Why does the stock market beat inflation?

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protagonist
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Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 12:40 pm

Over the course of my investing career I have heard the same mantra, that given enough time, the stock market beats inflation. I have heard annual expected market gains over time quoted as 8%, 10%, 12% depending on when the quoting was done. But is this really true, or just evidence that we are in the midst of a long bull market? And if it is true, why is it true? If it is true, there must be a "why".

I googled "Why does the stock market beat inflation?" in many forms, and did not get one satisfactory answer, or (surprisingly) even an attempt to explain it, in the first few pages of hits. The hits mainly centered around "it does", or "it did during x years", or by how much.

Assuming a DOW in 2014 of 17000, and based on an assumed annual gain of 8%, the DOW will be around 171,000 in 2044 when today's retirees will be dying, 37,396,000 in 2114 , 8.2x10*10 in 2214, and 1.8x10*15 in 2314. That's some serious industrial growth.

Can anybody explain WHY the stock market should beat inflation? Please focus on the WHY.

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Re: Why does the stock market beat inflation?

Post by VictoriaF » Tue Oct 14, 2014 12:46 pm

Stocks represent ownership of companies. When the value of a company rises, its stock price rises.

Companies create products. Inflation represents rise in products' prices; companies sell products at higher prices. As companies sell products at higher prices, their revenues rise, their value rises, their stock prices rise.

Victoria

EDIT: The above statements do not imply that stock markets beat inflation. They show that stock prices are correlated with inflation. Other factors are important, including taxes as discussed in the thread linked by Toons.
Last edited by VictoriaF on Tue Oct 14, 2014 1:00 pm, edited 1 time in total.
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Re: Why does the stock market beat inflation?

Post by Toons » Tue Oct 14, 2014 12:47 pm

"One does not accumulate but eliminate. It is not daily increase but daily decrease. The height of cultivation always runs to simplicity" –Bruce Lee

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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 1:01 pm

VictoriaF wrote:Stocks represent ownership of companies. When the value of a company rises, its stock price rises.

Companies create products. Inflation represents rise in products prices; companies sell products at higher prices. As companies sell products at higher prices, their revenues rise, their value rises, their stock prices rise.

Victoria
Wouldn't that imply that, given enough time, stocks would keep pace with inflation? Why would they exceed it, and by such a large amount?

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Re: Why does the stock market beat inflation?

Post by nordlead » Tue Oct 14, 2014 1:04 pm

protagonist wrote:
VictoriaF wrote:Stocks represent ownership of companies. When the value of a company rises, its stock price rises.

Companies create products. Inflation represents rise in products prices; companies sell products at higher prices. As companies sell products at higher prices, their revenues rise, their value rises, their stock prices rise.

Victoria
Wouldn't that imply that, given enough time, stocks would keep pace with inflation? Why would they exceed it, and by such a large amount?
Because they produce stuff. Let's say there is no inflation. Would you expect a company to turn a profit and increase in value?

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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 1:12 pm

Toons wrote:Prior thread on subject :happy

http://www.bogleheads.org/forum/viewtopic.php?t=58614
Scanning this thread, I see many explanations for why stocks keep up with inflation or are a good hedge against inflation. I understand that. This would also be my assumption. What I don't understand is why stocks should be assumed to BEAT inflation over the long term.

Certainly an assumed growth rate of 8%-10%+ annually is not only an assumption that it will BEAT inflation (given long-term inflation rate trends), but that it will beat it by a HUGE margin. Why should that happen?

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Re: Why does the stock market beat inflation?

Post by enc0re » Tue Oct 14, 2014 1:19 pm

Oversimplified, but true:

Real GDP, meaning GDP after inflation, grows over the long run. This is a measure of everything we produce. As a shareholder, you own a slice of that production. Because production grows in real terms, you are getting richer in real terms.

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Re: Why does the stock market beat inflation?

Post by avalpert » Tue Oct 14, 2014 1:21 pm

Because the economy grows, technology advances and companies get more productive - this explains why they have and why we expect them to continue to but it doesn't guarantee that the march of human history will continue.

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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 1:22 pm

nordlead wrote:
protagonist wrote:
VictoriaF wrote:Stocks represent ownership of companies. When the value of a company rises, its stock price rises.

Companies create products. Inflation represents rise in products prices; companies sell products at higher prices. As companies sell products at higher prices, their revenues rise, their value rises, their stock prices rise.

