Economic Growth And Investment Returns

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Where do investment returns come from?

For as long as I've been investing, people have said to put money into the stock market for growth and to own bonds for stability. That advice has gotten a little jumbled lately, but it still seems to hold true. The US stock market has returned 7.5% per year for the past 10 years, while the bond market has earned 5.25%. The same relationship holds for longer time periods stocks can be volatile, to be sure, but on the charts, the indices seem to move from the lower left to the upper right.

But why? Markets aren't magic. If you were a Japanese investor, you didn't earn much of anything from stocks over the last several decades. The 20-year return from their stock market has been -0.5% per year in Yen. Japan isn't some obscure country no one's ever heard of. They're a modern democracy with the world's third largest economy. What makes them different from the rest of the world?

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Nikkei 225 over last 20 years. Source: Bloomberg

Equities are residual claims on corporate cash flow. Equity holders get paid after everyone else - the bondholders, the employees, the vendors. For the past few decades, earnings at Japanese companies haven't grown at all. In 2006, they earned 750 yen per share, and last year, they earned 840. And in the '90s, their earnings were higher than they are right now. For over two decades, Japanese companies haven't grown their cash flow at all. So their equity investors have suffered. What's wrong with Japanese companies? It's actually pretty straightforward: their economy has been stagnant. In 1996, their economy was actually larger than it is now.

In fact, there's a pretty strong correlation between long-term economic growth and stock market returns.

The more economic growth there is, the more the market advances. This doesn't work every year - sometimes markets get overvalued and contract despite a decent underlying economy. But over the long haul, markets depend on the economy to generate earnings for shareholders.

The lesson here is clear: if we want the market to generate decent returns, we need to see the economy grow too. But that growth has to be sustainable.