A new study suggests that U.S. stock returns are now less about economic growth and more about shareholders. Larry Swedroe unpacks the research, and what it implies for the equity risk premium going forward.
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:
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:
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.
This commentary originally appeared May 8 on ETF.com
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