Victoria
Wouldn't that imply that, given enough time, stocks would keep pace with inflation? Why would they exceed it, and by such a large amount?
Because they produce stuff. Let's say there is no inflation. Would you expect a company to turn a profit and increase in value?
If wages and inflation are said to correlate strongly (as would make sense), then long-term data from Sweden would imply that inflation is certainly not a given. Quoting a post of mine from a previous thread:

"Does anybody else find this interesting? Maybe it's just me. It was on the webpage of the Swedish Riksbank. http://www.riksbank.se/Upload/Dokument_ ... 28_eng.jpg

Observations:
-Real wages stayed fairly constant (+/- about 50%) from 1540 through the mid-19th century and then skyrocketed during the Industrial Revolution. I assume, with hiccups, they continued skyrocketing through the 20th century, two world wars notwithstanding.
-for the first 200 years following 1540, real wages stayed, for the most part, below their 1540 level. fluctuating mostly between 50% and 100% of their 1540 level.
-Wages peaked in a short, rapid rise from about 50% of their 1540 level around 1720 to about 130-140% of their 1540 level around 1735. Whether this had anything to do with the collapse of the South Sea Bubble (which I think, if my memory serves me well, happened in 1720), or whether that was coincidence, I have no idea. I'm not versed in Swedish history.
-From ~1735 through the mid-1800s real wages steadily declined, bottoming out at an all-time low around 1810 (about 40% of 1540 level), then gradually rising and stabilizing until about 1850 when they were still only ~60% of the 1540 level.
-After 1850 the rise was meteoric and steady. By 1900 real wages were at 250% of 1540 levels. I presume due to the Industrial Revolution.


This graph reminded me of what a totally remarkable era we live in. Reliable long-term stock market records are, unfortunately, non-existent. But when we speak of "historical returns" in the stock market, for example, or any market, we are speaking of returns within this short, totally remarkable period, probably commencing with the Industrial Revolution. (note +/- 115 year steep decline/stagnation from 1735 through mid-19th century, declining about 70% from peak to trough, followed by +/- 160 year steep increase).

We are probably caught in the longest and most dramatic "bull market" in human history. It's a wonderful time to be alive. Where we are in this cycle is anybody's guess."

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Re: Why does the stock market beat inflation?

Post by VictoriaF » Tue Oct 14, 2014 1:24 pm

protagonist wrote:
VictoriaF wrote:Stocks represent ownership of companies. When the value of a company rises, its stock price rises.

Companies create products. Inflation represents rise in products prices; companies sell products at higher prices. As companies sell products at higher prices, their revenues rise, their value rises, their stock prices rise.

Victoria
Wouldn't that imply that, given enough time, stocks would keep pace with inflation?
Yes, that's true. I edited my previous statement to reflect this point.
protagonist wrote:Why would they exceed it, and by such a large amount?
Apart from inflation, other factors in the stock pricing include:
- dividends
- general growth of the economy (in real dollars)
- speculation.

The growth of the economy is represented by the GDP growth. If the GDP is predicted to grow, the sum total of the companies is predicted to have a greater value (in real dollars).

These statements reflect some reasons for the expectation of the stock market growth. These expectations may not materialize. The dividends may be cut, the GDP growth may slow down, and the speculation may result in the decline of the stock market value.

Victoria
Last edited by VictoriaF on Tue Oct 14, 2014 1:28 pm, edited 1 time in total.
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Re: Why does the stock market beat inflation?

Post by tsohg » Tue Oct 14, 2014 1:26 pm

One way to think about it is the sum total of global human output (global GDP) has always gone up and will continue to go up due to gains in efficiency through technology, exploiting previously unknown resources, new inventions, etc (barring a global catastrophe). Thankfully, we can ensure we participate in the worldwide growth by owning broadly diversified stocks. It's a good time to be alive. :sharebeer

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Re: Why does the stock market beat inflation?

Post by kenner » Tue Oct 14, 2014 1:30 pm


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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 1:35 pm

tsohg wrote:One way to think about it is the sum total of global human output (global GDP) has always gone up and will continue to go up due to gains in efficiency through technology, exploiting previously unknown resources, new inventions, etc (barring a global catastrophe). Thankfully, we can ensure we participate in the worldwide growth by owning broadly diversified stocks. It's a good time to be alive. :sharebeer
"Barring a global catastrophe" is a HUGE caveat.

There are many who believe that "global catastrophes", "black swans", major unpredictable events, etc are what ultimately drive complex systems, such as financial markets, evolution, human history, etc. The rest (including, for example, the 8% or whatever average annual appreciation of the stock market over the past century or less) is mostly noise.

