What drives Stock Market Returns?

“The stock market is nothing more than a ponzi scheme”

“It’s all just fake money”

“Stocks prices are completely arbitrary. It can rise or crash any day”

Chances are, you’ve heard some variation of the above, many times in your life. It’s hardly surprising – stocks play a crucial role in our economy and personal savings. And yet, most people have no idea what causes stock prices to go up or down. Hence the conclusion that stock valuation is completely and utterly arbitrary, with little room for rational analysis. 

The truth however, is the opposite. Anyone who has spent some time studying the fundamentals of finance, can tell you why stocks are valued the way they are, and what it portends for the long-term future.

The weather makes for a remarkably good analogy – it’s incredibly hard to predict the weather over the next week. But with even an elementary understanding of seasons, it’s easy to understand temperature fluctuations over the longer term. The same is true of stocks, and in this post, we shall explore how stocks generate long-term returns. We shall also use this knowledge to estimate the long-term returns we can expect from stocks, given today’s circumstances.


The key to understanding stocks, is that almost all valuations and returns are driven by corporate earnings. Ie, profits. There are numerous variations of this – short-term vs long-term profits, realized vs projected profits, volatile vs steady profits, etc etc. There are many other second-order factors as well, such as human psychology. But these are also predicated on the foundation that underpins stock valuations: how much profits the company will be making.

To give a simple example, suppose company XYZ has 1 million outstanding shares, valued at $1000 each, giving it a total valuation of $1B. Suppose also that this company has yearly profits of $50M. The earnings-per-share for XYZ is then $50M/1M = $50. Suppose you now purchase one share of XYZ. You have paid $1000, and in return, your slice of the yearly profits are $50.

Suppose XYZ’s business is perfectly stable, and that the CEO decides to give you your entire slice of the profits (ie, dividends), every year in perpetuity. In such a scenario, your investment is identical to putting $1000 into a bank which pays out $50 in interest annually. The interest rate you’re getting in such a scenario, is simply the earnings-per-share, divided by the share-price. Ie, 50/1000 = 0.05 => 5%. In the world of finance, this term is referred to as the Earnings Yield. Perhaps better known by its cousin: PE Ratio, which is simply the inverse of the Earnings Yield.

Of course, if things were really that simple, we wouldn’t need banks at all. For one thing, companies usually don’t return all of their earnings to their investors, ever year. Often times, the board would decide that it is in their investors’ best interests to reinvest the earnings or to buyback outstanding shares using that money instead. In both cases though, this is only done in the shareholders best interests. So even if you aren’t getting the money immediately, it should (in theory) leave you even richer in future.

A more important distinction between stocks and loans, is the following: corporate earnings are very volatile. A company like Ford could be making a lot of money today, but face heavy doubts over its future prospects. Conversely, a company like Amazon might have negligible profits today, but is projected to generate huge windfalls in the future. For this reason, unlike banks which offer near-identical interest rates, each company’s stock trades at very different PE ratios. And these PE ratios often rise and fall dramatically, based on the company’s future prospects.

Aggregate PE Ratio. Despite this per-company volatility, if you aggregate and average all the PE ratios in the stock market, you get something far more stable. Historically, the US equity market has averaged a PE ratio of ~16. This translates to a earnings yield of ~6%. Higher than bond interest rates, but still in the same ballpark. This earnings yield forms the bedrock of where long-term stock-market-returns come from. Though there are still 2 other factors at play, which boost returns even higher.

Real Earnings Growth. The PE ratio reflects earnings today, but the most important metric is projected future earnings. The profits generated by individual companies may rise and fall. But the aggregate profits generated by all companies in the economy, is much more stable. Real GDP Growth, since it tracks aggregate growth in economic activity and spending, serves as a very imperfect proxy for aggregate earnings growth. As real GDP grows every year (eg, America has averaged ~3% real GDP growth in modern times) we would expect aggregate corporate earnings to increase as well.

Note the effect this would have on stock prices: Given a stable PE Ratio, as earnings grow by 3%, stock prices would also grow by 3%. Thus giving an additional 3% return on our investments, in the form of higher stock prices.

Inflation. Similar to the above calculus, inflation has a similar effect as real GDP growth. For example, suppose inflation causes all prices to rise by the historical average of 3%. We would expect our corporation’s revenues to rise by 3%, while its margins would remain the same. Hence, corporate earnings would rise by 3% as well.

