It looks like the entire country is being gamed by politicians, unions and Wall Street. This is a prime 3 way example. Who manages the money? Some Wall Street group most likely. What do they get? A percentage. What is the plan? To sell the states overpriced stock. Who is going to gain? Probably no one, as the system is going to go broke. If it doesn't go broke, the above groups, save maybe the politicians who haven't arranged bribes, are going to be unjustly enriched.
So, we have a group that is having 30% of its income saved without any effort. The payout is based on ending salaries. If we have inflation, the ending salaries will go up with the CPI, if not faster. This eliminates the inflation part of the return on stocks. You can't inflate yourself out of these debts, but with 5% inflation, 8% should be available on bonds. This would work if there are no COLA's in the pension plans.
But, inflation increases volatility in the system, because it is the expansion of debt in excess of the growth in the economy. Interest rates will always normalize, Fed or no Fed and the assumptions of expenditures always comes up short of actual expenses. Debt always has to be paid or the principal lost.
The 8% assumption cannot be met without 5% inflation. As stated above, if that occurs, the payout side goes up and you have the snake swallowing his tail. I know stocks are supposed to yield something over time, but this is one more compound equation that cannot work. The financial valuation of stocks relates to what stock pay the shareholder, not what the market will pay for them at any given time. The later of these examples will show up from time to time, but this is what tops are made of, not what returns are made of. We have been in the later to some degree since 1987, with a blow between 87 and about 1992. 3% dividends are historically peak values that are followed by bear markets, as shown from 1929 and 1966. Real returns are dividends plus 1% on the bullish side and history is worse than that.
The point being we have a market that is valued in excess of GDP. GDP grows 3% plus inflation, the valuation of the market cannot grow more. If we are on a bottom and dividends are 6%, then we might be looking at a market valued at 40% of GDP. In that case, GDP can expand at a 3% real rate and the compound formula favors the market. The peaks in 29 and 66 were at 80% of GDP. The 2000 peak was over double GDP. At that point, potential growth would be limited to 1/2 nominal GDP or about 2.5% to 3%. This is not the path to the pearly gates of prosperity.
What is a stock but an open-ended bond with a variable payout? You are promised back zero and because you are promised back zero, there has to be an additional risk factor. Because this is an open-ended security, you can't use a valuation method that centers around the present and instead have to incorporate risk factors that encompass forever. This is especially true of one isn't a professional speculator (very few ever come out of that game intact)and have an investment philosophy of buy and hold. Thus, you can't compare stocks to 10 year treasuries or CD's or any of the sort. If you could find a 70 year treasury bond and add 3% to the rate, this would be a good discount for stocks.
I hope you guys are following this, as I am sure Karl is. A market with a value in excess of GDP cannot grow in excess of GDP forever. This would favor stocks only if the dividend yield was the actual return. But, the valuation model in stocks is dividend plus the rate of growth in dividends, not PE ratios, which are creations of accounting and other nonsense. Earnings do not flow from stocks, dividends do. Earnings go into the reinvestment formula of stocks, but nothing is guaranteed on investment and we are still looking at economic growth at best.
This brings us to the real conclusion that should be drawn out of this assumption. If the market is performing so well, where is the economic growth? China? Who owns the means of production in China? Is it corporate USA? If it is, then the foreign reserves of China actually belong to corporate USA. If it is the USA, where is the growth? Europe is a shrinking market and so is Japan. Thus if earnings are as high as stated, the investments being made are not paying off and we fall back into the compound formula and historical corporate profits, which are now being claimed to be among the highest in history against the GDP. The last record in this factor was the late 1920's. We all saw what followed.
To straighten out what I have written to layman's terms, Return equals dividend plus a maximum of 1% plus inflation. The return in stocks is a straight discount of the dividend with the growth factor subtracted out. To make 8% on the SPX, we would need 6% nominal GDP growth multiplied by the percentage of market value to GDP. Thus if the market was 50% of GDP, we would need 3% growth. If it is 120% of GDP, we would need 7.2% nominal growth. I would venture we are right about 100% at the present, but I also suspect GDP is on shaky ground.
I have thought about a scenario of where dividends would be 8%. For one, arbitrage would scrub that factor out, as long term the risk premium on stocks is 3% above risk free. 8% is about 3% above this factor. Also, 8% would take 75% off current valuations, so the growth would have to come from a lower level, using the current model. Also, corporate profits would have to be around 16% to 20% of GDP in order to support a market valued at 100% of GDP. I doubt this could be supported without there being a more population wide distribution of stock ownership.
Karl used 3% and I support that figure, if for no other reason than that is the dividend plus real growth number. Inflation is a zero factor, as it adds and subtracts at the same time and as I stated above, increases risk. If you are my age, you can recall the start and stop economies of the 1970's, where we had 2 recessions like the one we just had and a couple more in about 14 years. People under 40 haven't seen this mess before, but those of us between 48 and 60 came of age in this mess.
If someone wants a model that would support a proposed 5.5% real rate of return, they probably need to wait for stocks to trade at about 50% of current values and for the debt problem to be cleared out. This means the 2009 bottom was the buy point and nothing above that, save for some very select shares. What is going on now is nothing but pump and dump and it would be wise if the States kept their money out of the market, instead of the forced buying at double the price to achieve the return. Time won't fix this, as the purchase of stocks are a purchase of an open-ended security where you buy a return at the time of purchase and the tooth fairy doesn't show up to fix your mistake. At some time, the market is going to revalue, most likely when the world economy is going to be forced to deflate or collapse. Then it takes 14 years to break even on a 50% loss at a 5% growth rate. When we leave these valuations, it will be another generation before we see them again. http://market-ticker.org/akcs-www?post=178634&findnew#new