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Seriously, why does the market as a whole go up?


whiterose
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This is maybe a naive and possibly a philosophical question, but please hear me out:

I was wondering, why the market as such, let's say the S&P500 is expected to rise x% per year and even has been historically (7-10%) over long periods of time.

 

If one would assume, in an ideal world, stocks are (fairly) valued, based on discounting all of the real future cashflows, shouldn't the inflation adjusted price be essentially flat over time? It can only rise if there are some not yet discovered/materialised profits on the way (for now irrelevant to where they come from). Is it because investors as a group structurally underestimate positive surprises in growth/innovation/efficiency-gains?

 

I would like your thoughts on the matter, maybe I am missing something. Thanks!

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Assuming no inflation, you can value market as growing perpetuity ( http://www.pitt.edu/~schlinge/fall99/example_growth.htm ):

 

PV0 = C0 / ( r - g )

 

Since C grows at rate g, your PV next year will be:

 

PV1 = C1 / ( r - g ) == C0 * ( 1 + g ) / ( r - g )

 

Voila your market price just went up g%.

 

Now, maybe you will argue that inflation should have gone up g% too, but that's not necessarily true IMO. I'll let my chauffeur address this issue ( https://natarajank.com/2014/06/27/joke-of-the-day-my-chauffeur-will-answer-your-question/ ).

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I guess the short answer would be: inflation + real interest rate + equity risk premium = rate of return.

 

You're missing the fact that future cash flows are discounted at a discount rate which is equal to the theoretical rate of return. You wouldn't discount future cash flows at 2%

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I am not entirely sure what you are getting at.  The assumptions in all the other answers are missing the real reason markets go up: Rising population.  At some point in our lifetimes populations are going to stabilize or even shrink.  Markets will no longer rise as rapidly as they have in the past once that happens.  Japan is your leading indicator for this scenario. 

 

There will be some growth due to technology advance, but no inflation, and the 7-10% growth of the past will never be seen again.  But without inflation, lesser returns will be acceptable.  I actually think alot of the world is starting to exhibit slower growth due to slowing population growth now.  I think this is partly why all this ammo (QE) cant juice the major world economies the way it would have in the past. 

 

Governments, business, and investors are in denial: This time it really is different.

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@Jurgis

There is some uncertainty about g, but shouldn't the market guess future g and discount it at time 0 so that PV(1) or PV(infinity) can be derived/computed?

 

Like if you use the rate of return(inflation + real interest rate + equity risk premium) as the discount rate, isn't the PV kind of static(-/+error term as time goes by), assuming the "forecast" is validated by future observations/data?

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Check out Paths to Wealth through Common Stocks by Phillip Fischer, the *only* reason stocks go up is sentiment, not cash in the bank, not the 'truth'. There is some vague connection with inflation and growth in earnings but it could be anything. It could track this imaginary line below, at, or above forever or it might not for some mysterious and quarky reason. To some degree, the unpleasant truth is that stocks are a mass delusion but it's not something you have to worry about too much at the extremes. Now if you control the income stream, you really don't care, take your dividends and hope to negotiate a mutual sale at some future date (fingers crossed that the other party sees the logic of the valuation).

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I am not entirely sure what you are getting at.  The assumptions in all the other answers are missing the real reason markets go up: Rising population.  At some point in our lifetimes populations are going to stabilize or even shrink.  Markets will no longer rise as rapidly as they have in the past once that happens.  Japan is your leading indicator for this scenario. 

 

There will be some growth due to technology advance, but no inflation, and the 7-10% growth of the past will never be seen again.  But without inflation, lesser returns will be acceptable.  I actually think alot of the world is starting to exhibit slower growth due to slowing population growth now.  I think this is partly why all this ammo (QE) cant juice the major world economies the way it would have in the past. 

 

Governments, business, and investors are in denial: This time it really is different.

 

This is incredibly interesting to think about.

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I am not entirely sure what you are getting at.  The assumptions in all the other answers are missing the real reason markets go up: Rising population.  At some point in our lifetimes populations are going to stabilize or even shrink.  Markets will no longer rise as rapidly as they have in the past once that happens.  Japan is your leading indicator for this scenario. 

 

There will be some growth due to technology advance, but no inflation, and the 7-10% growth of the past will never be seen again.  But without inflation, lesser returns will be acceptable.  I actually think alot of the world is starting to exhibit slower growth due to slowing population growth now.  I think this is partly why all this ammo (QE) cant juice the major world economies the way it would have in the past. 

 

Governments, business, and investors are in denial: This time it really is different.

 

This is incredibly interesting to think about.

 

Incredibly terrifying when you think about how national finances have deteriorated alongside. Eventually, you'll have records amount of debt owed and far fewer people left to pay it.

