Stocks: the Long-Term Outlook
By Arnold Kling
an investment in the stock market becomes a bet on innovation. Do you think that the U.S. or the global economy has another wave of disruptive innovation coming? Then buy stocks. But if you think that we are stuck in permanent stagnation mode, then stay away from the stock market.
Pointer from Phil Izzo.
The most controversial algebra that I have ever written is this:
P/Y = (P/E) * (E/Y)
where P is the value of the stock market, E is the earnings of shareholder-owned corporations, and Y is GDP. Every time I write down this algebra, somebody says that I am a fool who is missing something. I am sure I will take grief again, but just keep in mind that the harsher the tone of your insults the more they apply to you rather than to me. And, no, dividends do not make a difference, so don’t throw that one at me. Been there, done that.
The point of this algebra is that for the value of the stock market to rise faster than GDP, one or both of the following has to happen: the price/earnings ratio has to rise, meaning that people are willing to apply a lower discount rate to earnings; or the ratio of corporate earnings to GDP has to rise, meaning that profits of shareholder-owned corporations increase as a proportion of overall income.
The historical return on stocks has been high in large part because P/E has trended upward. Past performance is not necessarily predictive of future returns.
I read Mandel as saying that a bet on the stock market is a bet on GDP growth. If so, then I agree.