Forecasting Stock Returns Using Macroeconomic Growth Factors

Over the long term, corporate earnings tend to comprise about 10% of GDP.  This number fluctuates, of course, but the long-term trend is relatively consistent.  Since corporate earnings are eventually reflected in stock prices and their share of GDP is relatively stable, we can use economic growth forcasts to predict future stock returns.  The long-term correlation between GDP per capita growth and the S&P 500 earnings growth is over 0.9% (Source: All About Asset Allocation).  The basic equation for this valuation method is:

Stock returns = corporate earnings growth + dividends + valuation changes

Corporate earnings growth and dividends are obvious and self-explanatory components or stock prices.  Valuation changes refers to the Price to Earnings Ratio (P/E), or the price investors are willing to pay for $1 worth of earnings.  If investors believe corporate earnings are likely to grow more quickly in the future, the P/E ratio will rise.  Conversely, the P/E ratio will fall if the market believes earnings growth will slow.  The market’s P/E ratio often fluctuates wildly in the short term, but these fluctuations tend to balance themselves once you start thinking in decades rather than years.

Long-Term Corporate Earnings Growth

Over the long term, the economy tends to grow at about 3% per year over inflation.  Of course, there is no reason to think the future must necessarily look like the past.  For the purposes of this exercise, we will assume the economy grows at only 2% per year to reflect increasing global competition.  We will also assume inflation holds at around 3% per year, giving us nominal GDP growth of 5% per year.  Since corporate earnings growth is a derivative of GDP growth, that means corporate earnings will also grow about 5% per year.

Cash Dividends

According to Morningstar, the US stock market currently yields about 2%.  Add that to our corporate earnings growth assumption of 5% and we have a total return of about 7% per year.  Not impressive but it could certainly be worse.  It is worth noting that only about 30% of corporate earnings are currently paid out as dividends.  This number certainly has room to grow, but higher dividend payouts imply lower earnings growth because less money is reinvested in productive enterprise. 

Valuation Changes

As of the end of February 2008, the P/E of the US stock market stood at about 16.8x earnings.  Prices have continued to fall over the last month so the current ratio is probably a bit lower than that.  This is pretty much in line with the historical average, so we can logically conclude it is unlikely to change significantly over the long term.  Sure, it may rise or fall significantly over short periods of time, but we aren’t likely to see anything resembling a permanent rise or fall in market valuation.  Thus, under the above assumptions, we can expect large-cap US stocks to return about 7% per year over the long term.  Please note that I made these numbers up just to illustrate this method.  I do not pretend to know if they are correct.  Real GDP growth could just as easily be 4% or 1.5% per year and inflation could be higher or lower as well.

This is part two in a series on predicting future stock market returns.

• Introduction: Predicting Future Stock Market Returns
• Part 1:  Stacking Risk Premiums:  Predicting Future Stock Market Returns