Arnold Kling  

Long Run Stock Returns

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Math and Economics... Prescribing Capitalism...

Because the stock market figures into most Social Security privatization plans, the Social Security Administration commissioned economists to estimate long-run returns from stocks. This analysis is three years old, but since I've brought up the issue on several occasions it seems worth a mention.

Keep in mind that when the economists were writing the market had fallen from its Internet Bubble peak, but the ratio of stock prices to earnings and to dividends was still high relative to historical averages.

John Campbell wrote,


the unadjusted dividend-price ratio has declined by 3.3 percentage points from the historical average. Even adjusting for share repurchases, the decline is at least 2.3 percentage points. Assuming constant long-term growth of the economy, this would imply that the geometric average return on equity is no longer 7%, but 3.7% or at most 4.7%

Peter Diamond wrote,

the 7 percent assumption [for annual stock market returns] throughout the next 75 years is not plausible in that it requires a rise in stock values to GDP that is implausible. The level of implausibility is not quite as high as two years ago, but it is still implausible.

John B. Shoven wrote,

My own estimate for the long-run real return to equities looking forward is 6 to 6.5 percent. I come to that using roughly the parameters chosen above. If the P-E ratio fluctuates around 20, the cash payouts to shareholders should range from 3 to 3.5 percent. I am relatively optimistic about the possible steady-state growth rate of GDP and would choose 3 percent for that number.

I share Shoven's optimism about long-run GDP growth, but I think that getting there will involve an acceleration of Schumpeterian competition, which might mean that stock portfolios invested in incumbent companies could perform less well than what otherwise might be expected.

For Discussion. Do you think that profits of major corporations as a share of GDP will increase, decrease, or remain about the same over the next decade?


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CATEGORIES: Social Security



COMMENTS (5 to date)

"Do you think that profits of major corporations as a share of GDP will increase, decrease, or remain about the same over the next decade?"

I think the private sector's share of profits will remain relatively constant. Possible that smaller companies may increase their share vis-a-vis the S&P 500 outfits. Anyone know how this proportion has fared over the last two decades?

Lawrance George Lux writes:

Prashant is right about the constant rate of Profits for major Corporations. Sector equalization across the Economy insists Corporate Sector share will not increase over the long-run. This is really not the Issue here.

Corporate structure presently limits Stockholder access to Corporate Profits, through rising Salaries and Benefits for Executives, issuance of Stock Options to maintain Stock pricing, and finding immunity from Stockholder discovery by offshore holdings of assets. Observance of Corporate practice will also notice Executive privilage Expenses have expanded at about twelve times the Inflation rate.

Corporate Stock will be held at about twice the rate of Return as Bank Interest, making Corporate Boards insistent on low Interest rates. This must be done to gain purchase of Stock Option Sales. The whole Process does not express much expectation of improvement of Social Security accounts by long-term Stock investments. lgl

Steve writes:

As the dollar tumbles (which it probably will for the next 3-5 years), firms who derive most of their profits from overseas will be the only ones who have any profit growth. These are generally not small firms, but huge multinationals.

I can't imagine how small firms can compete in this environment, nor why anyone would think that their share of the GDP profits pie would ever grow.

gerald garvey writes:

The question was not about the private sector's share of profits. That is a nonsense since profits only exist in...for-profit companies. Arnold's question was whether profits will increase faster than GDP.

1. The first-order answer is, yes, and duh. All that requires is leverage.

2. LGL's point is an important caveat to point (1). Leverage exists only when other claimants to the firm's revenue stream have relatively fixed claims, ie, their claims don't expand one-for-one as the firm does better. And it is not just execs, stock options, and perks. Labor economists have known for some time that more profitable firms pay more to even more "ordinary" workers. But the effect, as far as I can read the evidence, is not so strong as to absorb all incremental profit. Remember, we are talking about the entire market, not just those firms where execs stole most of the $.

Peter Harwood writes:

I think it depends on how much deregulation occurs. If there's no change in regulation, I would expect profits/GNP to rise, as proliferation of new products and industries leads to more and more monopolistic niches (this has been the historical trend). At the same time, a net decrease in regulations would raise Schumpeterian pressures and could reduce these monopolistic niches.

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