A Pragmatist's Guide to Long-Run Equity Returns, Market Valuation, and the CAPE
18 Pages Posted: 12 Oct 2014
Date Written: October 10, 2014
When practitioners evaluate the equity market, two important questions recur. What long-run returns should investors expect? And, are there fundamental yardsticks that reliably indicate when the market is overvalued? Researchers have not reached a consensus on either of these questions. Equity prices have been high relative to their historical average, which has led many analysts to predict future equity returns will be below their historical average. Forecasts for real returns vary widely, however, from as low as 2%, to approximately 6%, which is close to the 6.5% average since 1871. Disagreements about returns reflect disagreement about how earnings will be affected by slower GDP growth, lower dividends, share buybacks, and the profitability of retained earnings. The current paper introduces Federal Reserve Flow of Funds and S&P500 book value data into this debate, and these data are generally supportive of the optimistic forecasts for equity returns. Estimates of long-run returns have implications for valuation metrics such as Shiller’s CAPE (cyclically adjusted price-earnings ratio).
Keywords: Equity Returns, CAPE
JEL Classification: G10, G12
Suggested Citation: Suggested Citation