with Portfolio Insurance," Finance 0311004, EconWPA.
    12. Satyajit Chatterjee & Burcu Eyigungor, 2011. "A quantitative analysis of the U.S. housing and mortgage markets and the foreclosure crisis," Working Papers 11-26, Federal Reserve Bank of Philadelphia.
    13. William Goetzmann & Roger Ibbotson, 2005. "History and the Equity Risk Premium," Yale School of Management Working Papers ysm448, Yale School of Management.

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