People say that the market is unpredictable in the short run but more predictable in the long run. This makes little statistical sense to me since signal remains relatively constant whereas noise compounds over time. How confident are you that the DOW will hover around 171,000 in 2044, or exceed 37 million 100 years from now? (figures derived from assumption of 8% annual gains). Do you think that the chances of it exceeding 37 million in 2114 are significantly better than it being at 17000 or less in 2114? I can't answer those questions.
Last edited by protagonist on Tue Oct 14, 2014 1:48 pm, edited 4 times in total.

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Re: Why does the stock market beat inflation?

Post by Clive » Tue Oct 14, 2014 1:37 pm

Think of the simplest of businesses - buy a plot of land, grow and sell stuff.

The land price might generally rise over time with inflation, any profits made from growing/selling stuff on top of that are dividends.

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Re: Why does the stock market beat inflation?

Post by tsohg » Tue Oct 14, 2014 1:47 pm

protagonist wrote:
tsohg wrote:One way to think about it is the sum total of global human output (global GDP) has always gone up and will continue to go up due to gains in efficiency through technology, exploiting previously unknown resources, new inventions, etc (barring a global catastrophe). Thankfully, we can ensure we participate in the worldwide growth by owning broadly diversified stocks. It's a good time to be alive. :sharebeer
"Barring a global catastrophe" is a HUGE caveat.

There are many who believe that "global catastrophes", "black swans", major unpredictable events, etc are what ultimately drive complex systems, such as financial markets, evolution, human history, etc. The rest (including, for example, the 8% or whatever average annual appreciation of the stock market over the past century or less) is mostly noise.
When I said global catastrophe I meant like, a nuclear war or an asteroid strike. Something that stops or reverses human technological advancement. GDP has been rising quickly since the industrial age.

Image
How confident are you that the DOW will hover around 171,000 in 2044, or exceed 37 million 100 years from now? (figures derived from assumption of 8% annual gains). Do you think that the chances of it exceeding 37 million in 2114 are significantly better than it being at 17000 or less in 2114?
They are rhetorical because you know the answers already, we can't know but we make our plans the best we can. :)
Last edited by tsohg on Tue Oct 14, 2014 1:50 pm, edited 1 time in total.

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Re: Why does the stock market beat inflation?

Post by nisiprius » Tue Oct 14, 2014 1:48 pm

For the 17-year period, 1966 through 1982, inclusive, the stock market did not beat inflation. It's a detail, one moment in history, but an important detail.

That is what the much-derided 1979 Businessweek article, The Death of Equities: How inflation is destroying the stock market was all about.
Says Alan B. Coleman, dean of Southern Methodist University's business school: "We have entered a new financial age. The old rules no longer apply."

The one rule whose demise did the stock market in could be summed up thus: By buying stocks, investors could beat inflation. Stocks were a reasonable hedge when inflation was low. But they proved helpless against the awesome inflation of the past decade. "People no longer think of stocks as an inflation hedge, and based on experience, that's a reasonable conclusion for them to have reached," says Richard Cohn, an associate professor of finance at the University of Illinois.
Last edited by nisiprius on Tue Oct 14, 2014 1:52 pm, edited 3 times in total.
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Re: Why does the stock market beat inflation?

Post by Rodc » Tue Oct 14, 2014 1:49 pm

"Barring a global catastrophe" is a HUGE caveat.
Yes. So?

I can plan for minor catastrophes. Not sure what I can do about a global pandemic, nuclear winter, etc. And more to the point I can't solve those problems through investments.

Investing assumes the global economy mostly continues without total collapse. Some day of course it might, if for no other reason than someday our central start will go supernova, burn out, or otherwise fail us. If you have a solution to total collapse that is widely useful I would appreciate hearing about it.

It also will continue to go in fits and starts.

Otherwise we will all be in trouble. But golden retirements have never been guaranteed.
We live a world with knowledge of the future markets has less than one significant figure. And people will still and always demand answers to three significant digits.

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Re: Why does the stock market beat inflation?

Post by avalpert » Tue Oct 14, 2014 2:06 pm

protagonist wrote: People say that the market is unpredictable in the short run but more predictable in the long run.
Who are these people?

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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 2:12 pm

tsohg wrote:
protagonist wrote:
tsohg wrote:One way to think about it is the sum total of global human output (global GDP) has always gone up and will continue to go up due to gains in efficiency through technology, exploiting previously unknown resources, new inventions, etc (barring a global catastrophe). Thankfully, we can ensure we participate in the worldwide growth by owning broadly diversified stocks. It's a good time to be alive. :sharebeer
"Barring a global catastrophe" is a HUGE caveat.

