On 31 July of this year, I had the following exchange with a colleague at work.
Michael:
Over the long run, how can stock market returns be higher than overall GDP growth?
If they did differ, then either:
- Total company earnings as a % of total GDP would grow unsustainably, eventually reaching 100%
Or
- Price / Earnings ratios would increase indefinitely
What do I have wrong here?
Michael's Portfolio Manager Friend:
You don’t have it wrong. I’ve been trying to understand what’s going on as well.
As best as I’ve concluded:
TSX has returned 9.2% per annum NOMINAL since the 1930s I think. Breaking that down:
Probably 3% ish from inflation, so 6% real return.
Of that real return, maybe 3-4% is from GDP (post-war boom years and all that).
The other 2-3% is from a combination of higher valuation levels (more mutual funds, more focus on this area – Ben Graham’s advice no longer applies anymore – can’t find stuff that cheap) and % of public company earnings increasing as a share of GDP (less cottage industries, etc.)
So going forward, it sounds like it’s gonna be brutal for the markets:
GDP real of 2% and trending down as demographics catch up
Inflation of 2% but either way you don’t care what it is b/c it adds no real value for an investor
Valuations no longer climbing, and probably % of public company as a % of total GDP is flatlining.
Michael:
Exactly! So if we think that the trend away from cottage industries towards public companies has run its course, and that valuation levels are not going any higher, then we have to hope that real GDP grows at a fast clip. Or invest in places where that is the case.
One opportunity is in the fact that not every country in the world is developed yet. So until that happens (say over the next 50-100 years) we still have scope for publicly traded investment opportunities returning higher than domestic GDP growth.
Over that timescale though, I think the economics of the Singularity will dominate, and GDP growth will approach infinity for those positioned to benefit from it. (the rest will become charity cases)