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The index fund 6.5% myth


yadayada
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I keep hearing that if you invested in the general market in the past 50 years, you would have done somewhere between 5-7%. Now some people asked me about advice and I wanted to say index fund, but im having some second thoughts.

 

For starters, if you invested in the general market in the 50's, there was very little leverage, and the population was growing at almost 2% a year. debt GDP was like 120%. Now debt GDP is more like 350%, and the population is growing only 0.7% a year.

 

And generall GDP growth comes from population growth, debt growth and productivity growth.

 

Given that population isn't growing, and there is not much room for debt growth, wouldn't investing in an index fund that is heavily weighted on the EU and the US be a bad  idea?

 

If debt would decline to 240% GDP, that would be negative for GDP and holders of index funds. Growth would have to come from productivity (only about 1%) or population growth, (less then 1%).

 

On top of that, shiller PE is almost at all time highs now. And in the 50's PE ratio was about half it is now! The odds of a 5-6% return without huge variance over the next 10-20 years dont look good to me at all.

 

To break it down, ~4% of GDP growth came from debt growth, 1% productivity growth, and about 1.5% from population growth. This is nominal GDP growth, and an index roughly tracks nominal growth?

 

This growth:

 

Comes mostly from debt growth. And the fact that multiples were low in the 50's. I dont think the odds would be good to see a repeat in this, given that debt is unlikely to grow and population is actually likely to shrink in the first world!

 

Looking at this, you can see that in a leveraging and then a deleveraging, you would ahve done badly with the S&P 500 in the first 50 years of the 20th century:

 

Might as well buy real estate then? At least you would have made something in rental payments. (edit: i guess you get dividends, but with real estate, your networth has less volatility).

 

I guess to conclude, my thesis that an index fund is a really bad idea now is based on the fact that growth comes from three things, productivity (more money can be spent on other things and costs come down), debt growth and population growth.

 

So to be wrong here you would have to see productivity growth accelerating. Since the other ones are extremely unlikely to grow.

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This is just common sense thinking, but I think market growth looks like the following:

 

GDP growth + inflation + productivity gains = market return

 

The market cannot grow faster than those things.  If something is growing faster something is growing slower.  The caveat is companies that are part of a country market but have operations elsewhere.  So in a 2% GDP country where all of the companies are operating in 10% GDP growth Africa for example the market could grow much faster.  I don't believe that's the norm.

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The one addition is the change in valuation from one period to another.  John Bogle has a nice simple return estimation as dividend yield + earnings growth + change in earnings yield.  One key for index funds is the CMH (costs matter hypothesis).  It is very hard for diversified portfolios to outperform an index after costs.

 

Packer

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I agree.  Maybe, maybe over the next century you get a number like that but I think we are looking at 3-4% over the next 15-20 years, and that is sort of best case scenario.  That being said, I don't know of any better alternatives.  Cash? Only if we go into major depression and you time it right.  Real estate?  That is done here in Canada.  Gold?  It was at $250 in late 90's, who is to say it couldn't lose another 50 or 75% from here and no reason it will beat inflation over any long time period.  Bonds?  What a joke.  I don't know maybe art or some kind of collectible will do better but otherwise I think stocks are a better bet.

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This is just common sense thinking, but I think market growth looks like the following:

 

GDP growth + inflation + productivity gains = market return

 

The market cannot grow faster than those things.  If something is growing faster something is growing slower.  The caveat is companies that are part of a country market but have operations elsewhere.  So in a 2% GDP country where all of the companies are operating in 10% GDP growth Africa for example the market could grow much faster.  I don't believe that's the norm.

 

I think these are only indirectly correlated to the market return, which will be determined by starting level of valuation, growth, and dividends.

 

I agree with yadayada that now might not be a good time to buy an index fund, but a) that'll change when valuations change and b) it's still better than buying an active fund that charges a fee for hugging the index.

 

My advice to 'laymen' friends is to put a fixed amount into index funds every month.

