Summary
The article studies the relationship between investments and the returns on equity markets, along with the economic growth. It strives to demonstrate the fact the equity market performance is dependent upon the earnings growth of the companies and the earnings growth is somewhat capped by the real GDP growth of the economy as a whole. In other words, the equity markets are not to be conceived as a medium which could generate supernormal returns; instead, the return could be capped at about 4% over the real GDP return.
Review
The article highlights the fact that an economy will attract investments as long as the marginal return (represented by the marginal product of capital) is higher or equal to the cost of capital. The companies (which constitute the economic and commercial activities of the economy) will grow at a higher rate than inflation as long as the marginal product is equal to the cost of capital. Once that level is reached, the companies will be able to generate a return which is identical to the real GDP growth of the economy. In short, the companies will be able to generate a higher return than the GDP in the short run, but the return would be somewhat capped by the real GDP growth in the long run. This will have a direct impact on the returns of the capital markets. The real GDP growth seeks to impose theoretical limits on the earnings of the growth of the commercial entities
The above mentioned facts explain as to why the real long term growth for any economy remains constant with a positive bias. Much of the growth is also based on increase in consumption based demand owing to the increase in population. The capital markets constitute the weighted average of the outstanding shares of the listed companies. The listed companies can be said to be a replication of the actual economy operating within the country. The capital market return is dependent on the return of the shares of the listed companies. The performance of the listed companies is in turn is dependent upon their financial performance. As discussed and explained earlier the financial performance of the companies are capped by the real GDP growth. In other words, the returns on the capital markets can be assumed to be only slightly higher than the real GDP growth of the economy.
The article has studied the long term trends of earnings as a percentage of GDP and through the years 1947 to 2008 and also studied the percentage of earnings of the S & P as a percentage of GDP for the same corresponding period. It was noticed that both the above mentioned data did not follow any specific trend as such, but over the long term they ended more or less on the same proportion where they had started. Thus there was only a marginal increase in the percentage over the long term. It was also noted that the major contributors to the earnings growth was from relatively newer firms (start ups). The major reason cited behind the phenomena is that the firms which have already achieved substantial size are not expected to achieve phenomenal growth as they might have already exploited their resources to the fullest. The newer companies in the start up phase are expected to contribute higher proportion to the growth as they begin to utilize the resources as the marginal output for the use of resources is higher for the start up phase companies. It is also well known that the high growth startup companies keep getting listed on the bourses to boost their overall earnings growth. This is another reason as to why the equity investments give a higher return than the real GDP. However, it must also be noted that equity investments don’t give a much higher return than the real GDP, majorly because it is understood that the equity markets is a comprised of weights of all types of listed entities whereby some companies are start ups with high growth prospective while other companies may be reporting growths in the lines of real GDP only. Moreover, the high growth period for startups doesn’t last forever. The high growth period for the start up entity could last for 5-7 years after which the growth on these companies also come down to levels which mirrors the GDP growth. A few listed entities also report a growth lower than the real GDP. In other words, the equity investments are expected to give a return over and above the real GDP, but the premium should not be expected to be huge.
Conclusion
The article helps us draw a conclusion that the return on equity market depends hugely on the economic growth (represented by the real GDP growth). This is so because the growth of the listed entity is dependent on the economic growth and the return on equity is dependent on the growth witnessed and perceived for the particular listed entity. Thus it would be safe to assume that the return on equity over the long term should hover around 3-4% higher than the real GDP growth.