February 08, 2005
Why Capital Gains Are Likely to Lag Economy-Wide Growth
Why stock-index earnings growth lags economy-wide profit growth--and why, with a constant P/E ratio and a constant profit share in income, real GDP growth is likely to average 1% per year more than the (non buyback-induced) capital gains on a diversified stock portfolio.
Assume that the stock market is at its equilibrium price-earnings and price-dividend ratios, so that you don't expect P/E and P/D ratios to either rise or fall. What capital gains can you then expect on a diversified stock portfolio? Neglecting the effect of stock buybacks, your capital gains will be the the rate of growth of stock prices, which will be the same as the rate of growth of earnings of the stocks in your portfolio.
Suppose you could buy up all of the economy's stocks. The earnings on your portfolio this year would then be total publicly-traded corporate profits. But the earnings on your portfolio next year will be less than next year's publicly-traded corporate profits. Some profits next year will be earned by companies that did not exist or weren't publicly traded this year. So earnings growth for your portfolio will tend to be lower than profit growth for the economy as a whole.
Think of it this way: Profits are a return to two things--capital and entrepreneurship. Buying stocks this year gives you ownership of future returns to capital and ownership of returns to past entrepreneurship that have been capitalized into the current stock prices of public corporations. It doesn't give you ownership of future returns to future entrepreneurship. Thus the more entrepreneurial the economy, the more that you would expect capital gains to lag behind economy-wide profit growth.
How big is this wedge?
I have a simple and embarrassingly crude calculation.
If, as I said before, you buy up all the companies in the economy, your return is dividends plus stock buybacks (since you own all 100%, your selling stock in buybacks doesn't dilute your ownership stake) plus changes in the price-earnings ratio plus growth in the earnings of those companies. But economy-wide profits growth overestimates the growth of earnings of the companies in a widely-diversified portfolio. By how much? We calculated real GDP growth and S&P Earnings Growth from 1960-2000, and found the first averaging 3.46% per year and the second averaging 2.41% per year--a 1% per year wedge.
There are lots of things wrong with this calculation:
- I believe we deflated GDP by the GDP deflator and the S&P by the CPI. That's an extra 0.3% per year added to the wedge that shouldn't be there.
- &P real earnings growth includes the effects of stock anti-dilution produced by stock buybacks. That's an extra 0.2-0.3% per year subtracted from the wedge that shouldn't be.
- Ending in the boom year of 2000 imparts a bigger upward bias to earnings growth than to GDP growth.
- Reported accounting earnings aren't Haig-Simons earnings, but are distorted by a wide variety of things of which the inflation rate and depreciation rates are two.
- NIPA profits aren't Haig-Simons earnings either.
- The wedge is not a structural parameter. It depends on how firms churn their positions, and how the venture and IPO process works.
- The swings in earnings growth are wide (but they do have large negative serial correlations), and thus the estimate is a very crude and uncertain one. Here are the swings decade-by-decade...
Real GDP Growth S&P Real Earnings Growth 1960-70 4.18% 1.61% 1970-80 3.25% 2.87% 1980-90 3.08% -0.74% 1990-2000 3.34% 5.89% Average 3.46% 2.41%
But it does have the virtue of being an empirically-based estimate of the relationship between economy-wide profits growth and non buyback-induced capital gains *if* the price-earnings and price-dividend ratios are not expected to change.
Posted by DeLong at February 8, 2005 10:48 AM