There are many who believe that "global catastrophes", "black swans", major unpredictable events, etc are what ultimately drive complex systems, such as financial markets, evolution, human history, etc. The rest (including, for example, the 8% or whatever average annual appreciation of the stock market over the past century or less) is mostly noise.
When I said global catastrophe I meant like, a nuclear war or an asteroid strike. Something that stops or reverses human technological advancement. GDP has been rising quickly since the industrial age.

Image

Based on your graph, GDP has been growing much, much slower than the stock market. It looks like about a tenfold increase in GDP over the last century or so compared with maybe a thousandfold or so increase in the DJIA (gross estimates). Are assumptions such as yours above creating a "bubble" based on false expectations in the market? If it is not a bubble, there must be a "why" to explain the huge discrepancy between stock market performance and almost everything else.

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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 2:23 pm

avalpert wrote:
protagonist wrote: People say that the market is unpredictable in the short run but more predictable in the long run.
Who are these people?
Many claim that though short term market fluctuations are fairly random, over the long run you should make money in the stock market , and the stock market will outperform nearly everything else. These claims are based on priorresults if you bought and held for long periods from , say, the 1920s through today. We have all seen such claims based on past performance.

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Re: Why does the stock market beat inflation?

Post by nisiprius » Tue Oct 14, 2014 2:25 pm

avalpert wrote:
protagonist wrote:People say that the market is unpredictable in the short run but more predictable in the long run.
Who are these people?
James K. Glassman and Kevin A. Hassett:
The truth is that, over the long-term, stocks are no more risky than bonds or Treasury bills.
They wrote that in 1999, the title of their book was Dow 36,000, and Dow 36,000 was going to happen by early 2005 or "much sooner" because now that investors understood that stocks were no riskier than bonds, they would bid up stocks until the risk premium vanished, which they reckoned would be Dow 36,000.

They also recommended GE, Microsoft, and Tootsie Roll as surefire stock picks.
Last edited by nisiprius on Tue Oct 14, 2014 2:35 pm, edited 4 times in total.
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Re: Why does the stock market beat inflation?

Post by VictoriaF » Tue Oct 14, 2014 2:29 pm

protagonist wrote:
avalpert wrote:
protagonist wrote: People say that the market is unpredictable in the short run but more predictable in the long run.
Who are these people?
Many claim that though short term market fluctuations are fairly random, over the long run you should make money in the stock market , and the stock market will outperform nearly everything else. These claims are based on priorresults if you bought and held for long periods from , say, the 1920s through today. We have all seen such claims based on past performance.
While some people do claim that over the long run one will make money in the stock market, this is not a universal truth.

Bob K had links to some papers showing that over the long run, the expected value of the stock market is higher; but the variability in the returns is also rising, increasing the probability of worse outcomes.

Larry and others have presented an argument that if stocks were getting safer with time, longer-term options would be cheaper than shorter-term ones.

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Re: Why does the stock market beat inflation?

Post by avalpert » Tue Oct 14, 2014 2:35 pm

protagonist wrote:
avalpert wrote:
protagonist wrote: People say that the market is unpredictable in the short run but more predictable in the long run.
Who are these people?
Many claim that though short term market fluctuations are fairly random, over the long run you should make money in the stock market , and the stock market will outperform nearly everything else.
That is not the same thing as saying the market is predictable. It's also not based in historical results - it is based in economic and financial theories on the nature of economic growth, people's expectation on risk compensation etc.

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Re: Why does the stock market beat inflation?

Post by LFKB » Tue Oct 14, 2014 2:35 pm

Assuming a constant P/E or other valuation metric, stocks would theoretically match inflation if companies only increased their earnings due to inflation. Earnings increase due to technological innovation, operational efficiency, population growth, inflation, synergies and so on, all of which allow companies to grow their earnings at a rate in excess of inflation and therefore have stock prices grow more quickly than inflation.

I didn't read the other posts so apologies is someone offered a similar explanation already.

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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 2:41 pm

nisiprius wrote:For the 17-year period, 1966 through 1982, inclusive, the stock market did not beat inflation. It's a detail, one moment in history, but an important detail.

That is what the much-derided 1979 Businessweek article, The Death of Equities: How inflation is destroying the stock market was all about.
Says Alan B. Coleman, dean of Southern Methodist University's business school: "We have entered a new financial age. The old rules no longer apply."

