Saturday, March 19, 2011

Growth of GDP per Capita vs Stock Prices since 1871

Following up on last Sunday's "Long term Growth in U.S. GDP per Capita 1871-2009" we revisit Visualizing Economics.
The question embedded in this chart is:
"How can the aggregate of investment portfolios grow faster than the economy?"
The long term answer is "They can't".

As GDP is the sum of all the profits, those accruing both to capital and to labor, the only way capital can garner a larger proportion is for labor to accept a smaller percentage. This is a self correcting cycle, too extreme at one end and you get a capital strike, at the other, labor walks out.

Another mean-reversion is the price paid for the expected (sometimes hallucinated) income stream.
P/E ratios don't go to infinity (for the total market, individual issues sure can) nor do they go to zero (implying  the reciprocal fantasy, an infinite rate of return)

There are two methods of enlarging the total pie.
1) Increase revenues while maintaining profit margins.
2) Increase profit margins, usually by some combination of productivity enhancement e.g. capital investment, labor force education, waste minimization etc.

These are especially effective if combined, ie expanding revenue+rising margins.
Unfortunately at the corporate level there are upper bounds to both.

For portfolio investors the situation is even worse than for the overall economy.
You miss all the growth of private companies.

On the one hand private companies are often fine businesses which the owners have no desire to share and on the other hand the universe of private companies is where you find the younger, smaller, more dynamic and thus faster growing entities.

These two attributes are what private equity and venture capital, each in its own way, attempt to capture.
However, with large enough pools of money in the game aggregate private company returns can be lower than those found in the public markets, a widely known example were oil companies in the 1980's after the oil bust,
You could buy oil on the stock exchange cheaper than the cost of finding it via exploration & production.

Some folks are wondering if we are building to a similar overvaluation in Silicon Valley right now.

Anywho, that's a longer than usual intro, your patience will be rewarded by a short and sweet chart from Visualizing Economics:

(click to enlarge, click again if you;re over 50)
Comparing Real GDP per Capita growth to the real growth in S&P Composite (price only). However, the stock price series is adjusted for inflation using CPI-U while the GDP per Capita (from is adjusted with the GDP Deflator.