GMO
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HITE
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APER
August 2012
Reports of the Death of Equities Have Been Greatly Exaggerated:Explaining Equity Returns
Ben Inker
W
here do equity returns come from? As questions go, it may not be quite as profound as “Why are we here?”or as embarrassingly baf
fl
ing to most of us as “Why is the sky blue?”, but considering the number of peopleout there who spend their working lives dealing in the
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nancial markets, it is a question asked less often, and usuallyanswered less well, than it should be. This paper will not pretend to tell the whole story, but in a time when investorsare questioning what role equities should have in their portfolios, it is worth understanding where the returns toequities come from, and why, after a 12-year period in which U.S. equity returns have been negative, we can still becon
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dent 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 intheory.2) Stock market returns can be signi
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cantly higher than GDP growth in perpetuity without leading to any economicabsurdities.3) The most plausible reason to expect a substantial equity risk premium going forward is the extremely inconvenienttimes 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
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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 thereforea necessary condition for the long-term return to equities to be stable.The
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rst point to understand about stock returns is their relationship with GDP growth. In short, there isn’t one. Stock returns do not require a particular level of GDP growth, nor does a particular level of GDP growth imply anythingabout stock market returns. This has been true empirically, as the Dimson-Marsh-Staunton data from 1900-2000shows. Many investors are utterly convinced that strong GDP growth is the primary reason why one country’s stock market will outperform another. As we can see in Exhibit 1, this was certainly not the case in the 20
th
century.The trouble with picking stock markets on the basis of expectations of GDP growth is not that GDP growth is hard topredict (although it is harder than many people assume), it’s that even if you could predict it with perfect accuracy,it wouldn’t do you any good picking stock markets. As Exhibit 2 shows, this has also held true over the more recenttime periods (in this case 1980-2010) and as Exhibit 3 shows, it has held true for emerging countries as well asdeveloped ones.Insofar as there is any relationship here, it’s a perverse one. All else equal, higher GDP growth seems to be associatedwith lower stock markets returns. How could this possibly be? Don’t earnings grow with GDP and stock prices withearnings? Aggregate corporate pro
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ts should indeed be expected to grow with GDP. And overall market capitalizationof the stock market should be expected to grow along with aggregate earnings, as can be seen in the U.S. (Exhibit 4).
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GMO
Explaining Equity Returns – August 2012
Exhibit 1
Stock Market Returns and GDP Growth, 1900-2000
Source: Dimson, Marsh, and Staunton, Triumph of the Optimists
0%1%2%3%4%5%6%7%8%1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0%
R e a l R e t u r n 1 9 0 0 - 2 0 0 0
Real Per Capita GDP Growth 1900-2000
Return = 7.2% –1.0*(Per Capita GDP Growth)R
2
= .13
South AfricaU.S.AustraliaJapanSpainGermanyItalyUKSwedenFranceBelgium
Exhibit 2
Stock Market Returns and GDP Growth for Developed Markets, 1980-2010
Source: MSCI, S&P, Datastream As of 12/31/10
0%2%4%6%8%10%12%11.0% 1.5% 2.0% 2.5% 3.0% 3.5%
R e a l R e t u r n 1 9 8 0 - 2 0 1 0
Real GDP Growth 1980-2010
Return = 9.3% -1.1*(GDP Growth)R2 = .06
SwedenU.S.AustraliaJapanSpainDenmarkNorwayItalyAustria
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GMO
Explaining Equity Returns – August 2012
Exhibit 3
Stock Market Returns and GDP Growth for Emerging Markets, 1980-2010
Source: MSCI, S&P, Datastream As of 12/31/10
0%2%4%6%8%10%11.0% 2.0% 3.0% 4.0% 5.0% 6.0% 7.0%
R e a l R e t u r n 1 9 8 0 - 2 0 1 0
Real GDP Growth 1980-2010
Return = 8.9% -0.4*(GDP Growth)R2 = .07
ArgentinaThailandKoreaChileMexicoBrazilHong KongSingaporeIndiaSouth AfricaTaiwan
Exhibit 4
U.S. Profits and Market Cap vs. GDP
Source: BEA, Global Financial Data, Compustat As of 12/31/11
1 9 2 9 1 9 3 1 1 9 3 3 1 9 3 5 1 9 3 7 1 9 3 9 1 9 4 1 1 9 4 3 1 9 4 5 1 9 4 7 1 9 4 9 1 9 5 1 1 9 5 3 1 9 5 5 1 9 5 7 1 9 5 9 1 9 6 1 1 9 6 3 1 9 6 5 1 9 6 7 1 9 6 9 1 9 7 1 1 9 7 3 1 9 7 5 1 9 7 7 1 9 7 9 1 9 8 1 1 9 8 3 1 9 8 5 1 9 8 7 1 9 8 9 1 9 9 1 1 9 9 3 1 9 9 5 1 9 9 7 1 9 9 9 2 0 0 1 2 0 0 3 2 0 0 5 2 0 0 7 2 0 0 9 2 0 1 1
L o g R e a l G r o w t h I n d e x , S t a r t i n g 1 9 2 9
3.6%/Year3.3%/YearCorporate ProfitsMarket CapGDP
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