RE: Risky investments - Sen. Santorum's Response

["Steven H. Johnson" <info@sscommonsense.org>]

Dear Sen. Santorum,

I noted with interest your comments on the S&P 500 rate of return
over the past seventy years or so.

It's important, isn't it, to analyze exactly how that rate of return
was achieved?  Let's take apart the 10.89 percent you cite.

Roughly 3.5% of that represents the compounding effects of inflation.
The non-inflationary component of that return rate is only about 7 percent,
is it not?

Of the "real" 7 percent, roughly 2.3% comes from price appreciation, 
growth in the value of an index-related portfolio.  Right?

And roughly 4.6% of the annual growth comes from the reinvestment of
dividends paid out by S&P 500 companies.  Right?

Can the American people expect those two factors to continue unabated
for the next seventy years?

Let's start with price appreciation.  What's interesting about the
price appreciation rate is that it lagged the GDP growth rate by
a full percentage point.  While the overall stock market grows at 
roughly the same rate as GDP, an index grows a little more slowly.
As new companies are listed on the market, the value of the market
grows, but the value of the index remains unchanged.  As existing
companies issue new stock, the value of the market grows, but the value
of the index remains unchanged.

So it stands to reason that the value of the S&P 500 index, over the 
long haul, is likely to continue to lag the GDP growth rate.

Will GDP growth continue at 3.3% for the next 70 years?  GDP growth
is driven by two primary factors, over the long run - work force growth,
and productivity growth.  GDP's historic growth rate of 3.3% is a 
compound of more workers, with a workforce growing at 1.4% a year,
and more output per worker, with productivity averaging about 1.8% 
a year.  Right?  So what happens when the growth in the work force
slows from 1.4% a year to 0.4% a year?  Doesn't GDP growth slow
correspondingly?  And, therefore, won't long run S&P 500 price 
appreciation slow correspondingly as well?

Now to dividend yields.  The dividend yield is compounded of two
major numbers, is it not?  Total dividends paid, per year, divided
by the value of the stock on which they're paid.

Let's look at the total stock market, not just at the S&P 500.  
After all, the S&P 500 is way too small to cover the needs of
a workforce 150 million strong.  They'll need to invest in 5000-
stock index funds, not just 500-stock index funds.

As with individual stocks, aggregate dividend yields for the 
stock market as a whole are a composite of two factors - total
dividends paid out by public corporations, divided by the total
capitalization of the stock market.

Aggregate dividend payouts by corporations are roughly 2 1/4 to
2 1/2 percent of GDP, year in and year out.  Total market capitalization,
over the past seven decades, has averaged roughly 65% of GDP.
Aggregate dividend yields for the market as a whole, therefore,
have been roughly 3.5 to 3.8 percent.

Is it reasonable to expect the same rate in the future?  Yes and no.
Corporate dividend payouts are likely to hang in there at 2.5% of 
GDP, or slightly less.  But the aggregate value of the total stock
market has exploded in the past four years.  The Market Capitalization-
to-GDP Ratio is now somewhere around 180%, nearly three times the
historic average of 65%.  Dividend yields, therefore, which are 
obtained by dividing 2.5% (of GDP) by 180% (of GDP) have fallen
roughly to 1.4%.

To recap.  Price appreciation rates of 2.3% are likely to sag a bit,
as the workforce growth rate slows, and GDP growth slows correspondingly.
Dividend yields aren't likely to recover to the S&P's 4.6% level,
or even to the aggregate market's 3.8% level.  Even if the Market
Capitalization-to-GDP Ratio falls somewhat, a low inflation low
interest rate environment virtually ensures a Market Capitalization-
to-GDP Ratio of at least 100%, for the next seven decades, and 
dividend yields, therefore, of no more than 2.5%.

So total real return on stocks, if figured in exactly the same way
as the 10.89% nominal return number that you quoted in your comments,
is likely to be somewhere in the 4% to 5% range.  Exactly the same factors
that delivered real returns of 7% in the past seem poised to deliver
real returns of no more than 5% in the future.

The detailed charts that back up this argument can be found at the
Common Sense on Social Security website, http://www.sscommonsense.org
in the essay, "Are Seven Percent Returns Realistic?"

-Steve Johnson, Director
Common Sense on Social Security