Of course, the purchasing power of our money would also shrink by 3%. Hence, in inflation-adjusted dollars, we don’t get any real returns. But at least we avoid falling behind, which is what would have happened if we had put our money into fixed-payout bonds, or left it in our bank accounts.

Changes in PE Ratio. We would be remiss here, if we didn’t take a second to discuss changes in the PE ratio, and how that affects our returns. We earlier discussed how aggregate PE ratios are much more stable than company-specific PE ratios. However, even the aggregate PE ratio does vary quite a bit.

Looking at history, even if we exclude anomalous peaks, the PE ratio has varied all the way from 10 to 25. Driven largely by market sentiments (ie mob psychology), the PE ratio can also swing wildly from one year to the next. Even if corporate earnings were to remain stable, if the PE ratio were to rise from 15 to 20 as a result of market optimism, this would translate to an immediate 33% boost to our stock portfolio.

Given its sudden and dramatic impact on our portfolio, it is very tempting to obsess over upcoming changes in the PE ratio, and to think that our portfolio returns are primarily driven by changes in the PE ratio. However, such thinking is short-sighted. Over the long run, it is impossible for the PE ratio to keep rising forever. At some point, the earnings yield would be so low, that no one would be interested in buying them. All investment propositions built upon the Greater-Fool theory are bound to come crashing down eventually.

It is impossible to predict the precise value at which the PE ratio will stabilize, but it will certainly not rise forever. Hence, as compared to all the other factors we discussed above, changes in the PE ratio will have the least impact on our portfolio returns over the long haul.


Combine all of the above, and we now understand the primary drivers of long-term stock returns:

  1. Earnings yield
  2. Real GDP growth
  3. Inflation

It’s important to note that this isn’t a precise formula. Inflation isn’t uniformly distributed across all goods in the economy. Not all corporate earnings are efficiently distributed back to investors (plenty is certainly wasted in bad investments). And GDP growth isn’t neatly tied to earnings growth (there’s quite a bit of debate over the robustness of this correlation). For all these reasons, actual returns differ quite a bit from the simple sum of the above 3 factors.

Empirically, real returns have been ~10%. Not the 12% that one would assume from a 6% earnings yield, 3% GDP growth rate, and 3% inflation. The correlation between actual returns, and the above 3 factors, is explored in greater detail in a subsequent article.


What’s truly interesting is to consider what this portends for the future. American GDP growth has certainly slowed dramatically in recent times, as compared to the 20th century. But then again, real GDP growth in countries like China and India are significantly higher, bringing the global GDP growth rate to a vigorous ~3%. This bodes well for international and multinational corporations, but not so much for companies that operate primarily in America.

The far bigger variable does seem to be the PE Ratio. Historically, the American stock market has averaged a PE ratio of ~16. If you look at foreign funds, such as the emerging markets index, this continues to be the case today. However, the current S&P 500 PE ratio stands at an inflated 24. (note: this was written in mid 2018, and it has since fallen significantly, as a result of falling stock prices. Make of that what you will)

Does this mean that we are past due for a major market correction? Or that 24 is the new normal in the 21st century? Or perhaps we are destined to plateau out at far higher PE ratios, such as 40? These questions are impossible to answer, since they are inherently speculative. Hence why my advice is always to Buy-and-Hold your investments, regardless of what the talking heads on CNBC might be saying on any given day.

That said, what we can do is understand what the future looks like at different PE ratios. With a ratio of 24, the earnings yield drops from ~6% to ~4%. This leaves us between a rock and a hard place. Either there will be a market correction that brings the PE ratio back down to 16, requiring a 30% drop in stock prices across the board. Or we should expect long-term earnings yields to drop to ~4%. Combined together with the slowing GDP growth rate in America, this implies future returns on the S&P 500 to be significantly lower than its long term average.

Neither lower returns, nor a 30% drop in stock prices, sounds particularly attractive. Fortunately, there is a better answer: diversifying your stock portfolio across the entire world. The global stock market is currently averaging a PE ratio of ~20, and as discussed earlier, global GDP growth stands at a healthy ~3%. Emerging markets in particular, have even lower PE ratios and higher GDP growth rates.

If that isn’t reason enough, diversifying globally further insulates our portfolio against country-specific downturns. Diversification is indeed the only free lunch, and given current euphoria in the American stock markets, it is more important now than ever before.


Note: All figures given above are from mid-2018. They can and will change in the coming years, though the fundamental principles still apply.

Related Links:

The correlation between actual and projected Stock Market returns

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