What Drives Stock Returns?
Total return is generally decomposed into three components: Earnings Growth, multiple expansion or contraction, and Dividends.
I. Earnings Growth (Foundation):
- What is it: An increase in a company’s bottom-line profit (Earnings Per Share).
- Why it matters: Grounded in business reality—selling more products, raising prices, or cutting costs.
- Sustainability: Considered the most durable driver because a company can theoretically grow its profits indefinitely.
II. Multiple Expansion (Sentiment):
- What is it: An increase in the price-to-earnings (P/E) ratio. For example, if investors paid $15 for every $1 of profit last year but are willing to pay $20 today, the stock price rises even if the profit stays the same.
- Why it happens: Driven by investor psychology, optimism, or macro factors like falling interest rates.
- Sustainability: Multiples are “mean-reverting,” meaning they tend to fluctuate but eventually return to their historical averages. You cannot rely on investors paying an infinitely higher premium forever.
III. Dividends (Cash Return)
- What are they: Portion of a company’s profits paid out directly to shareholders in cash.
- Why they matter: Represent a “bird in the hand”—tangible, realized profit that doesn’t depend on someone else being willing to buy your stock at a higher price later.
- Sustainability: Since 1989, dividends have contributed approximately 13% to 15% of total S&P 500 returns. While smaller than earnings growth, they are the most stable component; companies are extremely loath to cut dividends because it signals financial distress to the market.
Earnings > Multiples
- Short Term vs. Long Term: In any single year, multiple expansions can easily be the biggest driver of returns (it outpaced earnings in 18 of the last 35 years). However, over the decades, those sentiments often cancel each other out, leaving earnings and dividends as the only permanent gains.
- Risk of “Multiple Contraction”: If a stock’s price rose mainly because of a high P/E ratio (multiple expansion) rather than profit growth, it is fragile. If sentiment cools or interest rates rise, that multiple can “compress,” causing the stock price to crash even if the company’s earnings remain stable
Equity Risk Premium (ERP)
This metric represents the extra return investors expect to earn from stocks over a risk-free investment like a 10-year Treasury note.
-
- Earnings Yield = (1 ÷ Forward P/E)
- Growth rate (Nominal GDP) = Real GDP (Atlanta FED’s GDPNow) + Inflation (GDP Price Deflator)
- Current reading for Nominal GDP is 5.8% {GDPNow = 2.1% + GDP Deflator* = 3.7%}.
* latest release US BEA – GDP (4Q 2025)
ERP = Expected Market Return – Risk-Free Rate
= [Earnings Yield + Growth rate] – Risk-Free rate
= [(1 ÷ Forward P/E) + (Real GDP + Inflation)] – Risk-free Rate
{*Fixed Variables: Forward P/E = 21.5x, Growth rate = 5.8%, 10yr yield = 4.13%}
Current ERP = [(1 ÷ 21.5) + 5.8%] – 4.13% = [4.65% + 5.8%] – 4.13% = 6.32%
Historical Context
The table below gives historical examples of ERP at various market sentiment levels. It must be noted that growth (GDP) expectations are the key to ERP. A high ERP (>8%) if GDP is low or expected to decline implies that the market views stocks as being too expensive. However, a high ERP (>8%) if GDP is in the historically high range or is expected to rise implies that the market views stocks as reasonably priced or even bargains. Historically, 6% is the ERP that is associated with a normal stock market where investors require a ‘fair value’ compensation to tolerate the inherent market volatility.
| Market Sentiment | ERP range | Historical examples |
|---|---|---|
| Greed / Extreme Risk-ON | < 5.0% | Dot-Com bubble |
| Risk-ON | ~ 5.10% - 5.25% | Post-COVID Bull market |
| Neutral | 6.0% | 100 year average |
| Fear / Risk-OFF | >8.0% | 2008 Financial Crisis |
Why this Matters
- Valuation: A lower ERP means investors are willing to accept less compensation for taking on stock market risk, which often coincides with higher P/E ratios (currently around 21.5x forward earnings). Current readings place it in the “Neutral” range.
- Asset Allocation: When the ERP is very low or negative, the “case for stocks” weakens relative to bonds, as the reward for choosing equities over “safe” Treasuries diminishes.
