Forget economic growth: Stocks compensate for risk

Periodic arguments that long-term stock market returns are a thing of the past have cropped up again, with noted bond investment manager Bill Gross calling the stock market a “Ponzi scheme.” He argues that U.S. stocks returned 6.6 percent per year over inflation during the last century, while gross domestic product, a measure of changes in the country’s production of goods and services, has grown by only 3.5 percent per year. “Somehow stockholders must be skimming 3 percent off the top each and every year,” Gross writes. He believes the stock market cannot continue to offer such high real investment returns in the future.

But GMO, an international investment firm with its U.S. headquarters in Boston, argues that stock prices do not necessarily coincide with GDP. In fact, it is the painful occasional stock market crash, which usually comes at the worst possible time, that causes stocks to offer a real return of about 6 percent.

The most likely explanation for the substantial premium that stocks seem to pay over inflation are the extremely inconvenient times that equity markets tend to lose investors … money,” writes Ben Inker, head of asset allocation for GMO. He says severe market drops tend to occur in recessions (bad), financial crises (very bad), depressions (very, very bad), and major wars (not good at all). “From the beginning of the 20th century until now, while the average return to the S&P 500 over this period was a reassuring 6.6 percent real, at those times when you were most at risk of losing your job, your bank account, your house, or your life, you could rely on equities to be piling on the misery?” he adds. Inker says it is “only rational” for stock owners to demand high returns “for taking that very unfortunate return path.”

Investors have long been convinced that strong GDP growth in a particular country should correspond with strong stock growth. Inker says that has not been the case in the 20th century. Japan, for instance, had the strongest GDP growth during that 100 year period, yet its market returns were below that of the United States, Australia, and Sweden, all of which had much lower GDP growth. Over the 30 years from 1980 through 2010 the same lack of correlation was noted between stock markets and GDP growth, he said. This has occurred even though it seems to make sense that a growing economy would produce higher corporate profits, which would be reflected in higher stock prices. This has not been the case, Inker concludes.

Why then do stocks offer higher returns? Because “workers invest to fund their retirements,” he says. In that case, they demand a high return to compensate for the risk that their portfolios will decline precipitously just at the wrong time. Inker notes that the internet bubble of 2000 was the worst point of overvaluation in the S&P 500’s history, and says the declines in valuation over the last 12 years “have been part of an essential healing process for U.S. equities.” He says the idea that historic equity returns are no longer relevant is wrong. “Equities are very likely to be priced to deliver strong returns into the indefinite future,” he concludes.