Dow 75,000 by 2033

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Dow 75,000 by 2033

In previous issues, we've explored how the Digital Revolution will transform the economy. But just how much economic growth can we expect, and how will that translate into greater wealth for individuals?

To predict the future performance of the stock market with precision, we have to examine the impact of the real economy on the market.

For this, we turn to some in-depth analysis recently performed by Bing Cao, Bin Jiang, and Tim Koller of McKinsey & Company.1 As they demonstrate, the equity market's performance over the past half-century is primarily a direct result of the strength of the real economy—which includes GDP growth, corporate profits, interest rates, and inflation. Despite spurts of volatility following the dot-com bubble and crash, as well as the housing bubble and the subsequent financial panic, the markets have always returned to "fair value" based on macro-economic fundamentals.

On this basis, all signs point toward solid returns on investments in equities over the next two decades. Consider that real growth of GDP has averaged 2 to 3 percent per year over the past five decades. If GDP continues to grow at that rate, which is a reasonable assumption, and the Fed keeps a lid on inflation, which is another reasonable assumption, then the stock market is likely to return 5 to 7 percent in real dollars for the next 20 years.

That's completely in line with the historic pattern of the past 50 years. Since the early 1960s, investments in stocks have earned an average of 9 to 10 percent per year; after adjusting for inflation, the annual real returns to shareholders have averaged 6 percent.

When Cao and his colleagues investigated the relationship between the stock market and the real economy, they found shareholder appreciation combined with cash yield has created shareholder returns of about 6 percent.

Let's look at shareholder appreciation first. From 1962 to 2012, real share prices grew at 2.7 percent per year. That's the same rate as real profit growth, which makes sense because the price-to-earning (P/E) ratio typically returns to a "normal" level of around 15 times earnings, provided that the economy, inflation, and interest rates remain in a "normal" range of stable longer-term levels. A P/E ratio of 15 is consistent with average returns on equity of 13 percent, a real cost of capital of about 7 percent, inflation of 2 percent, and long-term profit growth of 2.5 percent.

Turning to cash yield, from 1962 to 2012, investors earned another 3.1 percent annually in dividends and share repurchases. Overall, companies paid out around 55 to 65 percent of their profits to shareholders...

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