Question

The average returns for large-cap stocks have been around 9 or 10 percent. This is in a period where GDP growth has averaged 3 percent. How is this possible that stocks can produce a multiple of GDP growth?

If the “new normal” for GDP growth is 2% (or less) what would be your long-term average of future stocks returns? Why??

Answer 1

The ratio of stock prices to earnings is P/E.

The ratio of earnings to GDP is E/Y.

The ratio of stock prices to GDP is P/Y, which equals P/E times E/Y.

For stock prices to grow faster than GDP, either prices have to grow faster than earnings or earnings have to grow faster than GDP.

Stock prices certainly can rise faster than GDP for long but finite periods. If the P/E ratio starts at about 5 and gradually rises to about 25, that will do it. Also, if earnings of shareholder-owned companies start at less than 10 percent of GDP, then they can grow faster than GDP for a long time.

If the GDP growth is 2%, this implies that economy have faced a slowdown in its growth that is week macro economic factors. Hence, the earnings of Large corporates(major drivers of GDP in an economy) would have been affected due to poor business environment they work in. Hence, the returns for large cap stock would be less than 9%, somewhere around 6-7%. But this is fully subjective and mainly depends on micro economic factors of industry the company operates in.