In the proverbial 1,000-mile journey, it's best to begin with the first step, and that usually means equities, the primary asset class for generating risk premiums for most investors. There are many ways to calculate estimates for equity risk, but a reasonable place to start is with the so-called Gordon equation, one of the more unassuming (yet reliable) members of the discounted-cash-flow family of forecasting models. It's not a crystal ball, particularly if your investment horizon is less than ten years. But in the perennial quest to find context for thinking about future stock market performance, the Gordon equation deserves a spot in every strategist's analytical arsenal.
In its basic form, the equation tells us that the expected return for stocks in the long run is the sum of the dividend growth rate and the current dividend yield. A reasonable assumption, given that long-run investors will receive the current yield and any increases tied to higher dividend payouts. To the extent that actual returns differ from this basic formula, capital appreciation (or loss) is the reason. Forecasting that aspect of equity returns is virtually impossible, which leaves us to focus on what's clearer, as the Gordon equation does.
Financial planner William Bernstein, writing in his popular book The Four Pillars of Investing, says the Gordon equation is "an accurate way to predict long-term stock market returns." The history of the 20th century suggests as much. The average dividend yield from 1900 to 1999 was roughly 4.5%, which matches the compound growth rate of dividends. Based on the Gordon equation, the U.S. stock market should have delivered a 9% performance. The actual record is a bit higher, at 9.89%, Bernstein reports. "Not too shabby," he concludes.
What is the Gordon equation telling us these days? The outlook for equities has improved considerably in the last several years, as Figure 1 shows. From an outlook early in this decade that said stocks would return less than 4%-the lowest in the post-World War II era-the future looks more encouraging for equity investing. At the end of 2008, the Gordon equation was forecasting that the stock market performance would be around 9%, or slightly under its long-run historical record of 10%.
The prediction is heartening, given the losses of late, although it's important to remember that even the Gordon equation can only guess at what's coming. It might be an intelligent guess, but a guess nonetheless. Even so, the model's general trend through time is arguably more revealing than any particular numerical prediction at a given moment.
Take another look at Figure 1 and you'll see that the equation's forecast previously peaked in the early 1980s, which was another rough time for stocks and the economy. For the next two decades, a great bull market prevailed. As it unfolded, the outlook for equity returns fell, slowly but consistently, right up until the early 21st century. It's no accident that the Gordon equation's peak in the early 1980s and its trough in the early 2000s look like bookends for the intervening 20-year run-up. In short, higher prices generally reduce expected return, and lower prices boost the performance outlook.
We can debate exactly what the stock market will deliver in the future, but the Gordon equation's unambiguous message is that prospective returns for equities look quite a bit better now than they did earlier in the decade.
Then again, we have to be careful about forecasting the future without understanding the details of the model's inputs. Although the Gordon equation is a robust forecasting model, there's still ample room for interpretation-as well as mischief.
That's a nice way of saying that the model's predictions are only as good as the underlying assumptions.
With that in mind, let's consider the assumptions behind Figure 1. First, we're using the current dividend yield at last year's close, which was roughly 3.2%. According to the Gordon equation's forecast, we're then adding the current yield to the long-run growth rate in dividends. Here's where subjectivity plays a role: For our chart, we're using the rolling 10-year trailing dividend growth rate. But you can find any historical growth rate you want if you look. Consider these three figures for three different time periods: