Review of Stock Market Forecasting

1
Review of Stock Market Forecasting
2
9 Forever?

• The historical data from 1926-present of the
  SP500 has a very high arithmetic rate of return.
• Ibbotson forecast 10 in the 70s and he was
  right. Hes still forecasting 9 nominal, or
  about 7 real.
• So is the Social Security Advisory Board.
• Many others are shaving 3 off of this number.

3
John Campbells Calculation

• 1871-1997
• Div yield 5.4
• Geometric Stock Price Growth 1.6 (real)
• gt 7.0 real
• 1802-1997
• Div yield 4.9
• Geometric Stock Price Growth 2.1
• gt 7.0 real.

4
John Campells Calculation

• New Div Yield 1.4 (!!!)
• Dollars going to repurchases correspond to
  somewhat higher g, but only about 1.
• New real return should be in the neighborhood of
  3.7 to 4.7, not 7.
• (if we trust current dividend yield)
• ( 1.4 about 3 g)
• Since TIPS yielding 3.5, this is an equity
  premium of about 1. (!!!)

5
Why is current D/P so low?

• Guess 1 Prices now are simply too high.
• D/P will correct over time as market returns are
  disappointing.
• Guess 2 Dividends now are low.
• High prices mean that the market forecasts high
  growth in earnings. Once this growth is
  realized, the ratio will return to normal.
• Ibbotson favors this explanation, and uses
  historical D/P in his 9 forever calculation.
• Guess 3 Structural Decline in Equity Premium
• You might argue that 1 number for equity premium
  actually makes sense from an economic perspective.

6
Campbells Middle-of-the-Road Position

• Campbell retreats from his back-of-envelope
  calculation that equity premium is 1.
• Maybe all three explanations have some merit.
• Forecasts real geometric return of 5 to 5.5.
• Given TIPs return, this is a 1.5 to 2.0 equity
  premium.

7
Ritters Analysis

• Similar analysis as Campbell, but emphasizes
  interpreting g as growth rate in dividends rather
  than share prices.
• Argues that if dividends grow at a reasonable
  rate per capita, they will not eventually
  overwhelm labor income.
• Suggests g2.5
• D/P 1.5.
• gt Real return 4.0.
• Given TIPs return of 3.3, this is an equity
  premium of seven-tenths of a percent.