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The assumptions in all the other answers are missing the real reason markets go up: Rising population.

 

http://www.efficientfrontier.com/ef/402/mep.htm

 

These results shed a small amount of light on the sources of equity returns. GDP rises are good for stock prices only when they come from increases in individual productivity, as measured by per-capita GDP; they are bad when caused predominantly by population growth. The classic case of the latter is Pakistan, which, believe it or not, had the second highest gross GDP growth rate in our sample, but also one of the highest population growth rates. Needless to say, the Karachi Stock Exchange has not been a happy place the past four decades.
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There will be some growth due to technology advance, but no inflation, and the 7-10% growth of the past will never be seen again.  But without inflation, lesser returns will be acceptable.  I actually think alot of the world is starting to exhibit slower growth due to slowing population growth now.  I think this is partly why all this ammo (QE) cant juice the major world economies the way it would have in the past. 

 

Governments, business, and investors are in denial: This time it really is different.

 

The growth in M2 money supply has been significant over the last 8 years. However, the velocity of M2 money supply is at very low level, historically speaking. If the velocity of M2 normalizes over time and money supply continues to grow then it's hard to not expect future inflation, no? Chou raise this concern and I think it's a good one.

 

M2 Money Supply:

 

http://i728.photobucket.com/albums/ww289/MikeNCathy/image_zpsafkdjzjs.jpeg

 

Velocity of M2 :

 

http://i728.photobucket.com/albums/ww289/MikeNCathy/image_zpstfniddz4.jpeg

 

 

 

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There will be some growth due to technology advance, but no inflation, and the 7-10% growth of the past will never be seen again.  But without inflation, lesser returns will be acceptable.  I actually think alot of the world is starting to exhibit slower growth due to slowing population growth now.  I think this is partly why all this ammo (QE) cant juice the major world economies the way it would have in the past. 

 

Governments, business, and investors are in denial: This time it really is different.

 

The growth in M2 money supply has been significant over the last 8 years. However, the velocity of M2 money supply is at very low level, historically speaking. If the velocity of M2 normalizes over time and money supply continues to grow then it's hard to not expect future inflation, no? Chou raise this concern and I think it's a good one.

 

M2 Money Supply:

 

http://i728.photobucket.com/albums/ww289/MikeNCathy/image_zpsafkdjzjs.jpeg

 

Velocity of M2 :

 

http://i728.photobucket.com/albums/ww289/MikeNCathy/image_zpstfniddz4.jpeg

 

 

 

 

It would seem to me that the inflation we had from the 70s to the early 00s was primarily driven by the demand side of the equation: the baby boom generation across many of the countries that were principals in WW2.  Maybe these other factors will have temporary inflative effects. 

 

I usually stay out of macro discussions but this idea is greater than macro.  The lack of growth in returns from stock markets and other asset classes does not imply no profits.  It just implies a much lower growth rate. Perhaps what Matjone suggests. 

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The assumptions in all the other answers are missing the real reason markets go up: Rising population.

 

http://www.efficientfrontier.com/ef/402/mep.htm

 

These results shed a small amount of light on the sources of equity returns. GDP rises are good for stock prices only when they come from increases in individual productivity, as measured by per-capita GDP; they are bad when caused predominantly by population growth. The classic case of the latter is Pakistan, which, believe it or not, had the second highest gross GDP growth rate in our sample, but also one of the highest population growth rates. Needless to say, the Karachi Stock Exchange has not been a happy place the past four decades.

 

Of course there will be examples of the opposite in a dynamic world.  It would be interesting to clean up, and update that data set to reflect the last 20 years, in which several countries are on the verge of shrinking.  Over time, as population growth slows, demand for goods also slows, and an aging population is generally not a posiitve sign for an economy, all other things being equal. 

 

This can be seen in real time if you look at cities like Leipzig, or Detroit.  Detroit is 250 km from Toronto, has the same climate, the same location, on a Great Lake, and major highways, railways etc.  Due to its social issues, Detroit has shrunk.  As a result real estate is less than 1/5 the cost as in Toronto.  I have no proof of this but I am guessing that Laudromats, restaurants, cafes, and Home Depots in Toronto are collectively more profitable than Detroit.  Detroit is an extreme example with an actual decline in population.  Only a handful of countries are headed for actual declines at the moment.  My thought is that slowing population growth will lead to slowing profit growth for most companies, and slowing stock price appreciation, not outright shrinkage. 

 

edit: Strike Leipzig: It seems to have undergone something of a rennaissance lately.

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@Jurgis

There is some uncertainty about g, but shouldn't the market guess future g and discount it at time 0 so that PV(1) or PV(infinity) can be derived/computed?

