We can use the historical data to answer a simple question: Why have stocks provided long-term real returns of 7 percent? Answer: Almost entirely because of the rising earnings and dividends of U.S. corporations. The sum of real dividend yields and earnings growth generated during 1871-1997, adjusted for inflation, equals 6.7 percent in real terms. In other words, the total long-term real return on stocks derived from dividend yields and earnings is virtually identical to the 7 percent real return actually provided by the stock market itself. All other factors combined have almost inconsequential impact on the returns provided by these two fundamental factors alone.

There were, to be sure, significant variations around this norm. They were caused by the fluctuations in the valuations that investors were willing to pay for $1 of earnings - the price-earnings ratio. This speculative factor has often proven powerful enough to add as much as 4 percentage points annually to the fundamental return, or to reduce it by an equal amount. Over a 25-year period, for example, an increase in the price-earnings ratio from 8 to 20 times will add 4 percentage points to return; a drop from 20 times to 7 times will do the reverse. The difference between the fundamental and the actual return on stocks, then, is accounted for by the element of speculation - the changing valuation that investors place on common stocks, measured by the relationship between the stock prices and corporate earnings per share.

Figure 2.2 makes crystal clear the overpowering role of fundamental returns in determining the actual returns earned on stocks over the long run. In this chart, comparing the cumulative returns generated by the fundamentals and the returns of the stock market during the 1871-1997 period, the lines diverge over and over again, only to return to convergence. These divergences to and fro are explained by changes in the price-earnings ratio, but the fundamentals clearly dominate the relationship.