Method 1 – Building Blocks Method

Ibbotson and Sinquefield (1976a,b) develop a building blocks method to explain equity returns. The three building blocks are inflation, real risk-free rate, and equity risk premium. Inflation is represented by the changes in the Consumer Price Index (CPI). The equity risk premium and the real risk-free rate for year t,

ERP_t and RRf_t , are given by

R_t is the return of U.S. stock market represented by the S&P 500 index. Rf_t is the return of risk-free

assets represented by the income return of long-term U.S. government bonds. The compounded average for equity return is 10.70% from 1926-2000. For the equity risk premium, we can interpret that investors

⁴ Stock Market Returns in the Long Run

were compensated 5.24% per year for investing in common stocks rather than long-term risk-free assets like the long-term US government bonds.⁷ This also shows that roughly half of the total historical equity return has come from the equity risk premium, and the other half is from inflation and long-term real risk-free rate. The average U.S. equity returns from 1926 and 2000 can be reconstructed as follows:

Method 2 – Capital Gain and Income Method

The equity return can be broken into capital gain ( cg ) and income return ( Inc ) based on the form in which the return is distributed. Income return of common stock is distributed to investors through dividends, while capital gain is distributed through price appreciation. Real capital gain ( Rcg ) can be computed by subtracting inflation from capital gain. The equity return in period t can then be decomposed as follows:

The average income return is calculated to be 4.28%, the average capital gain is 6.19%, and the average real capital gain is 3.02%. Rinv , the re-investment return, averages 0.20% from 1926 to 2000. The average U.S. equity return from 1926 to 2000 can be computed according to

⁵ Stock Market Returns in the Long Run

Figure 1 shows the decomposition of the building blocks method and the capital gain and income method from 1926 to 2000.

Method 3 – Earnings Model

The real capital gain portion of the return in the capital gain and income method can be broken into

growth in real earnings per share ( g_REPS ) and growth in the price to earnings ratio ( g_{P / E} ),

Therefore, the equity’s total return can be broken into four components: inflation; the growth in real earnings per share; the growth in the price to earnings ratio; and income return.

The real earnings of US equity increased 1.75% annually from 1926. The P/E ratio was 10.22 at the beginning of 1926. It grew to 25.96 at the end of 2000. The highest P/E (136.50) was recorded during the depression in 1932 when earnings were near zero, while the lowest (7.26) was recorded in 1979. The average year-end P/E ratio is 13.76.⁸ Figure 2 shows the price to earnings ratio from 1926 to 2000. The U.S. equity returns from 1926 and 2000 can be computed according to

Date: 2016-01-14; view: 537