Why Do Valuation Ratios Forecast Long-Run Equity Returns?

A number of studies have documented the relationship between valuation ratios and long-horizon return equities. The author develops a simple analytic expression for the expected return and fair value of an equity market as a function of the economy wide return on equity and one or more valuation ratios. He also shows that the expected return of equities is now about 7%, and provides a simple explanation for why investors have come to believe, incorrectly, that it is 15% or greater. Finally, the author explores the implications of these results for tactical asset allocation.