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This is just common sense thinking, but I think market growth looks like the following:

 

GDP growth + inflation + productivity gains = market return

 

The market cannot grow faster than those things.  If something is growing faster something is growing slower.  The caveat is companies that are part of a country market but have operations elsewhere.  So in a 2% GDP country where all of the companies are operating in 10% GDP growth Africa for example the market could grow much faster.  I don't believe that's the norm.

yeah and about 60-70% of gdp growth came from debt growth in the last 60 years. So you get 1% productivity growth (the wildcard) and maybe 0.5% population growth? If the debt load shrinks in the next 20-30 years, then that will cause negative growth. So it seems even 3-4% is probably optimistic? Your lucky if you do 1-2% after inflation? And probably with huge variance. So a decent chance you will have your money locked up for at least 20 years if you dont want to take a loss.

 

So what is the best strategy here as a passive investor? Let's say you have 50k$. How about spreading out in countries with growth, low corruption (relatively), low debt, pe multiple of <15x and still larger population growth then west? And keeping like 50% in cash in case of a market crash in the west.

 

 

 

 

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I think these are good reasons why EM will likely outperform developed in the next 10+ years. GMO forecasts US equities will have negative real returns in their 7-yr forecast, and calls for EM equity to outperform, but still at a modest 3.8% real.

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I think these are good reasons why EM will likely outperform developed in the next 10+ years. GMO forecasts US equities will have negative real returns in their 7-yr forecast, and calls for EM equity to outperform, but still at a modest 3.8% real.

Which EM countries?

 

I have looked at a few, but couldn't really find good exchanges:

 

Botswana

Population: 2m people

Population growth: almost 2%

GDP per capita: 15k$ (higher then Mexico I think?)

Debt GDP: less then 100% total I think (cannot find exact figures)

Government debt GDP: 23%

Corruption: it ranks as least corrupt country in Africa at nr 30. Much lower corruption then China even.

 

And most jobs are in services, and main export seems to be diamonds. They dont have oil. And if I look at stocks, they seem to trade at multiples of around 10x earnings and almost all growing at double digits. But I cannot find a stock index.

 

Malaysia

Population: 30 million people

Population growth: still about 1.5% but shrinking

GDP per capita: 11k$

Debt gdp: 86% for consumer and 55% for government. So about 150% total?

Corruption: ranks at nr 60, still lower then China. But number of people with internet, and literacy, it ranks quite good.

 

I can't find how expensive Malaysia is, as they do have an index fund.

 

It seems putting 25-30% of your money in these two countries would be a better idea then in western countries.

 

For example to illustrate how little corruption these countries have, Italy ranks at place nr 69! And is considered first world. So they both rank better.

 

Jim rogers on Malaysia:

 

South Korea

Population: 50m

Population growth: 0.2 % ( :( )

GDP per capita: 28k$

Debt GDP: government debt is 33% of gdp and consumer debt about 35%? Which seems really low.

Corruption: Can't find exact rating, but it ranks very good on corruption, probably best of 3 so far.

 

And it seems Korean stock index is quite cheap? I dont know where to find exact PE of those. But GDP is growing very slowly. But if North korea opens up, that will cause population growth, and will be very good for South Korea. So with low debt, low corruption, and a lot of high tech industries there, it seems to be a good candidate to invest in for the next 30 years?

 

Jim rogers also thinks Korea is very interesting:

 

If you add up productivity growth, population growth, and an expansion of debt/gdp, then it seems very likely those countries will see a nominal gdp growth of 4-6% in the next 30 years.

 

 

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Philosophical Economics is a great blog to read IMO for thinking about general market valuation, and it tends to contradict a lot of common wisdom (i.e. a piece about a year ago which was negative on Shiller PE's predictive power)

 

But yeah, the way I think about it is that if you invest in the market, your returns are (a) dividend yield, plus or minus (b) change in GDP, © change in corporate share of GDP (pre-tax profit margins), (d) change in tax environment (corporate tax rates), and (e) change in market valuation (required equity rate of return).