 

Like if you use the rate of return(inflation + real interest rate + equity risk premium) as the discount rate, isn't the PV kind of static(-/+error term as time goes by), assuming the "forecast" is validated by future observations/data?

 

That's not true. You misunderstand PV calculations. Assuming stable growth and stable interest/discount rate, PV0 is not going to be equal to PV1. That's true even if you and every participant of the market have perfect knowledge and know g and r until eternity.

 

Edit: PV0 won't be the same as PV1 even if growth ceases at some point in the future.

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If we're just the boot sequence to an AI operating system, there probably isn't a lot of time left before all our concepts of earnings or markets disappear or become unrecognizable.  Maybe a couple hundred years?  On a cosmic scale it's basically happening tomorrow.  In the meantime we're stuck on this spinning rock being ejecting into the void of space, destined for certain heat death, confined to a fleshy body unsuitable for interstellar travel, and living in the 0.00000000000001% of history that upwards "S&P 500" or "real earnings" even matters.  Enjoy the ride ladies and gents. 

 

Wait, this isn't the drinking thread?

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There will be some growth due to technology advance, but no inflation, and the 7-10% growth of the past will never be seen again.  But without inflation, lesser returns will be acceptable.  I actually think alot of the world is starting to exhibit slower growth due to slowing population growth now.  I think this is partly why all this ammo (QE) cant juice the major world economies the way it would have in the past. 

 

Governments, business, and investors are in denial: This time it really is different.

 

The growth in M2 money supply has been significant over the last 8 years. However, the velocity of M2 money supply is at very low level, historically speaking. If the velocity of M2 normalizes over time and money supply continues to grow then it's hard to not expect future inflation, no? Chou raise this concern and I think it's a good one.

 

M2 Money Supply:

 

http://i728.photobucket.com/albums/ww289/MikeNCathy/image_zpsafkdjzjs.jpeg

 

Velocity of M2 :

 

http://i728.photobucket.com/albums/ww289/MikeNCathy/image_zpstfniddz4.jpeg

 

 

 

 

It would seem to me that the inflation we had from the 70s to the early 00s was primarily driven by the demand side of the equation: the baby boom generation across many of the countries that were principals in WW2.  Maybe these other factors will have temporary inflative effects. 

 

I usually stay out of macro discussions but this idea is greater than macro.  The lack of growth in returns from stock markets and other asset classes does not imply no profits.  It just implies a much lower growth rate. Perhaps what Matjone suggests.

 

This is a historical account of federal reserve policies during the high inflation period peaking late 70's and early 80's. When I read it, I keep in mind the current situation with respect to the growth in money supply.

 

http://www.federalreservehistory.org/Period/Essay/13

 

 

    While economists debate the relative importance of the factors that motivated and perpetuated inflation for more than a decade, there is little debate about its source. The origins of the Great Inflation were policies that allowed for an excessive growth in the supply of money—Federal Reserve policies.

 

From the chart above you can see the velocity of money from 1965 - 1980 was trending up while the money supply was increasing swiftly.

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PV0 won't be the same as PV1 even if growth ceases at some point in the future.

 

Ok that's true, but shouldn't then P1 be discounted again to P0?

According to an admittedly simplified Dividend Growth Model:

P0 = D1/(r-g) ~ (D2/(r-g))/r ?

 

The point is, could the market in the 1960s e.g. had predicted current earnings from 2016 and then discounted them correctly. It would be cool to have 40y rolling eps predictions to see the possibly permanent underrating of g or overrating of r.

 

 

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This is maybe a naive and possibly a philosophical question, but please hear me out:

I was wondering, why the market as such, let's say the S&P500 is expected to rise x% per year and even has been historically (7-10%) over long periods of time.

 

If one would assume, in an ideal world, stocks are (fairly) valued, based on discounting all of the real future cashflows, shouldn't the inflation adjusted price be essentially flat over time? It can only rise if there are some not yet discovered/materialised profits on the way (for now irrelevant to where they come from). Is it because investors as a group structurally underestimate positive surprises in growth/innovation/efficiency-gains?

 

I would like your thoughts on the matter, maybe I am missing something. Thanks!

 

The time value of money is your answer.  Cash flow X, to be paid on date Y, gets discounted by rate Z to give its value today.  As time passes, you discount by less time and so the value today rises, even if your assumptions for X and Y were perfect.

 

Uccmal's point about population growth feeds into GDP, which feeds into the growth rate you assume in calculating future cash flows.  But I think your original question was less about what drives cash flows up, and more about why (if the market has already efficiently estimated and discounted future cash flows) the inflation-adjusted price rises over time.  The answer to that is the time value of money.

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