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On GDP vs Equity Returns, Bill Gross Is In Fact Right... With A Twist
Two weeks ago, PIMCO's Bill Gross stirred up a few ivory-tower academics, permabull sell-side commission-makers, and bloggers pressured by Series [X] investors to generate maximum page views when he called for the death of the cult of equities. His main point was the apparent paradox that the total return on equities can outpace GDP growth over long periods. While there has been much gnashing of teeth over this comment, Morgan Stanley has very succinctly clarified and confirmed that this is not so much a paradox as a Catch-22. The key point is that, in aggregate, investors do not typically reinvest their dividends (or coupons); and akin to Keynes' paradox of thrift, if investors actually tried this en masse then the historical returns reported in total return indices would be unachievable. So here’s the Catch-22: over the long run theoretical total returns can exceed GDP so long as investors don’t actually try to capture those returns. But if ever investors try to achieve such GDP-plus total returns, it will be impossible for returns to stay above GDP growth. Hence, equities for the short- and long-term, are essentially a Ponzi scheme - as long as everyone buys-and-holds - but if 'someone' decides (or is forced) to take-profits, equity ROE will rapidly game-theoretically collapse to GDP growth.
Why Gross Is Right...
Morgan Stanley: Mind The Gap
High-trend GDP growth still underpins some investors' focus on EM equities. However, there's no correlation - even over very long periods - between GDP growth and equity returns.
This is another example showing that economic growth and equity returns are unconnected. This is true over even very long periods. Exhibit 2 shows the correlation between equity returns and GDP (and GDP per capita) growth over periods of up to 105 years. Ironically, many of the correlations are negative. But the more important point to note is that the explanatory power is very low.
Several factors can drive a wedge between GDP and equity returns. Exhibit 3 shows a long history of equity returns in the US. The returns are calculated over a rolling ten-year period, adjusted for inflation, and including reinvested dividends. Returns are driven by two factors: dividends and changes in share prices. The change in share prices can be attributed to either change in earnings per share or changes in valuation.
It is clear that historically valuation changes account for much of the variation in returns.
It is because dilution rates are correlated with GDP growth that EPS growth is not correlated with GDP growth. Exhibit 5 shows real GDP growth and real dividend growth for 16 markets over 100 years to 2000. There is no correlation. In short, even if you are far-sighted enough to look through valuation changes, and swings in profit share of GDP, economic success still doesn’t guarantee investment success.
Finally, a comment on the apparent paradox that the total return on equities can outpace GDP growth over long periods. In the US, for example, nominal GDP has increased around 850-fold from 1900, while $1 invested in equities over the same period would have multiplied 25,000 times (Exhibit 6). (This huge gap is the result of nominal GDP compounding by 6¼% per year while the nominal total return on equities has averaged 9½% per year.)
Note that this paradox is not peculiar to the US, and is not peculiar to equities. Indeed, any debt asset that, on average, provides a yield higher than nominal GDP growth will generate a total return that persistently out-strips nominal GDP. For example, Moody’s BAA US corporate long bonds have averaged a 7% yield since 1920, higher than the 5¾% nominal GDP growth. So while nominal GDP has increased 170-fold since 1920, the total return on an index of BAA bonds has increased by almost 650 times. To recycle Bill Gross’s phrase, on this basis, debt markets are as much a Ponzi scheme as the equity market is.
Note also that these GDP-defying returns only appear when returns are calculated on a ‘total return’ basis – that is, on the basis that the dividends (in the case of equities) or the coupons (in the case of debt) are reinvested back in the asset class.
However, this isn’t so much a paradox as an investment Catch-22. The key point is that, in aggregate, investors do not typically reinvest their dividends (or coupons). If investors actually tried this en masse then the historical returns reported in total return indices would be unachievable.
For equities, the surfeit of capital coming from a compounding cascade of reinvested dividends would, sooner or later, crush margins, hence earnings, hence capital values (and hence future dividends). Reinvesting in debt indices would be likewise unsustainable. For example, to reinvest in US corporate bonds would mean rolling back 7% of the debt stock each year as new debt. Corporate debt in 1920 was around 70% of GDP; it would now be 464% of GDP if it grew in line with ‘reinvested’ corporate bond returns.
So here’s the Catch-22:
over the long run theoretical total returns can exceed GDP so long as investors don’t actually try to capture those returns. But if ever investors try to achieve such GDP-plus total returns, it will be impossible for returns to stay above GDP growth.
Source: Morgan Stanley
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scholarship
So, lets' see if I'm following this correctly. Instead of Wall St. cashing out and crashing the system, they all mark these assets to unicorn, then use them as collateral to borrow more money in order to buy even more junk?
