Investors in U.S. equities have been well-rewarded in the post WWII era. For example, over the 70 calendar years from 1949 through 2018, the S&P 500 Index returned 11.24%. And with inflation rising 3.41%, it provided a real return of 7.83%.
Should investors extrapolate that return going forward? Before doing so, you should consider how the 11.24% return was achieved. Among the questions that should be asked are:
- How much of the return was due to economic growth (while corporate earnings’ share of the GNP is time varying, over the long term they should be expected to grow in line with the overall economy)?
- How much, if any, of the return was due to a shift in economic rents from employees to shareholders? You can see the general upward trend in this chart provided by the Federal Reserve Bank of St. Louis. Note that we ended 2018 with corporate after-tax profits at 9.7% of GNP. From 1951 through 2004, they bounced around between about 4% and 8% (except for a brief period in the late 1970s, when they slightly exceeded 8%). In the post 2004 period, except for a brief drop during the Great Financial Crisis in 2008, the ratio has generally been above 9%, and peaked at almost 12% during 2012.
- How much of the return was explained by falling interest rates and changes in valuations (price-to-earnings ratios)? For example, consider that we ended 1948 with the CAPE 10 for the S&P 500 being just 10.2. We ended the 70-year period with that valuation metric having risen to 28.3. In other words, the almost tripling in valuations contributed significantly to the return over the period. And while there may not be a reversion to the long-term mean (16.6) of that metric, one should certainly not expect the contribution to be repeated.
Daniel Greenwald, Martin Lettau and Sydney Ludvigson of the National Bureau of Economic Research sought to answer such questions in the April 2019 study “How the Wealth Was Won: Factors Shares as Market Fundamentals.” Their study covered the period 1952 through 2017.
Following is a summary of their findings:
- For the 29 years ending in 1988, the real net value added of the nonfinancial corporate sector (NFCS) grew an average of 4.5% per annum. Over the next 29 years, it grew an average of just 2.5% per annum. Despite the much lower net value added, for the 29 years from the beginning of 1989 to the end of 2017, the real value of market equity for the NFCS grew an average of 8.4% per annum compared with just 2.5% per annum in the prior period. In other words, there was a widening chasm between the stock market and the broader economy. In fact, at the end of 2017, the ratio of the market value to NFCS was at a post WWII high (higher than during the dot-com boom).
- Since 1989, equity values were boosted by persistently reallocated rents from labor compensation to shareholders. This shift explains 54% of the market price increase over the 29 years ending in 2017, and 36% of the increase over the 58-year period.
- Since 1989 equity values have been boosted by persistently declining interest rates and a decline in risk premia, with each contributing 11% to the increase in stock values.
- Growth in the real value of what was produced by the sector contributed just 23% to the increase in equity values since 1989 and 50% over the full sample. By contrast, from 1952 to 1988, economic growth accounted for 92% of the rise in equity values, but that 37-year period created less than half the equity wealth generated over the 29 years since 1989.
- Taxes played a negligible role in equity market fluctuations throughout the sample. (Note their data sample ends before the impact of the lowering of corporate tax rates in 2018 helped drive corporate earnings higher).
The authors concluded: “An implication of these findings is that the high returns to holding equity over the post-war period have been in large part attributable to good luck, driven primarily by a string of favorable factors share shocks that reallocated rents to shareholders. We estimate that roughly 2.1 percentage points of the post-war average annual log return on equity in excess of a short-term interest rate is attributable to this string of favorable shocks, rather than to genuine compensation for bearing risk. These results imply that the common practice of averaging return, dividend, or payout data over the post-war sample to estimate an equity risk premium is likely to overstate the true risk premium by about 50%.”
The bottom line is that factors shares have been more relevant than economic growth in explaining stock returns in the U.S. over the past 30 years. In fact, the stock market owes much of its return over the past 30 years not to economic growth but to shareholders earning an increasing share of that growth at the expense of workers. And this can only go so far before political actions occur (and we may be approaching that point).
The implication for investors is striking. Those who rely on the historical real return to U.S. stocks of about 7% are likely to be highly disappointed, as the equity risk premium (ERP) going forward is likely (though not certain) to be significantly lower. The reason is that the ERP it isn’t likely to benefit from a further increase in economic rents allocated to shareholders versus labor capital, a further drop in interest rates, or a further increase in equity valuations.
In fact, as labor’s share of economic rents is highly cyclical (tending to fall in periods of higher unemployment and rise in periods of low unemployment), it seems likely that this factor could be a negative for stock returns going forward. As supporting evidence, consider that corporate after-tax profits as a percent of GNP peaked at almost 12% in early 2012 and declined (along with the unemployment rate) to 9.3% at the end of 2018.
It’s important to not take the above to mean U.S. stocks are overvalued or that a bear market is imminent. It is, however, a warning that future returns are likely to be well below historical returns. Thus, plans should incorporate that expectation. Forewarned is forearmed.
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.