 

It seems to me that the last three elements are unlikely to be a significant positive force in stock returns going forward, and may indeed be a drag on returns. Valuations are fairly high [iMO justifiably so given interest rates], corporate tax rates particularly for multinationals are fairly low, and corporations are taking a very big slice of the GDP pie compared to historical norms.

 

Thus, I would rely on dividends and GDP growth only to drive returns, which is very different from the past 50 years, where all of the forces I mentioned have (for the most part) worked in tandem to produce an amazing return for the stock market.

 

 

 

 

 

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http://fortune.com/2011/06/12/buffett-how-inflation-swindles-the-equity-investor-fortune-classics-1977/

 

Buffet said in 1977 that your return will be Return on Equity adjusted for premium to book value.

 

And then in 1999 he changed it to a function of GDP Growth, profit margins and interest rates (which makes it look pretty poor right now).

 

http://www.tilsonfunds.com/MrBuffettStockMarket.pdf

 

Everyone's read these both 100 times, I'm sure, but I digress.

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To break it down, ~4% of GDP growth came from debt growth, 1% productivity growth, and about 1.5% from population growth. This is nominal GDP growth, and an index roughly tracks nominal growth?

 

This is just common sense thinking, but I think market growth looks like the following:

 

GDP growth + inflation + productivity gains = market return

 

The market cannot grow faster than those things.

 

You cannot expect to forever realize a 12% annual increase - much less 22% - in the valuation of American business if its profitability is growing only at 5%. The inescapable fact is that the value of an asset, whatever its character, cannot over the long term grow faster than its earnings do.

 

Inker's paper clearly explains why these comments are wrong.

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Constructive try this:

http://dqydj.net/sp-500-return-calculator/

 

If you dont reinvest dividends your average return is 3.89%, but if you do reinvest them then the  return is 7%. So it is certainly correlated to real GDP growth.

 

Also note that some of this return is due to multiple expansion (id say about 0.5-1%). And buybacks would jack up return without dividends reinvested as well.

 

I guess I should take into account though that if real GDP grows like 1%, you still get a several % boost by reinvesting earnings.

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Also note that some of this return is due to multiple expansion (id say about 0.5-1%). And buybacks would jack up return without dividends reinvested as well.

 

I guess I should take into account though that if real GDP grows like 1%, you still get a several % boost by reinvesting earnings.

 

Yep, and looking at countries over time, those per share effects overwhelm GDP, and make GDP growth uncorrelated with stock market returns.

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yeah it seems you are right, the S&P500 barely moved between 1900 and 1950, and you saw a huge delevering, yet real return is still over 5%.

 

It still seems you are better off investing in emerging countries though. If they have a balanced index, your returns will likely be 6-8% over the long run.

 

If you invested in 1920 when the market was cheap, and sold near the end of the century, your return is 8%! If you invested in 1982 and sold in 1998, your real return is 14% lol. So it can make a huge difference if you start at the right time.

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I think these discussions get confusing because people use some terminology inconsistently.

 

I think when you say return you have to add:

1) is it a REAL return (ie, adj for inflation)?

2) is it a TOTAL return (ie, including dividends)?

3) Is it pre-tax or post tax?

4) Is the return simple the size of the market, or the PER SHARE return (what we really care about)?

 

I believe there is a tremendous body of evidence that clearly states that aggregate market PER-SHARE, PRE-TAX, REAL, TOTAL returns (at the country level) are not *at all* correlated with long term GDP growth.  I think they are certainly correlated (in certain ways, maybe with a lead or lag) with changes in GDP growth from expectations.

 

This seems self evident if you look at a few data points, or just think about how business works.

 

China has grown like a weed for years, but it did so with lots of capital raising and external capital, FDI, etc.  So per share EPS or BPS growth lagged the economic growth adjusted for inflation substantially.  Basically, the growth of China (during the majority of the move) was not necessarily outside of expectations, so there was a lot of capital competition to get a piece of that growth.... driving down returns.