The one rule whose demise did the stock market in could be summed up thus: By buying stocks, investors could beat inflation. Stocks were a reasonable hedge when inflation was low. But they proved helpless against the awesome inflation of the past decade. "People no longer think of stocks as an inflation hedge, and based on experience, that's a reasonable conclusion for them to have reached," says Richard Cohn, an associate professor of finance at the University of Illinois.
One large moment in a very short history. A 17 year period out of maybe 90 or so??

I'm not a doomsayer. I am invested heavily in the market myself. I just think it is important to ask questions.

If we assume that the stock market should probably beat inflation (or anything else) over the long term, we should understand WHY.

And if we assume the market grows at an average 8%/year more or less over the long term and use that assumption in our future financial planning, we should be able to justify that with more than historical figures from a historically short and unusual period of time that could represent a bubble. People were saying 12-15% from now on in the 1990s because somehow we were living in a Brave New World streamlined by technology that changed history. I remember that and I got bitten by it. The tech bubble popped. The NASDAQ is still about 20% off its 20th century high. The Industrial Revolution bubble may still be inflating.

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Re: Why does the stock market beat inflation?

Post by postingname » Tue Oct 14, 2014 3:17 pm

protagonist wrote:

If we assume that the stock market should probably beat inflation (or anything else) over the long term, we should understand WHY.
I did a Google search on "stocks as an inflation hedge", which I think is more neutral than "stocks always beating inflation". A number of articles came up, This one may be to your liking in that it analyzes some of the 'reasons why it's not wise to make blanket statements about the role of stocks and inflation:

Inflation's Impact on Stock Returns

Some of the things discussed:

- expected vs unexpected inflattion
- high vs other kinds of inflation
- the volatility of the stock market during times of inflation

A couple of excerpts:
Most studies conclude that expected inflation can either positively or negatively impact stocks, depending on the ability to hedge and the government’s monetary policy. But unexpected inflation did show more conclusive findings, most notably being a strong positive correlation to stock returns during economic contractions, demonstrating that the timing of the economic cycle is particularly important for investors to gauge the impact on stock returns. This correlation is also thought to stem from the fact that unexpected inflation contains new information about future prices. Similarly, greater volatility of stock movements was correlated with higher inflation rates.
When examining S&P 500 returns by decade and adjusted for inflation, the results show that the highest real returns occur when inflation is 2 to 3%. Inflation greater than or less than the 2 to 3% tends to signal a U.S. macroeconomic environment with larger issues that have varying impacts on stocks. Perhaps more important than the actual returns are the volatility of returns that inflation causes and how to invest in that environment.
There were a number of other articles, the majority of which seemed to say the correlation of stocks with inflation was variable.

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Re: Why does the stock market beat inflation?

Post by tsohg » Tue Oct 14, 2014 4:32 pm

protagonist wrote: Based on your graph, GDP has been growing much, much slower than the stock market. It looks like about a tenfold increase in GDP over the last century or so compared with maybe a thousandfold or so increase in the DJIA (gross estimates). Are assumptions such as yours above creating a "bubble" based on false expectations in the market?
For one thing, that graph is average worldwide GDP (so averaging countries, I believe). In the past century America's GDP has grown at a much faster rate than the worldwide average. I don't know if the growth in the DJIA will continue or if its in a bubble/overpriced currently. All I can do is diversify my investments. I strongly believe the growth trend will continue for the reasons I gave earlier (technology, innovation, efficiency improvements, etc). My statement is about the worldwide market / sum total of human output, not the DJIA.

What actionable alternative do you propose?
And if we assume the market grows at an average 8%/year more or less over the long term and use that assumption in our future financial planning, we should be able to justify that with more than historical figures from a historically short and unusual period of time that could represent a bubble.
I don't see anyone in this thread assuming 8% growth over the long term. Well, besides you.

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Re: Why does the stock market beat inflation?

Post by ogd » Tue Oct 14, 2014 4:57 pm

protagonist: one simple reason, even if you don't buy any of the productivity increases (like you should) is that stock returns consist of present value plus accumulated earnings.

So if everything stays constant, earnings keep pace with inflation, book values keep pace with inflation, but their sum outpaces inflation. Sort of what we expect to see in the real estate market which doesn't have "productivity": rents keep pace, values keep pace, returns exceed.

Of course, you as an investor or someone down the line of heirs will eventually spend proportional with inflation, which would keep this no-productivity-gains outlook sustainable overall.

In different times, I would have said stock values and dividends respectively, but the tax treatment and resulting increased preference for buybacks make it unwise to think in those terms.

