Where is the Market Going? Uncertain Facts and Novel Theories
Will the stock market provide high returns in the future as it has in the past? The average US stock return in the postwar period has been about 8% above treasury bill rates. But that average is poorly measured: The standard confidence interval extends from 3% to 13%. Furthermore, expected returns are low at times such as the present of high prices. Therefore, the statistical evidence suggests a period of low average returns, followed by a slow reversion to a poorly measured long term average. I turn to a detailed survey of economic theory, to see if models that summarize a vast amount of other information shed light on stock returns. Standard models predict nothing like the historical equity premium. After a decade of effort, a range of drastic modifications to the standard model can account for the historical equity premium. It remains to be seen whether the drastic modifications and a high equity premium, or the standard model and a low equity premium, will triumph in the end. Therefore, economic theory gives one reason to fear that average excess returns will not return to 8% after the period of low returns signaled by today's high prices. I conclude with a warning that low average returns does not imply one should change one's portfolio. Someone has to hold the market portfolio; one should only deviate from that norm if one is different from everyone else.
Published: Economic Perspectives XXI: 6 (November/December 1997) Federal Reserve Bankof Chicago.