Economic Growth and Equity Investing

Bradford Cornell

Financial Analysts Journal, 2010, vol. 66, issue 1, 54-64

Abstract: The performance of equity investments is inextricably linked to economic growth. Nonetheless, few studies on investing have explicitly taken research on economic growth into account. This study bridges that gap by examining the implications for equity investing of both theoretical models and empirical results from growth theory. The study concludes that over the long run, investors should anticipate real returns on common stock to average no more than about 4 percent.The performance of equity investments is inextricably linked to economic growth. Nonetheless, few studies on investing explicitly take research on economic growth into account. This article bridges that gap by examining the implications for equity investing of both theoretical models and empirical results from growth theory.Bridging the gap involves two fundamental steps. The first is examining the sources of long-run economic growth. Growth theory teaches that in the long run, expansion of real GDP is determined almost exclusively by a combination of population growth and productivity growth attributable to technological innovation. Analyzing these two factors enables the placing of reasonable limits on future real GDP growth in the developed countries. Those limits turn out to be about 3 percent.The second step involves analysis of the relationship between real earnings and real GDP. If the ratio of earnings to GDP is stationary—and the data indicate that it is—then in the long run, real earnings can grow at a rate no faster than real GDP. Those real earnings, however, are the real earnings for the economy as a whole. The real earnings growth that existing investors can expect may be less because of dilution that occurs when new shares are issued, primarily by start-ups. In the case of the United States, for instance, updated data show that dilution drives a 2 percent wedge between aggregate real earnings growth and the real earnings growth experienced by existing investors.Putting the pieces together in conjunction with data on dividend yields, my analysis suggests that over the long run, investors should expect real returns on common stocks to average no more than about 4 percent. Moreover, this result holds for the entire developed world, not just the United States.

Date: 2010
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DOI: 10.2469/faj.v66.n1.5

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