Reading the financial media these days can feel a bit like reading the obituaries, as pundits like PIMCO founder Bill Gross rush to eulogize the stock market.
You almost expect to read something like, “Dow Jones had a long and profitable life. Like all mortals, though, his time eventually passed and now investors everywhere will have to face the future without him.”
So, are equities really dead?
Actually, fortunately for investors everywhere, though, Dow Jones and his family of equities are still alive and well.
The basic argument for the death of equities is that the stock market cannot long outpace the economy because the math just doesn’t work.
For example, the doomsayers claim that if the economy is only growing at 6% a year (real growth – the headline number – plus inflation), the stock market cannot continue its 10% historical average return for very much longer, because the overall size of the stock market is, logically, reigned in by the overall size of the economy.
So, they claim, because stock returns have outpaced the economy for more than a century (somehow), we who have been living on borrowed time must now suck it up and face dismal returns for the remainder of our investing lifetimes.
Uh oh. Sounds bad.
But will someone please tell the pundits (especially the ones running billion dollar bond funds!) that they fail Finance 101? They’ve left out the balancing effect of the debt market completely!
It’s the total value of corporations (enterprise value)—not the stock market alone—that is logically constrained by the growth of the economy.
Enterprise value is the sum of the stock market and the corporate debt market. And because corporate debt offers returns below the rate of economic growth, stocks must logically return more than the economic growth rate.
In fact, as long as corporations continue to issue debt, we can and should expect the stock market to continue to return its historical 10% over the long run.
Here is an example:
Suppose the entire U.S. economy is now embodied in just one firm: TED. And TED produced $100 of goods and services in 2011 (that’s GDP).
Let’s say that TED’s equity value is $100 on January 1, 2012 (that’s the stock market in our example). And TED also has $100 worth of debt on January 1, 2012. TED starts 2012 with a $200 enterprise value that is twice the firm’s output.
Now, let’s say that TED’s output grows 6% in 2012 to 106. And, of course in our example economy this means GDP grows 6%. In a perfectly balanced system, what happens to TED’s stock market value? And remember, TED is the entire economy so the question is really, what happens to the stock market when the economy grows 6%?
Because TED’s output grew 6%, to 106, we will assume that TED’s enterprise value also grows 6%, to 212. What happens to the value of TED stock depends crucially on TED debt. Suppose TED’s debt is paying 2% – debt does, after all, offer a much lower return than equity: just check what you’re making on your bank deposits these days! – then the value of the debt rises 2% to 102.
Because TED’s enterprise value rose to 212 and enterprise value is, by definition, the value of TED’s debt plus TED’s equity, TED’s stock market value must rise to $110. That’s a 10% return on 6% growth! And what’s true for TED is true for the economy as a whole.
Because the economy is supported by both the stock market and the debt market, the pundits heralding the death of equities are using faulty logic, and are, in fact, flat wrong (and, surprise, they’ve claimed this before and been wrong).
As this simple example shows, in an economy with corporate debt, or any relatively safe security offering low yields, on average the stock market will, over the long haul, return more than the economic growth rate.
While there can be long periods where the stock market underperforms, that doesn’t change the basic math.
Debt paying less on average means the stock market pays more in the long run, and can keep doing so forever.
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Contributions to this article were made by Robert J. Hendershott, PhD, Professor in the Finance Department at Santa Clara University’s Leavey School of Business, located in Silicon Valley, Ca. Robert researches, writes about, and teaches venture capital and private equity along with various topics in entrepreneurship. Robert is also a founding partner of BH Equity Research, a private investment consulting firm.
About Hilary Hilary Martin , MBA, CFP® specializes in comprehensive financial planning to help individuals and families successfully integrate their values and their lifestyle to achieve all that is important to them. Her combined technical knowledge and passion for facilitating others’ success are key aspects of her financial planning practice.
