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A General Theory of Stock Market Valuation and Return

Author

Listed:
  • Christophe Faugere

    (U at Albany)

  • Julian Van Erlach

    (Nexxus Financial Technologies)

Abstract

We show that the long-term total market and average investor's compounded stock returns are determined by GDP growth and are much less than believed because of the infeasible assumption that dividends can be fully reinvested. The long-term stock return closely approximates the return on risk-free debt, thus yielding a zero premium on a compounded per-capita basis. We demonstrate that the market earnings yield ratio (inverse P/E) is akin to a minimum nominal expected return and a direct function of inflation and a real required yield equal to long-term real GDP per capita growth, with marginal regard to risk. Our derived valuation formula is tested against the S&P 500 index and produces a 21% mean percentage tracking error, compared to 32% for the 'Fed Model' over the period 1954 - 2002.

Suggested Citation

  • Christophe Faugere & Julian Van Erlach, 2004. "A General Theory of Stock Market Valuation and Return," Finance 0403004, University Library of Munich, Germany, revised 17 May 2004.
    • Handle: RePEc:wpa:wuwpfi:0403004
    Note: Type of Document - pdf; pages: 32
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    References listed on IDEAS

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    Cited by:

    1. Christophe Faugere & Julian Van Erlach, 2004. "The Price of Gold: A Global Required Yield Theory," Finance 0403003, University Library of Munich, Germany.

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    More about this item

    Keywords

    Required yield; Earnings yield; Equity Premium; S&P 500 Valuation; Fed Model.;
    All these keywords.

    JEL classification:

    • G - Financial Economics

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