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February 02, 2005

Festival of the Stock Returns!

Yet another contribution to the ongoing internet festival of the stock returns in response to Paul Krugman's New York Times column of yesterday:

Consider this: from 1871 to 2003, the average one-year-ahead real return on stocks--the Cowles index linked to the S&P Composite--averaged 8.39% per year. The reported accounting earnings yield on stocks--annual reported earnings divided by the start-of-the-year stock price--averaged 7.67% per year. Of the difference, 0.56 percentage points is due to the fact that the price-earnings ratio more than doubled from 12 to 25 between 1871 and 2003, and 0.16 percentage points are due to the fact that reported accounting earnings understate true economic earnings by a little bit. But all in all, current earnings yields have for a century and a third been a good guide to very long-run expected returns.

Today the stock market's earnings yield is 4%.

It's very hard to get a high projected real stock return of 6.5%-7.0% for the future out of that 4% number. You could argue--unconvincingly--that even though accounting earnings have been a good guide to true earnings in the past, they are massively understating earnings today. You could argue--unconvincingly--that American firms' profitability is about to massively boosted via some side-effect of globalization. Or you could argue that the stock market is about to crash by 33% to 50%, and so return earnings yields to the 6%-8% range that have supported the healthy stock returns of the past.

Previous worthwhile contributions include Krugman, Samwick, and Baker channeled by Sawicky.

Posted by DeLong at February 2, 2005 02:02 PM