Facing Economic Reality

My friend Mike Northover points me to this Economist article about realistic rewards, which says that in upcoming years the stock market is likely to fail to meet investors' expectations.

However, a study by Martin Barnes, an economist at the Bank Credit Analyst, a Canadian research firm, concludes that, at best, the average return over the next ten years is likely to be half that over the past half century.

His sobering forecast is based on two assumptions, both very reasonable. The first is that, because of lower inflation, company profits are unlikely to rise by more than 5% a year over the next decade, a bit slower than the average of 7% a year over the past 50 years. In the long run, profits tend to grow in line with GDP, and America's nominal GDP is thought likely to grow by around 5% a year over the next decade (3% real growth plus 2% inflation). Although profits have outpaced GDP over the past couple of years, this is unlikely to continue because pre-tax profit margins are nearly at their highest in 35 years. And since firms now operate in a world of greater competition, profit margins are, if anything, more likely to fall than to rise.

Mr Barnes's second assumption is that there is little scope for a sustained rise in the valuation of shares. The S&P 500 is currently trading at around 18 times historic operating profits. That is far below its ratio of almost 30 at the peak of the bubble, but still higher than its 50-year average of 15. Mr Barnes's “optimistic” scenario assumes that the p/e ratio stays flat over the next decade as a whole and the S&P 500 rises in line with profit growth of 5% a year. Adding in dividends, this would give an average annual return of 6.7%. That implies an average real return of only 4.7%, compared with almost 10% in the half century to 2000. However, history suggests that there is a risk that the p/e ratio could fall over the next decade. In an alternative scenario, Mr Barnes assumes that the p/e ratio reverts to its historic average of 15. If so, the annual return would be a measly 4.7%.

However, my intuition (ha!) suggests that emerging markets like China and India have huge population bases that will inevitably increase the wealth of the world over the next few decades. It'll be profitable to invest there, and American companies will get their hands into the pot as well, making it profitable to invest here.

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My friend Mike Northover points me to this Economist article about realistic rewards, which says that in upcoming years the stock market is likely to fail to meet investors' expectations.

However, a study by Martin Barnes, an economist at the Bank Credit Analyst, a Canadian research firm, concludes that, at best, the average return over the next ten years is likely to be half that over the past half century.\n\nHis sobering forecast is based on two assumptions, both very reasonable. The first is that, because of lower inflation, company profits are unlikely to rise by more than 5% a year over the next decade, a bit slower than the average of 7% a year over the past 50 years. In the long run, profits tend to grow in line with GDP, and America's nominal GDP is thought likely to grow by around 5% a year over the next decade (3% real growth plus 2% inflation). Although profits have outpaced GDP over the past couple of years, this is unlikely to continue because pre-tax profit margins are nearly at their highest in 35 years. And since firms now operate in a world of greater competition, profit margins are, if anything, more likely to fall than to rise.\n\nMr Barnes's second assumption is that there is little scope for a sustained rise in the valuation of shares. The S&P 500 is currently trading at around 18 times historic operating profits. That is far below its ratio of almost 30 at the peak of the bubble, but still higher than its 50-year average of 15. Mr Barnes's “optimistic” scenario assumes that the p/e ratio stays flat over the next decade as a whole and the S&P 500 rises in line with profit growth of 5% a year. Adding in dividends, this would give an average annual return of 6.7%. That implies an average real return of only 4.7%, compared with almost 10% in the half century to 2000. However, history suggests that there is a risk that the p/e ratio could fall over the next decade. In an alternative scenario, Mr Barnes assumes that the p/e ratio reverts to its historic average of 15. If so, the annual return would be a measly 4.7%.

However, my intuition (ha!) suggests that emerging markets like China and India have huge population bases that will inevitably increase the wealth of the world over the next few decades. It'll be profitable to invest there, and American companies will get their hands into the pot as well, making it profitable to invest here.