In real life, productivity increases tremendously and will do so for the foreseeable future, if only because so much of Earth's population is low-productivity and moving higher, so you can expect even more excess. It's simply much easier to produce anything from food to iPhones with modern technology, vs the old human-powered plow.

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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 5:11 pm

postingname wrote:
protagonist wrote:

If we assume that the stock market should probably beat inflation (or anything else) over the long term, we should understand WHY.
I did a Google search on "stocks as an inflation hedge", which I think is more neutral than "stocks always beating inflation". A number of articles came up, This one may be to your liking in that it analyzes some of the 'reasons why it's not wise to make blanket statements about the role of stocks and inflation:

Inflation's Impact on Stock Returns

Some of the things discussed:

- expected vs unexpected inflattion
- high vs other kinds of inflation
- the volatility of the stock market during times of inflation

A couple of excerpts:
Most studies conclude that expected inflation can either positively or negatively impact stocks, depending on the ability to hedge and the government’s monetary policy. But unexpected inflation did show more conclusive findings, most notably being a strong positive correlation to stock returns during economic contractions, demonstrating that the timing of the economic cycle is particularly important for investors to gauge the impact on stock returns. This correlation is also thought to stem from the fact that unexpected inflation contains new information about future prices. Similarly, greater volatility of stock movements was correlated with higher inflation rates.
When examining S&P 500 returns by decade and adjusted for inflation, the results show that the highest real returns occur when inflation is 2 to 3%. Inflation greater than or less than the 2 to 3% tends to signal a U.S. macroeconomic environment with larger issues that have varying impacts on stocks. Perhaps more important than the actual returns are the volatility of returns that inflation causes and how to invest in that environment.
There were a number of other articles, the majority of which seemed to say the correlation of stocks with inflation was variable.
Interesting. I learned from this. Thanks.

I still am having trouble getting my brain around why stocks increase on the average a massive 8%/year if inflation only increases 2-3%/year on average.

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Re: Why does the stock market beat inflation?

Post by blueleaf » Tue Oct 14, 2014 5:11 pm

"Assuming a DOW in 2014 of 17000, and based on an assumed annual gain of 8%, the DOW will be around 171,000 in 2044 when today's retirees will be dying, 37,396,000 in 2114 , 8.2x10*10 in 2214, and 1.8x10*15 in 2314. That's some serious industrial growth."

Don't forget about dividends. Dividend income is historically the largest part of stock returns, and they are not reflected in the year to year change in the level of the index.Basically, stocks make money because they pay out a portion of corporate profits to shareholders, and hopefully also increase earnings a smidge faster than inflation.

More recently, in the US, companies have lowered their dividend payout and raised their share buybacks. Net buybacks increase earnings per share, increasing shareholder value in a way that is similar to reinvesting dividends.

That said, most smart boglehead analysts don't endorse planning around 8 percent real returns either. 3 to 6 percent seems common based on today's valuations.

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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 5:17 pm

tsohg wrote:
protagonist wrote: Based on your graph, GDP has been growing much, much slower than the stock market. It looks like about a tenfold increase in GDP over the last century or so compared with maybe a thousandfold or so increase in the DJIA (gross estimates). Are assumptions such as yours above creating a "bubble" based on false expectations in the market?
For one thing, that graph is average worldwide GDP (so averaging countries, I believe). In the past century America's GDP has grown at a much faster rate than the worldwide average. I don't know if the growth in the DJIA will continue or if its in a bubble/overpriced currently. All I can do is diversify my investments. I strongly believe the growth trend will continue for the reasons I gave earlier (technology, innovation, efficiency improvements, etc). My statement is about the worldwide market / sum total of human output, not the DJIA.

What actionable alternative do you propose?
And if we assume the market grows at an average 8%/year more or less over the long term and use that assumption in our future financial planning, we should be able to justify that with more than historical figures from a historically short and unusual period of time that could represent a bubble.
I don't see anyone in this thread assuming 8% growth over the long term. Well, besides you.
(haha) maybe not. And I never assumed 8%, I've just questioned why people feel that the future will reflect the past 100 years or so, and that stocks should continue outpacing inflation. As for the 8%, 10%, whatever number, I am going on past performance statistics I have often heard bantered around to confirm the superior performance of stocks in the long run. I think most estimates of stock performance for the short to intermediate time frame that I have heard are much more modest, such as those mentioned above by blueleaf.