 

Same is true in reverse for slow growing countries... people aren't building up lots of plants etc in Europe to compete... because it's... Europe.  So you would think that marginally European focused firms can make a little more money, or pay a little more dividends, buy a little more stock, etc etc etc.

 

There are of course certain kinds of firms with wonderful moats which can for (perhaps a long time) grow with the economy they are in without getting their margins competed away, but perhaps those firms are the exception, not the rule.

 

The things linked by Constructive above are quite good to read IMO...

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I believe there is a tremendous body of evidence that clearly states that aggregate market PER-SHARE, PRE-TAX, REAL, TOTAL returns (at the country level) are not *at all* correlated with long term GDP growth.

 

I thought there was an inverse correlation?

 

"When measured over long periods of time, the correlation of countries' inflation‐adjusted per capita GDP growth and stock returns is negative."

http://www.alphaarchitect.com/blog/2014/01/31/finance-mythbuster-economic-growth-doesnt-help-investors/#.VNEbxWjF_h4

 

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Isn't the problem with China that financials are heavily overrepresented in the index? It is not very balanced?

 

I really underestimated the effect of reinvesting dividends though. After playing around with that calculator, Even investing in the middle of the dot com boom, and selling now 15 years later, you get a after inflation return of 2%. And in 2002 it is already 4%. So if you average in, then getting less then 4% seems extremely unlikely over a 15-20 year period. Even if another financial armageddon happens in the mean time.

 

Edit: I think what we are confusing here is returns if you DONT invest the dividends. That really skews it. Over the long term, real GDP growth does seem to correlate with growth in value of stocks. If you take out dividends reinvested, then they do correlate almost exactly. So growth of the S&P 500 would correlate, but actual growth if you reinvested dividends, does not correlate. That is much higher.

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I believe there is a tremendous body of evidence that clearly states that aggregate market PER-SHARE, PRE-TAX, REAL, TOTAL returns (at the country level) are not *at all* correlated with long term GDP growth.  I think they are certainly correlated (in certain ways, maybe with a lead or lag) with changes in GDP growth from expectations.

 

 

There is a good book that has data that provides a very compelling case for inverse correlation between GDP growth rate and stock market returns.

 

Triumph of the Optimists: 101 Years of Global Investment Returns

 

Vinod

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I believe there is a tremendous body of evidence that clearly states that aggregate market PER-SHARE, PRE-TAX, REAL, TOTAL returns (at the country level) are not *at all* correlated with long term GDP growth.  I think they are certainly correlated (in certain ways, maybe with a lead or lag) with changes in GDP growth from expectations.

 

 

There is a good book that has data that provides a very compelling case for inverse correlation between GDP growth and stock market returns.

 

Triumph of the Optimists: 101 Years of Global Investment Returns

 

Vinod

 

So this would mean that over long periods stock returns are always negative right?  If countries continue go grow (GDP growth) then returns should be negative over the long haul?  If you extrapolate out a bit it would mean that equity investing is a losing game, as the world grows we're trying to swim against the tide.  Yet this doesn't seem to be the market experience.

 

Since we have numbers the US has grown as an economy and our market has been biased upwards.  So how does this jive with the research?

 

 

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I believe there is a tremendous body of evidence that clearly states that aggregate market PER-SHARE, PRE-TAX, REAL, TOTAL returns (at the country level) are not *at all* correlated with long term GDP growth.  I think they are certainly correlated (in certain ways, maybe with a lead or lag) with changes in GDP growth from expectations.

 

 

There is a good book that has data that provides a very compelling case for inverse correlation between GDP growth and stock market returns.

 

Triumph of the Optimists: 101 Years of Global Investment Returns

 

Vinod

 

So this would mean that over long periods stock returns are always negative right?  If countries continue go grow (GDP growth) then returns should be negative over the long haul?  If you extrapolate out a bit it would mean that equity investing is a losing game, as the world grows we're trying to swim against the tide.  Yet this doesn't seem to be the market experience.

