What return assumptions can we expect going forward?

The major driver of stock market returns, all else being equal, is earnings growth, which while not totally equivalent to nominal GDP growth, tends to exhibit similar rates of growth. 

Gross revenue should more or less increase at the same rate as expenditure based GDP growth, even though earnings growth will differ due to changes in corporate taxes, depreciation factors, cost cutting and productivity factors.

From December 1966 to December 2011, real US earnings growth (source Shiller data) rose by some 1.85% per annum, while real GDP growth (BEA data) has been some 2.02% – all figures are geometric averages.   Nominal GDP growth had averaged 6.65%.   

Total real return, going forward, based on this data would be 1.85% per annum + the dividend yield (close to 2%).  So for say the US, if the future were to represent the past, we would expect non compounded real returns of 3.85% per annum: compound real returns would differ, but not everyone receives compound returns, especially those living off their assets. 

But the future is not going to be like the past for a number of reasons:

  • We are deleveraging and will continue to reduce debt for some time – debt reduction will be  a drag on growth.  Much of the GDP and earnings growth to date are reflective of accumulated debt.   
  • Corporate profits, especially after tax corporate profits as a % of National income in the US is at historically high levels.   Profits could fall by 30% to 40% if they were to revert to average historical relationships and by a larger margin if conditions were to deteriorate from here on.
  • Also, long term averages are rarely relevant to those in retirement who are drawing on income and capital.

While average real geometric annual GDP growth has been 2.8% from 1966 to 2011, the average return based on rolling 10 year time periods has been between 1.25% and 4.34% since the 1950s.  If the demographic, financial and economic imbalances of the present dominate those of the past, as I would tend to argue, real growth going forward, in the next 10 year time frame could easily be at the bottom of, or even below, the range noted below – graph data sourced from the BEA


I would argue, that sustainable GDP growth rates have been trending down since the 1960s, and have only been maintained up till the mid 2000s with aggressive monetary easing and fiscal accommodation.

Real earnings growth on the same basis over a similar time frame, has also been volatile (the chart data is sourced from the Yale Shiller data set):


Excluding the 2008/2009 blip caused by the financial crisis, earnings growth over the last 20 years have been strong.   Profits as a share of national income have also risen (graph data sourced from Federal Reserve Z1 data):


If real GDP growth were to average no more than 1% over the next 10 years, and profits were to correct by 30% to 40% as a % of national income, then real earnings growth could easily struggle to breach the 0% level.    Market returns would depend on compounding and valuation changes, + any special dividends or share buybacks using current retained earnings.

Total real returns could be wholly dependent on dividends, and total nominal returns on dividends and inflation.

Just look at Japan:


Real annual geometric growth in GDP (excluding government expenditure) has been 0.5% a year since 1994 (source data the Cabinet Office).  The following graph shows real annual GDP growth (ex gov’t expenditure) for rolling 10 year periods from Q1 2004 to Q1 2012:


Note also the Japanese 10 year government bond yields, which have more or less flat lined since the late 1990s and have held well above both nominal and real GDP growth rates during the last two decades. 


If 10 year bond yields hold important information about expected nominal and hence real GDP growth, then what of US GDP growth going forward?


The above chart shows the starting 10 year bond yield for a given year mapped against the nominal GDP outcome, with the exception of the current year, 2012, where the current bond yield of 1.64% is based in June 2012 yield levels.  

In other words, nominal and real returns on world stock markets could well be lower than many expect.

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