Understanding Stock Market Returns

I don’t spend much attention to discussions in the financial media of stock market returns, especially forecasts of them. They’re so misbegotten it is almost comically. On those occasions when I find a good discussion of equity returns, I refer it to you.

This piece from PIMCO explains how the fund firm analyses equity returns and how that analysis leads to its forecast of returns for the next five to 10 years. What I particularly like about this discussion is a section you don’t see too many other places. That is the part about the relationship between corporate profits, its share of GDP, and government spending. This is particularly important now and in coming years, because government spending as a share of GDP in the U.S. and elsewhere is likely to shrink in the coming years. If you’re interested in a serious discussion about the sources of stock returns and what’s likely to happen in coming years, take a look.

We have shown initial valuations drive forward returns due to the mean-reverting nature of prices to earnings over time. But are there other factors that drive valuations too? A historical analysis of P/E multiples (see Figure 12) shows that equity investors are most exuberant during periods of low but positive nominal GDP growth (greater than 2% but less than 6% per annum) but quickly become more pessimistic when nominal GDP growth either falls below 2% per annum or rises above 6% per annum. This is partly explained by the fact that the volatility of GDP and earnings is higher in the wings of the growth distribution, but is also driven by the fact that negative growth is associated with permanent losses and double digit growth is associated with rising costs of credit/discount rates. The growth and discount rate factors discussed above will also be critical in forecasting returns below.