 

Since we have numbers the US has grown as an economy and our market has been biased upwards.  So how does this jive with the research?

 

When you have a lot of growth, doesn't the market typically assign a high multiple to valuations which reduces investment returns?  I think back to when people paid up for emerging markets because you were paying 15-20x for lots of growth.  Returns ended up being negative (so far).

 

When there is almost no growth you have very low market valuations, such as the current situation in Japan.  This allows for higher future investment returns.

 

Seems intuitive to me.

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I believe there is a tremendous body of evidence that clearly states that aggregate market PER-SHARE, PRE-TAX, REAL, TOTAL returns (at the country level) are not *at all* correlated with long term GDP growth.  I think they are certainly correlated (in certain ways, maybe with a lead or lag) with changes in GDP growth from expectations.

 

 

There is a good book that has data that provides a very compelling case for inverse correlation between GDP growth and stock market returns.

 

Triumph of the Optimists: 101 Years of Global Investment Returns

 

Vinod

 

So this would mean that over long periods stock returns are always negative right?  If countries continue go grow (GDP growth) then returns should be negative over the long haul?  If you extrapolate out a bit it would mean that equity investing is a losing game, as the world grows we're trying to swim against the tide.  Yet this doesn't seem to be the market experience.

 

Since we have numbers the US has grown as an economy and our market has been biased upwards.  So how does this jive with the research?

 

The stock market is a discounter of the future? So maybe market goes up when gdp is declining, but expectations are that gdp will rise in the future? Depends on if you take rolling 5-10 year correlations, or 1 year correlation snapshots. I don't know.

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I believe there is a tremendous body of evidence that clearly states that aggregate market PER-SHARE, PRE-TAX, REAL, TOTAL returns (at the country level) are not *at all* correlated with long term GDP growth.  I think they are certainly correlated (in certain ways, maybe with a lead or lag) with changes in GDP growth from expectations.

 

 

There is a good book that has data that provides a very compelling case for inverse correlation between GDP growth and stock market returns.

 

Triumph of the Optimists: 101 Years of Global Investment Returns

 

Vinod

 

So this would mean that over long periods stock returns are always negative right?  If countries continue go grow (GDP growth) then returns should be negative over the long haul?  If you extrapolate out a bit it would mean that equity investing is a losing game, as the world grows we're trying to swim against the tide.  Yet this doesn't seem to be the market experience.

 

Since we have numbers the US has grown as an economy and our market has been biased upwards.  So how does this jive with the research?

 

Dont take it too literally. It just means it would be a a bad idea to expect higher equity returns just because it has a higher growth rate.

 

The data if you care to look in the book, shows that countries that have higher growth rate are priced higher. So equity returns tended to disappoint investors who naively investing in high growth countries. Does this remind you of value investing?

 

Part of the explanation is also that to fund additional growth you need to make additional investments via debt and stock market issues which dilute existing shareholders.

 

Vinod

 

 

 

 

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Fwiw, it seems productivity growth was over 2% in the last 65 years. Cannot find data before that, but would be interesting. I can imagine it would be massive as we went from horses to ocean flights in 50 years. So I can imagine a huge increase there as well.

 

So 2% in productivity and about 1% in population growth. Debt load grew 4% a year since 1950. Nominal GDP grew 6.5%. Real gdp about 3.3%. I guess you add up debt growth, money printed and population growth and you get Nominal GDP? Then you subtract inflation and add back productivity growth?

 

So if productivity growth was 2% , then real inflation was like 5%? But productivity growth of 2% partially made up for that, to net out at about 3%?

 

A reason why earnings growth is not correlated could be that a bigger share of the pie is generated by a smaller amount of conglomerates? Like how you used to have lot's of convenience stores in the 50's, and now it is just walmart? That must impact the S&P 500 quite a bit. You used to have lot's of smaller brands of ketchup and beans, and now it is just Heinz? Lot's of car companies to only a few large ones etc.

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