Equity Market Valuation Cannot Outgrow The Economy Over The Long Run
July 1, 2000
Business Economics, Vol. 35, No. 3 (July 2000), pp. 53-58
Macroeconomic Theory and historical evidence suggest that bond prices help cause long-run convergence between stock market and GDP growth.
Over the very long term the total dividend and capitalization of an economy’s equity market should grow at the same rate as the GDP. Using this relationship, the expected total return to the equity market is the sum of the expected GDP growth rate and current dividend yield. Long-term U.S. historical data show a remarkable consistency with this proposition. A risk premium parameter that takes into account GDP growth potential, the interest rate and the dividend yield is identified. An equation that relates the risk premium to the interest rate and dividend yield is derived using the familiar LM curve of macroeconomic theory. Using this equation, it is suggested that bond prices are the ultimate check that brings stocks and GDP growth in line over the long run.
Equity Market Valuation Cannot Outgrow The Economy Over The Long Run – Introduction
The U.S. stock market has been putting up an astonishing performance for the past decade. Equity market capitalization as measured by the Wilshire 5000  index quadrupled from the end of 1989 through 1999, creating enormous wealth. The combined capitalization of stocks listed on the New York Stock Exchange and Nasdaq  totaled Si7.4 trillion at the end of 1999. The (NYSE+Nasdaq capitalization)/GDP ratio changed from 0.80 in 1993 to 1.87 in 1999. In these six years, the New York Stock Exchange and Nasdaq have created wealth that equals 1.8 times 1993 GDP .
Many believe that the fast pace with which the equity market has been advancing in the past decade can be maintained and even be surpassed in the future. Some predictions of the level of the Dow-Jones Industrial aver ages in the near future were raised from 36,000 to 40,000 to 100,000 [3,4,5], (The Dow was 11,497 at the end of 1999.) On the other hand, others are nervous about the high level of the stock market and fear that a crash of unprecedented scale is in the making. One author predicted that the Dow is likely to fall as much as ninety eight percent in early 2000s, and the market will probably not bottom out until it reaches a level of ninety-five .
While this paper will not make another prediction of the future market level, it does provide a framework that takes into account key macroeconomic factors that deter mine the market level in the long run.1 Within this frame work, one can make a sensible judgment on the possible long-run future market level and can factor that into investment decisions.
Corporate Profits, Dividends and GDP
On the income-side of the GDP accounts, corporate after-tax earnings are the total amount available for distribution each year to the owners of corporate business. The total dividend is the amount that is actually distributed. Wages, taxes, interest, rent and depreciation are the other main categories of factor income comprising the income side of GDP accounts. The share of dividends in the total GDP should be fairly stable in order of magnitude over the long term. This share is determined by the structure of the economy. Figure 1 shows the after tax earning and dividend as percentage of GDP in the U.S. for 1959-1999 .
After-tax earnings averaged 5.5 percent and dividends 2.7 percent of GDP for this period. The maximum and mini mum of dividend/GDP ratio were 4.1 percent and 2.0 per cent over this period.
Over the long term the dividend/GDP ratio is expect ed to fluctuate, but the order of magnitude should remain the same, under normal conditions. It is unlikely for the dividend/GDP ratio to get to, say, fifteen percent without a complete structural change of the economy coupled with drastic wealth redistribution. In the limiting case of an infinite time horizon, the expected average dividend growth rate must converge toward the GDP growth rate. Otherwise, the dividend/GDP ratio will either go up unbounded (when dividend grows faster than the GDP) or go down to zero (when dividend grows slower than GDP). Both cases are not possible for a functioning economy. We summarize this notion as following proposition.
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