Brad De Long is a mine of original thinking.
The real return on the 20-year U.S. Treasury inflation-protected bond is 2.1%, while the current annual earnings yield on the S&P composite stock market index is 5.7%. These numbers suggest an expected equity premium today of 3.6%, lower than the 6% premium equity return of Mehra and Prescott (1985), but far, far higher than the value of 0.25% per year of Mehra's (2003) baseline representative-agent model for a coefficient of relative risk aversion of 2. and an equity premium of 3.6% per year is enough to double your relative wealth over twenty years, and quadruple it over forty. Plus you get substantial immunity from long-run inflation risk as well. The equity premium remains a puzzle. And there is no reason to think that it is a puzzle about to vanish. As Rajnish Mehra (2003) wrote:There are those like Victor N. who seem to think that the fact that stocks yield the double of bonds means that that the stock exchange prices may double in the future. But it doesnt seem to be happening, the oscillating nature of the stock exchange puts the fear of God in the hearts of the investing public and that irrational fear causes stocks be sold half its "real" worth. Israeli stocks may be undervalued more than most, because the prevailing opinion is that Israel will not last, it cannot last, and even the steady growth shown by this outfit in the last hundred years will not change that perception. So there must be lots of investment opportunities here and not only in real estate.
The data used to document the equity premium over the past 100 years are as good an economic data set as analysts have, and 100 years is a long series when it comes to economic data. Before the equity premium is dismissed, not only do researchers need to understand the observed phenomena, but they also need a plausible explanation as to why the future is likely to be any different from the past. In the absence of this explanation, and on the basis of what is currently known, I make the following claim: Over the long term, the equity premium is likely to be similar to what it has been in the past and returns to investment in equity will continue to substantially dominate returns to investment in T-bills for investors with a long planning horizon.
Or as Warren Buffett wrote twenty years ago: [T]he secret has been out for fifty years, ever since Ben Graham and Dave Dodd wrote Security Analysis, yet I have seen no trend toward value investing in the 35 years I have practiced it. There seems to be some perverse human characteristic that likes to make easy things difficult. The academic world, if anything, has actually backed away from the teaching of value investing.... It's likely to continue that way.... [T]hose who read their Graham and Dodd will continue to prosper