Dec 16
The Gordon Equation
Market Return = Dividend Yield + Dividend Growth Rate is known as the Gordon Equation. This simple equation provides a way to predict long-term stock market returns, and we need to emphasize long-term. Quoting Bernstein from his “Four Pillars of Investing” book, page 57, “…the Gordon Equation is useful only in the long term–it tells us nothing about day-to-day, or even year-to-year, returns. And even in the very long term, it is not perfect.”
Dr. Bernstein seems to contradict himself on the prior page (#56) with this paragraph. “And what does the Gordon Equation tell us today about future stock returns? The news, I’m afraid, is not good. Dividend growth still seems to be about 5%, and the yield, as we’ve already mentioned, is only 1.55%. [It seems a stretch to include three significant figures.] These two numbers add up to just 6.55%. Even making some wildly optimistic assumptions–say a 6% to 7% dividend growth rate–does not get us anywhere near the 10% annualized returns of the past century.”
Keep in mind that “Four Pillars” has a copyright of 2002 and Dr. Bernstein likely wrote some of this material near a market high. The market certainly did not look good in the latter part of 2000. If we included the market returns over the last decade, that 10% annualized figure is not quite so high.
Now move forward to Bernstein’s third book, “Investor’s Manifesto,” with a copyright date of 2010. Assume most of it was written in late 2008 and early 2009. Quoting from this book (page 35), “The Gordon Equation currently suggests that there are better returns to be earned in both stocks and corporate bonds for the first time in more than a decade, perhaps in the range of 4 to 8 percent real returns for stocks of various kinds, and 2 percent real returns for bonds. Both of these, in my opinion, are high enough to compensate for the risks of owning them.”
While the extensive quotes do not align with his argument that the Gordon Equation is not useful for short-term projections, Bernstein was right on with both calls as the NASDAQ fell off the cliff after the first quarter of 2000 and we have witnessed a roaring bull market since March of 2009.
This post only touches on the fringes of the Gordon Equation. Premium Content readers can expect more over the next week. This equation feeds into our reasoning of why it makes sense to tilt portfolios the way we do in order to outperform the total market, as measured by Vanguard’s Total Market Index Fund, VTSMX.
Photograph: Last box off the last truck of the last Catlin Gabel Rummage Sale – 2009.
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