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A General Theory of Stock Market Valuation and Return

  • Christophe Faugere

    (U at Albany)

  • Julian Van Erlach

    (Nexxus Financial Technologies)

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://econwpa.repec.org/eps/fin/papers/0403/0403004.pdf
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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
Contact details of provider: Web page: http://econwpa.repec.org

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  1. 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.
  2. 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.
  3. Shiller, Robert J, 1981. "Do Stock Prices Move Too Much to be Justified by Subsequent Changes in Dividends?," American Economic Review, American Economic Association, vol. 71(3), pages 421-36, June.
  4. Eugene F. Fama & Kenneth R. French, 2002. "The Equity Premium," Journal of Finance, American Finance Association, vol. 57(2), pages 637-659, 04.
  5. Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc.
  6. 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.
  7. Ellen R. McGrattan & Edward C. Prescott, 2000. "Is the stock market overvalued?," Quarterly Review, Federal Reserve Bank of Minneapolis, issue Fall, pages 20-40.
  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. Steven A. Sharpe, 2002. "Reexamining Stock Valuation and Inflation: The Implications Of Analysts' Earnings Forecasts," The Review of Economics and Statistics, MIT Press, vol. 84(4), pages 632-648, November.
  10. 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.
  11. 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.).
  12. Pritchett, Lant, 1995. "Divergence, big time," Policy Research Working Paper Series 1522, The World Bank.
  13. R. Mehra & E. Prescott, 2010. "The equity premium: a puzzle," Levine's Working Paper Archive 1401, David K. Levine.
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