In this chapter, the reader is taken through the last several decades of stock and bond returns, and a method for predicting stock returns going forward is put forth.
Specifically, Malkiel divides the last 60 years into three periods, each of which contained a different set of circumstances that dictated the outcome of stock and bond returns. For example, periods with high unanticipated inflation would see poor bond returns, since bond prices would have to drop in order for bond buyers to receive a rate of return that was higher than inflation. While stock prices are believed to be rather neutral to inflation, history shows that stocks also performed poorly during bouts of high inflation.
The formula Malkiel uses to predict stock returns is as follows:
Stock return = Current Dividend Yield + Dividend Growth Rate + P/E change
The P/E change is the most difficult factor to predict. When the market is optimistic (pessimistic), market P/E's will rise (fall). Over the long-term, however, the effect of this valuation change reduces in significance; but over short periods, this factor can have a dominant effect. The current dividend yield is easily calculable, while the dividend growth rate can be approximated. (Malkiel appears to use recent history to estimate the dividend growth rate, but other methods also exist such as multiplying the market's aggregate return on equity by its retention ratio, the percentage of earnings that the market does not pay out in dividends.)