RE: Privatization?! Not for me!

["Steven H. Johnson" <cdempro@erols.com>]

"Remember, the S & P 500 (the market indicator of the leading 500 firms)
has averaged
just under 11% over the last 60+ Years.  That even covers the
29
market crash.  Mac"

This message is for Richard Arsinow, Al Abbott, Javier Jimenez, William Larsen, Robert MacDonald, Jeff Anderson, and Steven Head, and all those who believe that privatized investment accounts can rely on stock market returns of 7% a year for ever and ever.

The 11% number for returns to the S&P 500 investor can't be taken at face value.
Let's dissect it and see what it really means.
More than 3.5% of this 11% is from inflation.
The non-inflationary component of the 11% return number is approximately 7%.

Second, the 7% real return number consists of two pieces, price appreciation and reinvested dividends.

Price appreciation over the past 70 years averaged about 2.3% a year, in real terms, for the faithful S&P 500 investor.
(This faithful investor is probably a mythical construct.  But, somewhere out there, there may have been one or two actual investors who fit the profile.)

Meanwhile, real GDP growth averaged 3.3% a year.  In other words, price appreciation in the S&P 500 actually lagged GDP growth, by roughly a full percentage point.
It also lagged growth in total market capitalization, which roughly parallels GDP over time.

Why would an index grow more slowly than the market as a whole?
Because, when new firms are listed, the market grows, but an index doesn't grow.
Because, when existing firms issue new stocks, total market capitalization grows, but an index doesn't grow.

So - if S&P 500 real price appreciation was only 2.3% a year, where does the rest of the 7% return come from?
It comes from reinvested dividends.
Average dividend yields for S&P 500 firms, over the past seventy-some years, were roughly 4.6% a year.
Those who like math realize that 1.023 x 1.046 is roughly equal to 1.07.
In other words, 2.3% price growth, multiplied by reinvested dividends of 4.6%, works out to compound real returns of 7%.

Can we expect 7% returns to continue in the future?

Start with price appreciation.
If S&P 500 stock price appreciation ran a percentage point more slowly than GDP growth in the past, it probably will do so again in the future.

GDP growth, it turns out, is expected to slow.
Over the long run, GDP growth is driven by two factors - population growth, and productivity growth.
Productivity growth may well hang in there at about 1.8% a year.
But population growth is expected to slow considerably, from about 1.4% a year to perhaps only 0.4% a year.
As this happens, it's almost inevitable that GDP growth will slow correspondingly.
And it's likely that S&P 500 price appreciation will also, over the long run, slow correspondingly as well.
So we may not see long-term price appreciation of 2.3% in the future.
Future price appreciation rates may well be lower than 2.3%, thanks to slower population growth and slower GDP growth.

Now turn to dividend yields.
A dividend yield is the value of a dividend paid, divided by the value of a stock.
For the economy as a whole, aggregate dividend yields are calculated by figuring total dividends paid, divided by the total market capitalization of the entire stock market.

Aggregate dividends paid out by all listed corporations tend to run betwee 2.25% and 2.5% of GDP.
Historically, total market capitalization has averaged about 65% of GDP, ranging between lows of 35% of GDP and highs of 105% of GDP.
It's not hard to see how 2.5% of GDP (dividend payout) divided by total market value equal to 65% of GDP produces a dividend yield close to four percent.  (2.5 divided by 65 equals 3.8, actually)
For the S&P 500, which consists of companies that pay dividends more aggressively than the market as a whole, the dividend yield was a little higher, as mentioned, at 4.6%.

Can these two factors - dividend payouts, and market capitalization levels - be expected to continue in the future?  Payouts at 2.25% to 2.5% of GDP?    Market capitalization at 65% of GDP?  Producing aggregate dividend yields of 3.8%?

Start with dividend payouts.
Will corporate dividend payouts continue to run in the 2.25% to 2.5% of GDP range?
Probably.  The GDP is full of ratios that are pretty darn constant over time, and the dividend payout ratio seems to be one of those really constant ratios.

Will market capitalization continue to average 65% of GDP?
Probably not.
Current market capitalization is well above 160% of GDP right now!
Aggegate dividend yields, therefore, are now about 1.5%.

At some point, the current S-curve runup in the market comes to an end.  
Total market capitalization levels off and resumes its historic pattern of growing at about the same rate as GDP.

What kind of long run returns will this give us?

Suppose we have price appreciation of only 2%, in real terms, thanks to slower population growth.
Suppose we have dividend payouts at 2.5% of GDP.
Suppose we have the total stock market capitalized at 165% of GDP.
As a result, suppose we have aggegate dividend yields of only 1.5%.

The analysis is sobering.

The same price-and-dividend factors that produced real returns of 7% in the past now seem poised to give real returns of only 3.5%.

These factors could kick in any day now.
As soon as the stock market's current S-curve runup comes to an end, they will kick in.

Steve Johnson
Common Sense on Social Security

Those who want to see the charts that back up this argument can find them at http://www.sscommonsense.org/page04.html