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Stocks for the Medium Run

Microsoft Excel

Take the Campbell-Shiller smoothed earnings yield--the ratio of the current value of the S&P Composite to a ten-year trailing moving average of its earnings. Take the ten-year-ahead real return on the S&P Composite. Plot them together, and you have the graph above.

Real earnings on the S&P Composite grow by about 2%/year. That means that if the current ratio of permanent earnings to prices were a good forecast of future returns, you would expect future returns to be 11/10 of the Campbell-Shiller smoothed earnings yield--you would expect the red line to be perhaps a percentage point above the blue line. That aside, the net cumulative gap between the red line and the blue line is made up of (a) corporate opportunities to invest retained earnings in projects that yield more than the stock market return, (b) corporate dissipation of retained earnings in projects that yield less than the stock market return, and (c ) secular changes in the price-earnings ratio.

The current Campbell-Shiller smoothed earnings yield is 4.5%/year. The upward adjustment makes it 5.0%/year. Unless you think we are looking forward to (a) a substantial shortfall in future earnings growth relative to historical trends, or (b) a future collapse in the price-earnings ratio, it is hard to see how stocks can return less than 5%/year over the next decade. And in an environment in which you have to pay the Treasury 0.6%/year to watch your real value over the next decade, that is a very attractive expected return.