GDP is different from stock market returns because:
"...over the long run theoretical total returns can exceed GDP so long as investors don’t actually try to capture those returns. But if ever investors try to achieve such GDP-plus total returns, it will be impossible for returns to stay above GDP growth."
This is Boomer retirement in a nutshell. The system saw the boomer demographic and needed a way to steal their aggregate wealth. Thus was born the IRA and the 401(k).
The wealth, quite obviously, will not be there when the boomers start retiring. Which is now.
Or maybe the stock market return reflects the return from debt/equity leveraging while GDP growth reflects nothing of that sort?
Besides, GDP includes both the economic winners and losers while the stock market index only includes the winners.
Actually not, any well made index performance reflects the drop-outs as well (the drop-outs of relatively large players, thats clear)
and of course there is the accumulation of debt that possitively impacts on gross oparating surplus (coporations friendly with the men in power) and to a lesser degree on employee compensation
Certainly helps explain why the retail investor is continuously told to buy and hold.
Your comment cuts right to the heart of things. If anyone is still taking advice from a "broker", after clearly being shown that Wall St. has, in general, absolutely no regard for their financial health, then they deserve being treated like a muppet, or worse. Clearly these predators do not have anyone's best interests at heart except for their own.
We can now see that any "advice" profferred by these same people should immediately be suspect and recognized as a self-serving statement designed to better their account at the muppet's expense.
As in the fairy tale, greed kills the golden goose. Only this ain't no fairy tale.
Buying and holding is one thing, but automatically reinvesting quarterly dividends sounds like a basis declaration nightmare when you eventually cash out.
The IRS is going to want to see your data if they aren't in a good mood.
Duh.......sounds GOOD!
How do I get in on it!
No effing shit. Equities are where some people take money from other people? Stop the presses! Gee- Thanks for clearing that up Mr. Gross!
Is there anything peddled by today's institutions today that ISN'T a fucking Ponzi scheme?
No.
If paper leaves your hand and you get something physical and tangible in return; you just made an investment.
If anything leaves your hand and you get a piece of paper in return; you should get a kiss afterwards, 'cause you just got screwed.
Hand tools are a great investment. Why buy what you can build? For the price of a, say, table, you can buy the lumber and the tools and the time to figure out how to use them, and at the end, you have not only a table but the huge capacity to build more tables.
slightly off topic ... take a look at the volume today It is unbelievably light.
Lets rerun this analysis starting in 1968....
For shits and giggles, lets compare GDP, the S&P and gold....
"over the long run theoretical total returns can exceed GDP so long as investors don’t actually try to capture those returns. But if ever investors try to achieve such GDP-plus total returns, it will be impossible for returns to stay above GDP growth."
~~~
IOW ~ We'll hold your money for you... Just don't ever ask for it back or else the whole economy will go up in flames... We'll be over here on our fortified private islands while you contemplate your potential fate & what you want to do about it...
...prisoner's dilemma.
www.tradewithdave.com
Hence, equities for the short- and long-term, are essentially a Ponzi scheme - as long as everyone buys-and-holds - but if 'someone' decides (or is forced) to take-profits, equity ROE will rapidly game-theoretically collapse to GDP growth.
So what you're saying is if the baby boomers cash out because they have been fooked on the buying power of their savings, fooked on their interest income, fooked on their Social Security, fooked on the health care, etc., etc.; that we're fooked?
The market's dead people. Shows over. Last call.
You forgot the "magic" of compounding - taking the time value of fooking, and multiplying by Pi (e), we find that the fooking in 1968 purchasing pariety fooks means that in 2013 we get fooked 6,239,629, 394 times...
there were in fact goods and services before 1600, only no one was calculating 'gdp'.
the growth of the limited stock company ---companies in which you could buy and only lose the stock you bought in them-------grew rapidly . because NONE existed beforehand , and they were a succesful vehicle for attracting investors.
from these--over time---grew entire stock markets.
so entire stock markets were created out of thin air-------from the existing goods and services that were out there----because they were an attractive way for people with savings to risk their savings, relative to what existed before.
One could say the the performance of stock markets as a whole necessarily outpaced the performance of the growth of the goods and services of society ( gdp ) -----because it was derivative from them. it was a parasite. a parasite must always grow faster than the host grows at some point. and at some point it must also die with the host, or find a new one.
Common stock as a derivative. Interesting concept. Don't like where that takes us though.
I remember the last time Bill Gross was shitting on equities - 2002 - longs should be thanking him for being bearish.
