Yes, Arnold, Stock Returns Can Outpace Economic Growth Indefinitely

One of my favorite economic bloggers, Arnold Kling, recently wrote:

Every few years, I have this argument with a new round of commenters.

The ratio of stock prices to earnings is P/E.

The ratio of earnings to GDP is E/Y.

The ratio of stock prices to GDP is P/Y, which equals P/E times E/Y.

(Note that the basic math here uses stocks that turn all of their earnings into capital gains, paying none as dividends. Including dividend payouts makes the story more complex, but does not change the economic analysis.)

For stock prices to grow faster than GDP, either prices have to grow faster than earnings or earnings have to grow faster than GDP.

Stock prices certainly can rise faster than GDP for long but finite periods. If the P/E ratio starts at about 5 and gradually rises to about 25, that will do it. Something like that happened in the 20th century. Also, if earnings of shareholder-owned companies start at less than 10 percent of GDP, then they can grow faster than GDP for a long time.

Looking forward from today, which do you think is going to happen? Is the P/E ratio going to go up, because people become more willing to hold stocks? Or is the share of national income that goes to shareholder-owned companies going to go up? If you have a good story for one of those two happening, let me know.

(For example, one story is that U.S. firms will earn increasing profits overseas. I do not think that this will be a big enough effect over a sufficiently long period of time to drive earnings growth much above GDP growth. Still, it is an empirical issue.)

But if you think that stock returns will be higher than GDP growth without either ratio increasing, then one of us is incapable of doing simple algebra, and I am going to guess that it’s not me.

Arnold, I’m afraid it’s you. But the good news is that it’s not your algebra.

The reason I highlight this is because it gets to the heart of what it means to invest in stocks. Returns to stock investors can remain higher than economic growth indefinitely (even leaving aside the issue of equity valuations). This is a crucial point. The problem is, it’s hard to explain easily.

There are lots of good explanations in the comments of Arnold’s post, but I’ll try to make it as basic as I can: when you buy a stock, you’re buying all of its future cash flow. Economic growth impacts the growth of that cash flow.

When you buy stocks, what you’re buying is the future cash flow. Think of it like buying a river. All that water that passes though, is yours to keep.

Economic growth would determine how much the river expands or contracts — even though water is still flowing. If economy expands (metaphorically, our river widens) then even more water flows through. The growth of the economy is not the same as what accrues to the shareholder.

The size of the river can’t expand than the economy forever, but the stream owner keeps all which passes through.

Posted by on July 11th, 2011 at 3:11 pm


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