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Why the Stock Market is a Bad Bet

Posted By on February 4, 2009

Suppose there was an economy the entire size of which was 10 trillion dollars, 1 trillion of which was made up of corporate profits.  Suppose further that corporate profits are projected to increase “over the long term” at a rate of 10% per year.  Now suppose the economy as a whole is expected to grow at a rate of 3%.  Do you see the problem here?

In 100 years corporate profits will have grown to $13,780 trillion.  The economy as a whole will have grown to $173 trillion.

Despite the impossibility of that scenario, it’s consistent with some folks’ expectations.

John Bogle, in Common Sense on Mutual Funds, says the long term total return on stocks is 10.3%.  “While it is important,” he writes, “to know what to expect from the stock market in the long run,” stocks sometimes fail to perform in the short term.  His view is consistent with the view of other financial advisors, who say ordinary people should be invested in stocks, so long as they’re investing “for the long term.”

Meanwhile, economists agree that the long term rate of growth for the US economy as a whole is right around 3%, which is what it has been, more or less, for the last hundred years or so.

But the fact is corporate profits – which are what all stock prices are ultimately based on – cannot grow indefinitely faster than the entire economy.  The part cannot become greater than the whole.

So either the US economy has to start growing at a pace faster than it ever has before – and faster than any developed country has ever grown – or stock prices have to fall.

As food for thought, here’s a pretty chart:

Profit margins are probably the most mean-reverting seies in finance...

Profit margins are probably the most mean-reverting seies in finance...

Chart by Vitaliy Katsenelson.  link

What the chart shows is that corporate profits generally have made up about 8 or 9% of the economy, but have swollen up recently to more than 12%.

If the revert to mean, corporate profits need to fall by 31%.


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