SUPPLY SIDE DETERMINANTS OF STOCK MARKET VALUATION
John Carter Armstrong, Randolph-Macon College,
P.O. Box 5005, Ashland, VA 23005; e-mail: firstname.lastname@example.org
David A. Brat, Department of Economics and Business, Randolph-Macon College,
P.O. Box 5005, Ashland, VA 23005; e-mail: email@example.com
Is the stock market over valued or under valued? In order to assess these claims one must be able
to indicate a true value from which deviations may occur. Many economic papers promise to
explain valuation and many deliver by providing insights into various relationships between
financial variables. However, very few papers have tried to determine a baseline value for the
stock market based on supply side economic variables. This paper attempts to tie GDP growth to
earnings growth and ultimately the S&P 500 index price. Several papers have supplied bits and
pieces of this puzzle and this paper is an attempt to put them together into one framework.
In the long run, we want to argue that stock market performance cannot exceed the pace set by
growth in GDP. Exactly what the relationship between these two variables is remains to be seen.
Figure 1 shows GDP, S&P 500 nominal price, nominal earnings, and nominal dividend
normalized to a value of 1. Clearly, all four variables increase at similar rates. These series
suggest several points immediately. To simplify, let’s assume that nominal GDP has grown at
6% over the long run. Then Figure 1 shows that nominal S&P dividends have grown at 3% and
nominal S&P Price has grown at 3%. Thus, this simple model would suggest that if the total
return to the S&P is composed of the dividend payment plus capital appreciation, we should
expect a long run total return of about 6%. According to Diermeier (1984) we are not far off as
he concludes in his study that the total return is about 5.4%. However, when one includes the
studies which include the recent run up in stock prices, authors such as Lansing and Ibbotson et.