If you are an investor in the stock market, it makes sense to understand the nature of stock market returns. If you are trying to outperform the market, you need to understand how the market works. The long-term performance of the stock market is not based on chance, but rather is largely explained by the growth of corporate profits.
As Keynes noted, this growth occurs because, in aggregate, corporations, “Do not as a rule, distribute to shareholders the whole of their earned profits. In good years, if not in all years, they retain a part of the profits and put them back in the business. Thus there is an element of compound interest (Keynes’ italics) operating in favor of sound industrial investment.” This is exactly the same thing that happens when you add money to a savings account. Assuming a steady rate of return, if you increase the funds in your account by 10%, your yield will go up by 10%.
Since 1950, firms in the S&P 500 have, on average, earned approximately 12% annually on their invested capital. This figure, which is often referred to as return on equity, is a highly useful figure because it measures how effective a company is in utilizing its capital.
On average, firms in the S&P 500 have paid out 50% of their earnings in the form of dividends and retained the balance for reinvestment in their business. (This example does not consider other uses of capital, such as share repurchases, spin-offs, etc.) In round numbers, this reinvestment of 6% – half of the 12% return on equity of companies in the S&P 500 – largely explains the growth in corporate profits over the past hundred years.
If you had a savings account earning 12% annually, and you spent half the interest and reinvested the balance, your 12% yield would grow at a rate of 6%. The reason is that you would have increased your invested capital by 6%, and this additional capital would also earn a return of 12%.
If you’re wondering why the S&P 500 does has not historically paid a dividend yield of 6%, it is because, on average, investors in U.S. equities have paid over two times book value for stocks. The same thing would happen if you deposited $1 million in a savings account that paid 12%, but you had to pay a $1 million one-time surcharge to gain access to this rate of return; it would cut your effective yield in half. In the past twenty years, dividend yields have declined as average stock valuations have increased and as corporations have returned larger amounts of capital in the form of share repurchases in lieu of higher dividends.
This growth in corporate profits of 6% roughly tracks the growth rate of the United States’ gross domestic product (GDP), which is a broad measure of the country’s overall economic output. The GDP’s average growth rate has historically comprised about 3% real growth plus an additional 3% from inflation. The relationship between the growth in corporate profits and GDP is firmly established and grounded in the fact that corporate profits are a significant component factor of GDP, which is an aggregate figure. Historically, after-tax corporate profits have fluctuated in a range of 4.5% to 6% of GDP. These profits have at times ballooned to 10% of GDP and shrunk to 4%, but consistently regress to a mean of around 6%.
Given the relationship between corporate profits and GDP, your expectations for stock market returns should be grounded in your assumptions about GDP. Looking forward, if you expect GDP to grow at a 5% – 3% real growth plus an additional 2% for inflation – then you can expect stocks to grow at a similar rate. Add in 2% for dividends and that gives you an expected total return of 7%. Of course, if 2% or more of the growth comes from inflation, your real return will only be around 5%, which is certainly much lower than what many investors are expecting.