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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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