And yes, I picked up on the worldwide/US thing when I looked at the graph. I don't know if US growth has exceeded worldwide growth or not over the past century. I just figure that, when dealing with a difference that huge ( roughly approximating a factor of a hundred), my point would still be valid.

Actionable alternative....I don't know. Like I said, I am trying to understand something. I think we should always be asking "why?"

The only actionable alternative I am proposing at this point is to question our assumptions.
Last edited by protagonist on Tue Oct 14, 2014 5:59 pm, edited 1 time in total.

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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 5:34 pm

ogd wrote:protagonist: one simple reason, even if you don't buy any of the productivity increases (like you should) is that stock returns consist of present value plus accumulated earnings.

So if everything stays constant, earnings keep pace with inflation, book values keep pace with inflation, but their sum outpaces inflation. Sort of what we expect to see in the real estate market which doesn't have "productivity": rents keep pace, values keep pace, returns exceed.
Somebody posted a graph here in a previous thread demonstrating that real estate values have just kept up with inflation since the late 19th century. I can probably find that post again if you desire.

I also think that, as long as homebuyers are encouraged to spend beyond their means and buy houses with money they do not have, you will have more buyers willing to spend more money and house prices will inevitably rise proportionately (explaining the huge housing boom since WW2). That is an easy "why" to answer. Rents theoretically increase with inflation commensurate with expenses. If anything, I think expenses have probably outpaced rent increases in most markets since I believe it is harder to count on positive cash flow from rentals now than it had been in the past.

If earnings and book values kept pace with inflation, their sum should keep pace with inflation,not exceed it, correct? (ax+bx)=(a+b)x , no? (Maybe there is something there I am not understanding.....I'm not a finance person or economist).
Last edited by protagonist on Tue Oct 14, 2014 5:55 pm, edited 2 times in total.

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Re: Why does the stock market beat inflation?

Post by Kevin M » Tue Oct 14, 2014 5:45 pm

VictoriaF wrote: While some people do claim that over the long run one will make money in the stock market, this is not a universal truth.

Bob K had links to some papers showing that over the long run, the expected value of the stock market is higher; but the variability in the returns is also rising, increasing the probability of worse outcomes.

Larry and others have presented an argument that if stocks were getting safer with time, longer-term options would be cheaper than shorter-term ones.

Victoria
I believe the credit for the option pricing argument goes to Zvi Bodie. I think he wrote a paper about it, and it definitely is included in the Investments textbook that he co-authored. He also explains the variance of expected long-term returns as well (in his Investments textbook).

Of course we've had many long discussions about this. One of the counterarguments is that although the long-term variance of terminal wealth is larger than for safer investments, historically even the lower end of the returns distribution for stocks has been higher than for safe investments. The counter argument to that is that we don't have enough independent long-term periods to provide a large enough sample size for conclusions that are statistically significant. And back and forth and on and one it goes.

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Re: Why does the stock market beat inflation?

Post by Clive » Tue Oct 14, 2014 5:50 pm

As for the 8% [real]
Taxes and costs historically were much higher than they are in more recent times. 5% inflation (or whatever), 8% real = 13% total, less 33% 'costs/overheads' = 8.7% nominal = 3.7% real (simplistic).

Investors used to buy via post and market makers spreads could be very wide. Fund fees in some cases might have been north of 4%. Taxes in some cases were higher and there were few/none tax-efficient accounts/options.

As costs/overheads have declined, its only reasonable to assume that expected gross rewards might also decline.

My highlights

Federal Reserve Bank of Minneapolis
Research Department Staff Report 313
January 2003
Average Debt and Equity Returns: Puzzling?
Ellen R. McGrattan
Edward C. Prescott

ABSTRACT

Mehra and Prescott (1985) found the difference between average equity and debt returns puzzling because it was too large to be a premium for bearing nondiversifiable aggregate risk. Here, we re-examine this puzzle, taking into account some factors ignored by Mehra and Prescott–taxes, regulatory constraints, and diversification costs–and focusing on long-term rather than short-term savings instruments. Accounting for these factors, we find the difference between average equity and debt returns during peacetime in the last century is less than 1 percent, with the average real equity return somewhat under 5 percent, and the average real debt return almost 4 percent. As theory predicts, the real return on debt has been close to the 4 percent average after-tax real return on capital. Similarly, as theory predicts, the real return on equity is equal to the after-tax real return on capital plus a modest premium for bearing nondiversifiable aggregate risk.

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Re: Why does the stock market beat inflation?

Post by VictoriaF » Tue Oct 14, 2014 5:57 pm

Kevin M wrote:
VictoriaF wrote: While some people do claim that over the long run one will make money in the stock market, this is not a universal truth.

