The reason for the long post is that I believe Gordon equation is extremely useful and can calculate the expected returns of the next few years. I don’t see a lot of people using Gordon equation, but I feel it is a must use tool in investing. Buying stocks when expected equity returns is higher the risk free return is logical, because there is a risk premium. Selling stocks when expected equity returns is lower the risk free return is also logical, because there is no risk premium or in fact a negative risk premium.

My conclusion is that using Gordon Equation satisfy the first principle of investing: investing requires adequate return and the safety of principal even in a volatile asset class.

@Henry: I think p/e ratios are fair now. If you use Robert Schiller’s method of averaging the earnings of the previous ten years, S&P 500 trades at about 16 times earnings. Earnings growth over 10 year periods is fairly stable around 6%, so we get:
Expected returns = 2.5% + 6.0% = 8.5%

That leaves us with changes in valuation. I’d go with 0, as p/e is about average now.

Compared to this, bonds are trading at 3.5%. Stocks provide a comfortable margin of safety today.

Expected Return = Dividend Yield + Earning Growth + Change in P/E ratio

Dividend yield is 2.5%. Earning growth should be above average for the next few years due to the economic recovery (maybe 7%). Change in P/E ratio is the trickiest and might be negative due to the fact that S&P 500 trailing P/E ratio is at 31 times according to Wall Street Journal (maybe -2%).

According to Gordon Equation, expected return right now for S&P 500 should be positive at 7.5% using my estimation and higher than 3.5% for 10 year Treasuries. However, this is not always the case. On the top of the market in 2007, Gordon Equation suggested negative returns due 1% dividend yield, 0% earning growth (that is what John Bogle said), and possible decrease in P/E ratio (S&P 500 had a P/E ratio of 25 at that time, very high in comparison with a historic average of 15.) 10 US Treasury was yielding from 4.5% to 5.0% in 2007.

I am wondering if Gordon Equation is the best way to calculate expected returns, which can be used as a good estimation for risk premium of investing in a broad stock market index.

I think the stock market has become less stable in the last two decade due to the fact that a significant portion of market return is depended on earning growth and change in P/E ratio. I believe dividend yield is most stable and reliable part of Gordon Equation and today’s dividend yield is much lower than the historic norm. I expect a lot of volatility in equity markets in next few years due to the fluctuation of earning growth and P/E ratio.

Now, I use Gordon Equation as my fundamental analysis tool for tactical asset allocation investing and SMA 200 as my technical analysis tool for market timing and risk management.

Tell me what you think of Gordon Equation.

I think the point about adverse timing is the best one. From what I remember of other studies I think adverse timing creates more than a 3% difference between the average investor and simple buy-and-hold investing. In that case it explains everything; if you hang on to the index you get the premium but if you buy high and sell low you lose it (when you’re affected a little too much by the risk in the risk premium). That merely means that many people are bad at investing in stocks, not that investing in stocks is a bad idea.