With fear index down, robo computer will rule the market.
http://www.freefdawatchlist.com/2012/08/eurozone-on-verge-of-double-dip.html
Waaaait a minute - Are you suggesting that someone, somewhere in the bowels of Margin Stanley, was actually doing work? ... ??? ... ???????
Intern.
Could this analysis be done with average holding period...good GOD I'd love to see that chart. You'd have the return for each month since 1900 until present broken down to dynamic data points from the average holding period.
The parasite that is HFT would be evident. I wouldn't know if that data even exists, but that would be eye-opening.
Holding period could maybe have been measured in months in the beginning, now, I think it would have to be measured in seconds.... Maybe that will get equity investing (gaming) believers to open their eyes and see what's happening on ground zero.
Someone do this ANALYSIS! And make it a mandatory disclosure in every presentation regarding equities.
This is ridiculous. Anything denominated by decree, by "fiat", is worthless when the promise to pay is worthless. Gross wants me short the yield curve and out of equity? Why?
Because he sells bonds, that's why.
So, the first one to exit the burning theater is not the one who panicked.
Nope. It's the guy who set the place on fire.
This analysis shows that the stock market is like a Ponzi scheme in that the returns of present investors depend on future investors wanting to get into the game. If more people want in than want out, the stock market will rise. The converse is also true; if more people want out than want in, the stock market falls. All of this happens regardless of the economic situation at the time.
Now, let's extend this line of reasoning to the demographic realities of the US...
http://dareconomics.wordpress.com/2012/08/15/baby-boomers-retiring/
Bill just yelled "FIRE"...
Mandatory Roth IRA For Make Glorious ETF Everyone Forever!
Buy and hold's
the only way
to keep Charles Ponzi's ghost
away.
I would like to see that last chart with SGS inflation corrected GDP, since 1980.
I still don't believe the stock market is a real Ponzi scheme, it's more like many "investors" are running Martingale schemes.
Who says GDP is a good measure of wealth? For starters, wouldn't NDP (net domestic product) be better? GDP is a measure of aggregate economic activity: divorces, cancer treatment, financial deals. Compare GDP rises to debt rises and it seems even more inappropriate.
Return on investment is about profit. Analyze based on corporate profits from the same GDP report and you will come to a different conclusion.
We are not in business to generate sales. We are in business to generate profits.
Have a closer look at the chart "Ponzi invests with equities"!
Isn't it interesting to see that nominal GDP and equity returns somehow converged until the mid 20s (or roaring twenties) where a lot of credit fuelled a bubble especially in the stockmarket which came to pop in the Great Depression? Where did this money come from?
The FED opened doors in the aftermath of the 1907 crisis, to be more precise in Dec. 1913, and with it came fractional reserve banking. And with fractional reserve banking came unheard levels of leverage which in the end lead to the debt-fuelled, margin account gamblings in the stock market in the 20s.
As time passes by the charts of GDP and equity returns started to deviate ever more strongly with the invention of ever hotter ways to lever the debt-loaded fiat money system up which found its "stellar moments" in crazy things like ABS/CLOs, rehypothetication etc.
So why does anybody wonder that we have these deviations while we still have the FED & its helicopter pilots, fractional reserve banking, shadow banking/rehypotetication and this toilet paper we call money?
Gravity is like (economic) reality. It brought Icarus back on planet earth... it will also do its job on the inflated asset markets. The only question remaining is - how long can this keep going?
Check figure 1 here:
http://www.dai.de/internet/dai/dai-2-0.nsf/0/44A48800FA5F6F22C12574890034B117/$FILE/67E0AA303FA4DFEFC125747C0053B2C7.pdf?openelement&cb_content_name_utf=KS_3-2004_Gielen_English.pdf
to get some sense what might be still in the box at least in nominal terms!
"Exhibit 2 shows the correlation between equity returns and GDP (and GDP per capita) growth over periods of up to 105 years. Ironically, many of the correlations are negative."
Ironic indeed...
Objectively speaking (I hate hft) then those HFT funds are really doing the right thing, not focused on long term, not focused on fundamentals, rather just the here and slightly into the future (couple mili seconds).
One could even go so far as to say that HFT's know the market is broken and they are saying "lets play it this way because hey, all we know is paper shuffling anyway so we gotta do something.
I think the only way to play the market would be to do the HFT thing or float your own company with a tiny float/low volume amongst your employees and maybe 1-2 small sub 10% investors. This way you can enjoy the benefits of credit borrowing easily or more easily than your private competitors, if your compliance costs are in line with the headache.