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Pragmatic Capitalism

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Stock market returns vs economic growth

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I know it has been asked before, but I can’t grasp why stock market returns are so much better than GDP growth. Corporate profits as a share of gdp doesn’t really change much, and the stock market should sort of be valued using corporate profits, so what gives?

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Posted by laskerfan12
Posted on 12/20/2016 1:02 PM
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Posted by vlad
Answered on 12/20/2016 11:03 PM
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    I have been knocking this around in my brain a little, and I think I understand why stock market returns always and forever outpace GDP. To make things simple, if you are in a country with zero gdp growth, zero corporate profit growth, and a well managed currency with zero inflation, investing in the stock market is still profitable based on earnings yield. If you buy the market with a p/e of 20, then you expect to average a 5% return going forward which clearly is always and forever outpacing gdp.

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    Posted by laskerfan12
    Answered on 12/25/2016 9:52 AM
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      Exactly: in your example, zero earnings *growth* does not imply the earnings themselves (and hence stock market returns) are zero.

      The link I gave above references several papers, including this one by Vanguard: https://pressroom.vanguard.com/nonindexed/9.24.2013_The_outlook_for_emerging_market_stocks.pdf

      I quote:
      >”The answer is not that economic growth is irrelevant for stock market investors. Rather, it requires a recognition that the relationship between the two is far more subtle than many appreciate and that other influences are at work. When thinking about the relationship between growth and returns, investors should be mindful of four factors:
      1. The difference between expected and actual GDP growth.
      2. The importance of global capital claims on a country’s GDP growth.
      3. The process of “financial deepening”—or expansion of the capital markets—within fast-growing emerging countries.
      4. And, most important, the fact that market valuations reflect the price paid for earnings growth.”

      And then further on page 10 the authors give two historical examples, US and China, with very opposite growth outcomes for earnings and market returns, and conclude:
      >”Equity returns are not based on growth. Indeed, there can be very long periods of weak growth (or even a decline) in earnings that do not necessarily result in negative market returns. As long as expectations reasonably match reality, equity investors can expect to be compensated for the risks they bear in supplying capital to corporations.”

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      Posted by vlad
      Answered on 12/25/2016 3:59 PM
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        In my opinion, GDP growth of 2-3% is similar to corporate earnings growth of 2-3% and the remainder is made up in the FCF yield (buybacks and dividends etc) which was like 5% in the S&P last year

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        Posted by bhcohen1
        Answered on 12/25/2016 6:26 PM
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          There’s a mix of things going on here, but the two big factors are:

          1) Corporate profits /= GDP. The problem here is a fallacy of composition. Any sector in the economy can grow at the expense of others. Corporatiions, for instance, can earn lots of domestic income while other sectors do not. So, corporate profits can grow even while GDP growth is low because they’re the primary beneficiary of growth. In a productive economy with a govt that runs a budget deficit this becomes a feedback loop of sorts because the deficit necessarily adds to corporate profits which, when productive, makes the deficit sustainable….

          2) Corporate accounting. The biggie here is dividends. Since dividends are distributed profits then corporations can account for dividends in an unusual manner – they are not expenses. So, the payment of dividends actually ADDS to corporate profits, all else being equal. This is the main point lots of people miss in this discussion. And you’ll find that the rate of profit growth over GDP is roughly equivalent to the dividend yield across time.

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          Cullen Roche Posted by Cullen Roche
          Answered on 12/26/2016 1:45 PM
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