The Good News and the Bad News About Long-Run Stock Market Returns

Abstract

If stock prices followed a random walk, uncertainty about future stock prices would be so great that the observed bias towards equities in long-term investment portfolios would be surprising. The good news is that if, as a growing body of research suggests, there is even a weak tendency for stationary valuation indicators to predict future stock prices, long-run returns can become markedly more predictable. We illustrate this in a cointegrating VAR, with Tobin's "q" as one of the cointegrating relations. The bad news is a corollary of the good news: "q" and most other indicators point to massive overvaluation at end-1997, and hence the prospect of weak stock prices well into the next century.

JEL Classification: C32, C52, E44, G10, G14