Equities must crash because they outpace GDP: Fisher's financial mythbusters
Every now and then, some 'expert' blusters: 'Equities must crash because they outpace the economy's growth!' But real GDP growth has averaged about 3 per cent, whilst equities have appreciated at an annualised 10 per cent average.
If you think (incorrectly) the two rates should match, then the gap is worrisome - except that equity returns and GDP growth aren't linked. Equities can, should and probably will continue annualising a higher rate of return than GDP growth. And that makes sense, if you think about what GDP is and what equities are.
GDP is an attempt to measure national output, built on surveys and assumptions. It doesn't measure assets or wealth. Rather, it's a standard economic flow.
See it this way: As of year-end 2015, America's GDP was about $18 trillion (£14.66 trillion). If full-year 2016 GDP growth were 0 per cent, America's GDP would still be $18 trillion.
WHAT IS GDP?
If America's growth were flat for five years it would have still put $90 trillion of output into the world economy at the end of those five years.
And though many people believe it to be so, GDP isn't perfectly reflective of economic health. Its headline number is calculated thus:
- GDP = private consumption + gross investment + government spending + net exports (exports - imports)
Gross investment includes non-residential investment (business spending), residential investment and inventory changes. GDP measures net exports; because the UK and US are net importers, they get dinged on this.
Importing more than you export detracts from output but isn't necessarily bad: major developed nations that are net importers tend to have higher growth than net exporters (such as Japan and Germany).
Shrinking government spending detracts from GDP - but that can be positive! Consider Portugal, Italy, Greece and Spain. Decades of bloated government spending have crowded out their private sectors.
The private sector is smarter and more efficient than government, so their economies are less competitive than much of core Europe.
SAME DATA, DIFFERENT SCALES
Which brings us to equities. Before we get into what equities are, let's clear up another misperception. A variation on the GDP-stock mismatch is that equities have risen too far, too fast, and what goes up must fall.
Typically, those making this argument cite a chart looking something like Exhibit 1 (click to enlarge), which shows S&P 500 total returns over time.
Through history, equities had pretty steady returns. Starting in the mid-1980s or so, equities took off. Then, in the late 1990s, things got super-crazy unsustainable. And then we experienced two bear markets - which look massive on this chart - confirming 'too far, too fast' fears.
First, think about those two bear markets - the biggest since the Great Depression. Now look at 1929 on the chart. Barely a blip! Weird.
Now look at Exhibit 2, which also shows long-term returns, but isn't top-heavy or scary. Yet the data are identical. The difference is the former is a linear scale and the latter is logarithmic.
Linear scales are used all the time for measuring returns. The problem, using a linear scale over longer periods when measuring something that compounds, is that every point move takes up the same amount of vertical space.
On a linear scale, a move from 1,000 to 1,100 looks huge, but a move from 100 to 110 looks tiny. Yet that's not reality. Both are 10 per cent moves and should look the same!
Because of the impact of compounding returns over nearly 100 years, on a linear graph, later returns look stratospheric because the index itself is higher.
A logarithmic scale is a better way to consider long-term market returns, as percentage changes look the same even if absolute price changes are vastly different. That's how you and your portfolio experience market changes.
WHAT ARE EQUITIES?
Equities are a piece of firm ownership, not a slice of current or future domestic economic output. When you buy equity, you own a slice of a company and its future earnings, which you expect to rise over time.
Exhibit 3 shows S&P 500 earnings per share over time, overlaid with S&P 500 price returns. Not always or perfectly, but they track pretty closely. And they should! But earnings aren't calculated in GDP. Corporate spending is, but not earnings.
Earnings are a function of revenues minus costs - and headline GDP has no direct connection to either.
Companies function in the economy, but the stock market and the economy aren't the same, and nor remotely interchangeable. Rates of GDP growth and stock returns aren't directly linked, and shouldn't be.
Earnings, and therefore equity prices, can and likely will keep growing faster than GDP over time - equities represent the non-stop exponential upward sweep of innovations, contributing to higher earnings over time. You can't capture that in an economic flow.
Ken Fisher is founder and chairman of Fisher Investments.