# * Czechoslovakia Switzerland ♦ Hungary *lsrael Norway **Chile * Czn^ Uruguay Mexico* Fmland, * ♦ U.K. * ^J1113 Germany Ireland *Aug*ra|ia Austria * Netherlands ♦ France Italy | ♦ Spain * Egypt * Poland > Greece New Zealand* Belgium Brazil Portugal t Ne * Pakistan *So thAfric> Venezuela * India Philippines     ♦ Colombia Argentina Peru 0 10 20 30 40 50 GO 70 80 10' Years of Existence since Inception FIGURE 5.2 Compound Annual Real Capital Gains on Global Markets through 1996 Of course, we can do better than merely look at the historical average performance of global equity markets. For investment policy purposes, we should also be interested in the underlying economic drivers of equity markets in general and the equity premium in particular. In principle, the market value of equity should reflect expectations of future earnings growth. Over the long run, these expectations should in turn be linked to economic growth in the long run. Consequently, we have another path to follow in understanding the historical performance. For example, Ibbotson and Chen show that the realized, long-run real return on equity (not the ERP) is equal to long-run dividend yields plus long-run real earnings growth rates plus expected future P/E growth. Suppose that markets are fairly valued, so that expected P/E expansion (or contraction) is zero. Since aggregate economic growth includes earnings growth, and if the corporate sector is assumed a constant proportion of the overall economy, it follows that long-term real earnings growth is equal to long-term real economic growth.3 How are dividends related to real economic growth, then? Some researchers on this topic incorrectly assume that dividends are an independent input into the expected real return on equities. For example, Arnott and Bernstein (2002) take the unusually low current dividend yield as proxy for long-run dividend income and at the same time link long-term real earnings and economic growth. However, the implication of their assumption is that dividend payout does not affect earnings growth, which is nonsensical because an increased retention in earnings should lead to higher future earnings growth. Take two otherwise identical 3One could instead assume that the corporate sector is a growing segment of the economy, but this can't be true in perpetuity and we are talking about equilibrium conditions here.