Stocks Will Need More Than GDP Growth to Prosper
Forecasting the long-run return on equities is one of the key challenges in financial planning. Jeremy Siegel, the author of “Stocks for the Long Run,” wrote that he had examined 210 years of stock returns and found that "the real return on a broadly diversified portfolio of stocks has averaged 6.6 percent per year.” Public pension funds make similar assumptions. 1
Forecasts of real long-term gross domestic product growth come in around 1.5 percent to 2.5 percent a year. If the stock market outperforms GDP by 5 percent per year, total stock market capitalization will double as a fraction of the economy every 14 years. Is that sustainable for any extended period of time? 2
The graph below shows 30-year annualized real returns for U.S. GDP and S&P 500 investors from 1871 to 2018; the scale shows the period end-year. 3 Only investors who started in the mid-1960s or later -- pretty much anyone under retirement age -- experienced sustained equity returns significantly more than twice GDP growth (these returns show up on the graph as periods ending from the mid-1990s and later). If future real GDP growth is under 2 percent, as the graph trend suggests, and equities revert to a normal relation to GDP, long-term real equity returns are under 4 percent a year.
That may be too optimistic. The next chart shows corporate profits as a percentage of GDP and price/earnings ratios 4 since 1947. 5 Both appear to be near natural limits. Typical profit margins for large businesses are around 5 percent to 8 percent. Sure, some industries have higher margins, but those invite competition and demand for increases in wages, taxes and the prices of inputs. 6 So even if all of GDP represented corporate revenue (it doesn't) there isn't a lot of upside for corporate profits to increase their share of GDP from current values.
P/E ratios seem unlikely to increase much beyond the current level of 32.77, 7 which implies a 3 percent equity earnings yield. If the ratios and corporate profitability both increase, earnings yields head down from 3 percent while corporate profitability moves up from 10 percent. 8 At some point, investors will sell stocks and start businesses or buy assets like real estate or commodities. Stock prices would then fall due to the stock sales, business profitability would fall from additional competition and increased input prices.
The chart shows estimated corporation capitalization as a multiple of GDP. 9 Over the last 35 years it soared from 33 percent to almost 300 percent, fueled by stock returns much higher than GDP growth. Let's be generous and assume P/E ratios can get to 35 and stay there for the long run, while corporate profits as a share of GDP climb to 12 percent. That implies corporate capitalization of 420 percent of GDP. If stocks give a real return of 6.6 percent while real GDP growth is 2 percent, we hit that limit in less than nine years.
The simplest interpretation is that stocks cannot provide a return greater than GDP growth over the long-term; in fact they may have trouble keeping up with GDP. 10 This would crater financial plans for many individuals and institutions. Another possibility is that investors will pay much higher P/E ratios than they in the past. That's no more optimistic. It does mean better stock returns during the period of P/E increase, but those gains have to hit a limit sometime, and afterward investors will earn much lower than historical returns.
Another possibility is that the economy will restructure to allow much higher profit margins, perhaps something like the 36 percent that surveys show average Americans believe corporations enjoy. But that's bad news for customers, employees and governments, which all want slices of corporate revenue. If real GDP growth is 2 percent and the share of corporate revenue going to shareholders quadruples, someone else, probably everyone else, is going to have to tighten belts.
I don't claim that stocks will be a bad investment over the next 30 years. I'm playing with aggregates, and aggregation can mislead. I do claim that naive extrapolation of the historical relation between GDP growth and equity returns lead to implausibilities. Stocks may still be the best investment for the long run 11 but they will have to find new ways to grow. The old ways seem about to run out of gas.
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While public pension funds typically do not publish asset-class return forecasts, it's possible to back out that most of them assume real equity returns of around 7 percent a year over the next 20 to 30 years.
Of course, it has been true for a while. Forty-two years ago was three 14-year doubling periods. But in 1976 stock market capitalization was only 13 percent of GDP. Three doublings multiplies that by eight. But does it seem likely that we can get another three doublings to take stock market capitalization above 800 percent of GDP?
The S&P 500 scale is twice the GDP scale, so you can see that over the period stocks have had close to twice the real return of GDP.
Robert Shiller's Cyclically Adjusted Price/Earnings ratio or CAPE
The product is an estimate of the total value of all U.S. corporations divided by GDP.
Profit margins are higher during good times, but it's hard to imagine average profit margins across the economy over the full business cycle being too much higher than 10 percent.
That level was exceeded only for a couple of years at the height of the internet bubble.
These percentages are not directly comparable. Return on equity is profit divided by investment, profitability is profit divided by revenue. So the two can diverge if it takes increasing amounts of capital to produce a dollar of revenue. But it seems likely that there is some limit to that process.
The estimate is corporate profits as a share of GDP times CAPE.
As noted above, the facts that real stock returns were roughly double real GDP growth for a century up to the mid-60s, and nearly double real GDP growth since the mid-60s, doesn't contradict this. Corporate capitalization started as a tiny fraction of GDP. 147 years of growth have brought it to 300 percent. It's a stretch to assume that can continue so corporate capitalization can grow to 2,500 percent or 25,000 percent of GDP.
They form the core of my personal investment portfolio.
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Max Berley at firstname.lastname@example.org