Stocks need ‘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.
Forecasts of real long-term gross domestic product growth (GDP) 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?
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. If future real GDP growth is under 2 percent, 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. 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. 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, 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. 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.
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. 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 but they will have to find new ways to grow. The old ways seem about to run out of gas.

—Bloomberg

Aaron Brown is a former Managing Director and Head of Financial Market Research at AQR Capital Management. He is the author of “The Poker Face of Wall Street