Nominal GDP, Forward P/E, & ERP
Nominal GDP is the market value of all finished goods and services produced, and it can increase purely due to rising prices (inflation) even if the actual volume of production (Real GDP) remains flat. As an example, If Nominal GDP is 5.8% but Real GDP is 0.0% then that means that Inflation is +5.8%. This is Stagflation and it was what the US experienced in the 1970’s. Even if earnings match inflation, P/E multiples will contract severely as investors will not value “inflation-driven” earnings as highly as “real growth-driven” earnings. Consequently, investors will demand a much higher ERP to keep their money in stocks.
current: S&P500 = 6740; Risk-Free Rate (10yr yield) = 4.13%; Forward EPS = $313.48; Nominal GDP = 5.8%
Forward P/E = 6740 ÷ 313.48 = 21.5
Earning Yield = 1 ÷ 21.5 = 4.65%Scenario 1: {current}
GDP = 5.8% ⇒ ERP = 6.32%
Scenario 2: {stronger growth}
GDP = 6.4% ⇒ ERP = 6.92%
Scenario 3: {weaker growth}
GDP = 5.2% ⇒ ERP = 5.72%
Economic Scenario Nominal GDP (%) ERP Target (%) Earnings Yield (%) Forward P/E S&P value Return (%)
Current 5.8 6.32 4.65 21.5 6740 0
Higher ERP 5.8 6.92 5.25 19.05 5971.8 -11.4
Lower ERP 5.8 5.72 4.05 24.69 7739.8 14.83
Bull 6.4 6.32 4.05 24.69 7739.8 14.83
Higher ERP 6.4 6.92 4.65 21.5 6740 0
Lower ERP 6.4 5.72 3.45 28.98 9085 34.8
Bear 5.2 6.32 5.25 19.05 5971.8 -11.4
Higher ERP 5.2 6.92 5.85 17.09 5357.4 -20.5
Lower ERP 5.2 5.72 4.65 21.5 6740 0
- If investors demand a higher return to own stocks where ERP in Scenario 1 got to 6.92% (holding GDP, future earnings projections & risk-free rate constant), then that means that Forward P/E must be lower.
Earnings yield = ERP + Risk-free Rate – GDP = 6.92% + 4.13% – 5.8% = 5.25%
Forward P/E = 19.05
S&P500 = 19.05* 313.48 = 5971.8 which is a decrease of -11.40%
- If investors are willing to take a lower return to own stocks where ERP in Scenario 1 got to 5.72% (holding GDP, future earnings projections & risk-free rate constant), then that means that Forward P/E must be higher.
Earnings yield = ERP + Risk-free Rate – GDP = 5.72% + 4.13% – 5.8% = 4.05%
Forward P/E = 24.69
S&P500 = 24.69* 313.48 = 7739.82 which is an increase of 14.83%
How Interest Changes Affect the S&P500
Changing interest rates directly alters the “required yield” (the hurdle rate) for stocks. If rates rise, the stock market’s price must drop (higher yield) to maintain the same “risk bonus” (ERP) for investors. Conversely, if rates fall, stocks can trade at higher valuations for the same premium.
current: Nominal GDP = 5.8%; Forward EPS = $313.48; S&P500 = 6740; Risk-Free Rate (10yr yield) = 4.13%; ERP = 6.32%
S&P500 value = Forward EPS ÷ (Risk-Free Rate + ERP – GDP)
= $313.48 ÷ (4.13% + 6.32% – 5.8%)
= $6740
| Interest Rates | 10yr Yield (%) | ERP | Earnings Yield (%) | Forward P/E | S&P500 Value | Return (%) |
|---|---|---|---|---|---|---|
| Rise [+50bp] | 4.63 | 6.32 | 5.15 | 19.42 | 6087 | -9.7 |
| Current | 4.13 | 6.32 | 4.65 | 21.5 | 6740 | 0 |
| Fall [-50bp] | 3.63 | 6.32 | 4.15 | 24.1 | 7554 | 12.1 |
- “Rate-Hike” Correction (-9.7%): If sticky inflation or geopolitical tension pushes the 10-year yield up to 4.63%, current 21.5x P/E becomes “too expensive.” To keep paying investors a 6.32% risk premium, the S&P500 must drop to 6,087. This explains why the market often “sells the news” when bond yields spike.
- “Rate-Cut” Rally (+12.1%): If the Fed successfully guides a “soft landing” and the 10-year yield falls to 3.63%, the S&P 500 is mathematically justified at 7,554 without a single extra cent of earnings growth. Falling rates act as a “tailwind” for multiples.
- “When Bad News isn’t Bad”: Note that a 0.50% drop in rates more than cancels out the 11.4% drop in the S&P500 (under the 5.2% GDP Scenario with 6.32% ERP). This is why “bad economic news” (lower GDP) can sometimes make the stock market rise—if investors believe it will force the Fed to cut rates.