Long-Run Stock Returns: Participating in the Real Economy

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.

Until 2001, investors had not seen consecutive negative annual stock market returns since the 1970s. To the contrary, during the 1980s and 1990s, the market produced its best 20-year performance ever. But neither the past two years nor the past two decades are good predictors of the long run.

We establish a new method for forecasting the future return of stocks over bonds by building on the relationship between the stock market, earnings, and the overall economy. We analyze historical equity returns by decomposing the 1926–2000 returns into supply factors commonly used to describe the aggregate equity market and overall economic productivity—inflation, earnings, dividends, the P/E, the dividend-payout ratio, book value, return on equity, and GDP per capita. We examine each factor and its relationship to the long-term supply-side framework.

We discuss several key findings. First, the growth in corporate productivity, as 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 (1.25 percentage points of the total 10.70 percent). The bulk of the return is attributable to dividend payments and growth in nominal earnings (including inflation and real earnings growth). Third, the increase in share of equity relative to the overall economy 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.

We used historical information in the supply-side models to forecast the equity risk premium. Contrary to several recent studies on the premium that declared the forward-looking equity risk premium to be close to zero or negative, we found the long-term supply of the equity risk premium to be only slightly lower than the straight historical estimate. We estimated the expected premium to be 3.97 percentage points in geometric terms and 5.90 percentage points on an arithmetic basis. This estimate is about 1.25 percentage points lower than the straight historical estimate.

The differences between our estimates and those provided in several other recent studies arise principally from the inappropriate assumptions those authors used, assumptions that violate the Miller and Modigliani theorem. Also, our models interpret the current high market P/E as the market forecasting high future growth, rather than a low discount rate or overvaluation. Our estimate is in line with both the historical supply measures of public corporations (i.e., earnings) and overall economic productivity (GDP per capita).

Our estimate of the equity risk premium is far closer to the historical premium than it is to zero or a negative number. The implication is that stocks are expected to outperform bonds over the long run. For long-term investors, such as pension funds and individuals saving for retirement, stocks should continue to be a favored asset class in a diversified portfolio. Because our estimate of the equity risk premium is lower than historical performance of the premium, however, some investors should lower their equity allocations and/or increase their savings rate to meet future liabilities.