A General Theory of Stock Market Valuation and Return
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.
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.:
- 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.).
- 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.).
- 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.
- 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.
- 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.
- R. Mehra & E. Prescott, 2010.
"The equity premium: a puzzle,"
Levine's Working Paper Archive
1401, David K. Levine.
- Rajnish Mehra, 2003. "The Equity Premium: Why is it a Puzzle?," NBER Working Papers 9512, National Bureau of Economic Research, Inc.
- Pritchett, Lant, 1995.
"Divergence, big time,"
Policy Research Working Paper Series
1522, The World Bank.
- Eugene F. Fama & Kenneth R. French, .
"Forecasting Profitability and Earnings,"
CRSP working papers
456, Center for Research in Security Prices, Graduate School of Business, University of Chicago.
- 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.
- Eugene F. Fama & Kenneth R. French, 2002.
"The Equity Premium,"
Journal of Finance,
American Finance Association, vol. 57(2), pages 637-659, 04.
- 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.).
- Ellen R. McGrattan & Edward C. Prescott, 2000.
"Is the stock market overvalued?,"
Federal Reserve Bank of Minneapolis, issue Fall, pages 20-40.
- 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.
- 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.
When requesting a correction, please mention this item's handle: RePEc:wpa:wuwpfi:0403004. See general information about how to correct material in RePEc.
For technical questions regarding this item, or to correct its authors, title, abstract, bibliographic or download information, contact: (EconWPA)
If references are entirely missing, you can add them using this form.