Capital Market Expectations and The Equity Premium

Throughout the history of financial markets, participants have endeavored to predict the return prospects of financial assets. Today is no different, as many investors and financial professionals are asking the same question: “What is the ‘new normal’ for capital markets?” Some, like Bill Gross, founder and managing director of PIMCO, have declared the days of high stock returns to be over. In a recent letter to investors , Gross compared stock returns to a Ponzi scheme, and predicted that they will return only slightly more than bonds in the foreseeable future. Mr. Gross has made some very inaccurate market predictions over the years including a statement in April of 2009 that “bull markets as we have known them are over.” However, from April 1, 2009 to October 3, 2012, the S&P 500 is up 92.67%; Bill could not have been more wrong. Throughout 2009, PIMCO talked about a “new normal” where corporate growth is slower and profit margins are narrower. Here, again, we can examine the record and see that corporate earnings have actually grown at a rate of around 15% per year since April of 2009.

In July of 2007, we presented a prudent approach to creating market return estimates, or “capital market expectations” (CME). In this letter, we update our capital market estimates and discuss the concept of an “equity premium.”

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