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January 04, 2005

Equity Returns in the Future

Dean Baker critiques the reporting of the New York Times's Daniel Altman:

Economic Reporting Review by Dean Baker January 3, 2005: Daniel Altman (2004), "The Risky Assumption in Social Security Change." New York Times December 26, 2004, Section 3, page 4: This article discusses projections for average annual stock returns in a privatized Social Security system. It notes that returns in the future are likely to be less than in the past. The article implies that lower stock returns are probabilistic, like betting on dice. In fact, lower returns are actually a logical implication (e.g. as in two plus two equals four) of the low profit growth projections of the Social Security trustees, coupled with the relatively high price-to-earnings ratio in the stock market at present

The Social Security trustees project that profit growth (measured against the consumer price index) will average just 1.5 percent annually over the seventy-five year Social Security planning period. This means that if the price-to-earnings ratio remains constant, stock prices will rise an average of 1.5 percent annually. (No economist has suggested the alternative, that the price-to-earnings ratio will rise indefinitely.)

The current price-to-earnings ratio in the stock market is just over 20 to 1, far above the historic average of 14.5 to 1. This means that if firms pay out 60 percent of their earnings as dividends or share buybacks (saving the rest for re-investment), then the average dividend yield will be approximately 3.0 percent (earnings are 5 percent of the share price). This produces a total return of approximately 4.5 percent (1.5 percent capital gain plus 3.0 percent dividend yield)

No economist has been able to show a set of capital gains and dividend yields that will produce the 6.5-7.0 percent returns assumed by proponents of privatization.

I think it's a little bit worse than Dean thinks. Old companies die. New companies are born. Profit growth in new companies not yet publicly traded, listed, or included in the standard indices will not make it into the private-accounts equity returns. Think not 4.5% per year but 4.0% per year for the real equity index return--if we adopt Social Security actuarial assumptions. Of course, I don't believe them--but if you don't believe them, then you don't believe in the 2042 trust fund exhaustion date either.

Posted by DeLong at January 4, 2005 01:56 PM


'Note again that there is an enormous spike after 1997, when the ratio rises until it hits 44.3 by January 2000. Price earnings ratios by this measure have never been so high. The closest parallel is September 1929, when the ratio hit 32.6.
In the latest data on earnings, earnings are quite high in comparison with the Graham and Dodd measure of long-run earnings, but nothing here is startingly out of the ordinary. What is extraordinary today (2005.01.05) is (still and strangely) the behavior of price, not earnings.'

Posted by: Punch (oh?) Villa at January 4, 2005 03:35 PM

Hold on just a gosh darn minute now!

You all have left out the really good news, which is that our Republican gummint is gonna redouschinate regulations, emasculadaminate hinderances to the finer, more better business mechanisms and methodologies.

Surely, SURELY, the stock market will go KABLOOEY! in one direction--or the other, as a consequence of these improvements.

Posted by: ritchie at January 4, 2005 06:41 PM

"If privatization will work it won't be necessary, if privatization is necessary it won't work"

Numbers are just biting the asses of privatizers. They are desperately trying to ignore the plain lessons taught by reading the Trustees' Reports. Those numbers used to support their position, reality intervened and now they don't. And they have nowhere to turn.

The results returned for Alternative ( I ) in this table from the Reports require no more than 2.2% productivity growth in ANY year from now to 2080, and in most years require much less. We won't perform down to these levels. And if we do stocks are not going to be a good bet.


Posted by: Bruce Webb at January 5, 2005 07:20 AM