Where do Equity Returns Come From?

Just passing along a good paper here from GMO explaining where equity returns come from and why the death of equities has been greatly exaggerated:

Where do equity returns come from? As questions go, it may not be quite as profound as “Why are we here?” or as embarrassingly baffl ing to most of us as “Why is the sky blue?”, but considering the number of people out there who spend their working lives dealing in the fi nancial markets, it is a question asked less often, and usually answered less well, than it should be. This paper will not pretend to tell the whole story, but in a time when investors are questioning what role equities should have in their portfolios, it is worth understanding where the returns to equities come from, and why, after a 12-year period in which U.S. equity returns have been negative, we can still be confident that the returns will, after all, be there in the long run. We will begin with a summary of our basic points:

1) GDP growth and stock market returns do not have any particularly obvious relationship, either empirically or in theory.
2) Stock market returns can be signifi cantly higher than GDP growth in perpetuity without leading to any economic absurdities.
3) The most plausible reason to expect a substantial equity risk premium going forward is the extremely inconvenient times that equity markets tend to lose investors’ money.
4) The only time it is rational to expect that equities will give their long-term risk premium is when the pricing of the stock market gives enough cash fl ow to shareholders to fund that return.
5) Disappointing returns from equity markets over a period of time should not be viewed as a signal of the “death of equities.” Such losses are necessary for overpriced equity markets to revert to sustainable levels, and are therefore a necessary condition for the long-term return to equities to be stable.

Read the full paper here.

Source: GMO

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Cullen Roche

Mr. Roche is the Founder of Orcam Financial Group, LLC. Orcam is a financial services firm offering research, private advisory, institutional consulting and educational services.

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Comments

  1. “These deficits have allowed aggregate demand to hold up in a period in which corporations have been lowering wages and shedding jobs.
    The deficits are not sustainable, and we believe the profit margins they enable are not either.

    While the paper is well done–its presents a simple 4 variable model

    Population Growth, Productivity, Govrn deficits, Corp Job Cutback

    I’m sure this model was “In Fashion”(early 1900’s) before “railroads” “Autos” “computers” “smartphones” etc.

    I think these variables are not counted here.
    All facets of “Technology” can sustain corp profits
    All facets of “Invention” can sustain corp profits
    All facets of “Accessibility” can sustain corp profits
    All concepts of “Part-time/Temp Workers” can sustain profits

    I hate to say:
    The only thing that lives forever is a “Government Deficit”
    It is “naive” to think otherwise–and raiding SS is not balancing the budget???

    Note on “Employment”

    Our economy has created more “Part-Time/Temp Workers” than ever before
    I posted 3 yrs ago that the solution to “Unemploymet” was to reduce the minimum wage.

    Fast forward to today:
    Part-Time/Temp earn less wage
    Part-time/Temp has No Retirement benefits
    Part-Time/Temp has No Health Insurance

    Many Part-Time/Temp workrers have 2 jobs
    Whats the yodel–“2 for the price of 1″

    Whats is the biggest threat to Corp Profits?
    Full Time Workers with Full-Time pay ,Benefits,and Health Insurance

  2. The majority of new jobs now are in the $9 an hour range. While the stats show less unemployment among the better educated, that is not where the todays gains are. The new jobs, waiters, beauticians, sales, guards, etc. are the ones not shipped overseas or replaced by computer programmed machines. The resulting lower purchasing power leads to lower profits, bringing lower payscales leading to less purchasing power.. and the cycle repeats until an unwanted reaction.

  3. Why the sky is blue and not white is because a photon from the sun bangs into a problem. A particle, a molecule or some piece of matter tosses the photon off course and scatters it into oblivion, taking some white with it. I think this is one issue missing from Mr. Inker’s analysis. A perfectly good brand new company, with young employees, new equipment and lots of enthusiasm for its new product (not available before), makes its way from the Sun of ideas to the promised land. It grows and grows making it a good equity bet for possibly many years. It’s added to the DJIA maybe. However due to newer disruptive technologies it gets knocked off track, kick out of the DJIA and possibly dragged along by inertia for years and years until it burns out in oblivion. The DJIA only counts the survivors so it’s skewed toward the successful on track lights, and the dim ones fade away and are no longer counted. The total market is like Mr. Inker says, but you can make money if you ride the “fads” for a brief time. Some folks call this momentum investing. It’s like riding a photon then hoping on another just at the right time just before it gets blasted into oblivion turning the sky blue.