Bob K had links to some papers showing that over the long run, the expected value of the stock market is higher; but the variability in the returns is also rising, increasing the probability of worse outcomes.

Larry and others have presented an argument that if stocks were getting safer with time, longer-term options would be cheaper than shorter-term ones.

Victoria
I believe the credit for the option pricing argument goes to Zvi Bodie. I think he wrote a paper about it, and it definitely is included in the Investments textbook that he co-authored. He also explains the variance of expected long-term returns as well (in his Investments textbook).
That sounds right. My opinions are significantly shaped by the information provided by Bob K (bobcat2), and Bob draws his information from Zvi Bodie and other academic economists and financiers.
Kevin M wrote:Of course we've had many long discussions about this. One of the counterarguments is that although the long-term variance of terminal wealth is larger than for safer investments, historically even the lower end of the returns distribution for stocks has been higher than for safe investments. The counter argument to that is that we don't have enough independent long-term periods to provide a large enough sample size for conclusions that are statistically significant. And back and forth and on and one it goes.

Kevin
I usually superficially review these discussions but don't study them in depth, because I have established the fundamentals of my investment approach, and the theoretical debates, while interesting, are not relevant to my decisions.

Bob K has firmly planted in my head that the expected market returns, safe withdrawal rates, and other parameters typically used by the Bogleheads are far less important than liability matching and lifecycle consumption smoothing. My priority is getting the income stream supporting the desired quality of my life, not maximizing my returns.

Victoria
Last edited by VictoriaF on Tue Oct 14, 2014 6:05 pm, edited 1 time in total.
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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 6:05 pm

VictoriaF wrote:
Bob K has firmly planted in my head that the expected market returns, safe withdrawal rates, and other parameters typically used by the Bogleheads are far less relevant than liability matching and lifecycle consumption smoothing.

Victoria
Not knowing specifically what you are referring to re:BobK, nor having any idea what "liability matching" means (and only being able to guess about "lifecycle consumption smoothing"), I think I still emphatically agree with you, Victoria. (hoping you are laughing at me....) I put very little faith in expected market returns (hence the "why?"- I want reason not faith) or safe withdrawal rates.

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Re: Why does the stock market beat inflation?

Post by VictoriaF » Tue Oct 14, 2014 6:19 pm

protagonist wrote:
VictoriaF wrote:
Bob K has firmly planted in my head that the expected market returns, safe withdrawal rates, and other parameters typically used by the Bogleheads are far less relevant than liability matching and lifecycle consumption smoothing.

Victoria
Not knowing specifically what you are referring to re:BobK, nor having any idea what "liability matching" means, I think I still emphatically agree with you, Victoria. (hoping you are laughing at me....)
Liability matching is not a laughing matter, protagonist! {OK, now I can laugh}

Bob K posts as bobcat2 and is worth paying attention to. Some of the key concepts I've learned from are as follows:
- Equities are risky, period. If you don't want to run out of money, have safe sources of income that satisfy your needs, such as Social Security (maximiized), TIPS ladder, and alike.
- Liability Matching is matching safe income to the times when you have liabilities. For example, if you need money for a house, college, or retirement income (i.e., various "liabilities"), have TIPS that mature at the time when you encounter these liabilities.
- Consumption smoothing is avoiding large disparity in spending during different periods of one's life. Thus, it's foolish to starve for years in order to become a rich retiree.
protagonist wrote:I put very little faith in expected market returns (hence the "why?"- I want reason not faith) or safe withdrawal rates.
What will you do if you don't find a satisfactory answer?

Victoria
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Re: Why does the stock market beat inflation?

Post by bhsince87 » Tue Oct 14, 2014 6:21 pm

Also keep in mind that the S&P 500 and the Dow have a survivorship bias. Companies that go out of favor, or even fail outright, are removed from the index and replaced with something more successful.

This is also a factor in the total market. A large number of businesses fail before they even become publicly traded companies.
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Re: Why does the stock market beat inflation?

Post by ogd » Tue Oct 14, 2014 6:21 pm

protagonist wrote:
ogd wrote: So if everything stays constant, earnings keep pace with inflation, book values keep pace with inflation, but their sum outpaces inflation. Sort of what we expect to see in the real estate market which doesn't have "productivity": rents keep pace, values keep pace, returns exceed.
Somebody posted a graph here in a previous thread demonstrating that real estate values have just kept up with inflation since the late 19th century. I can probably find that post again if you desire.
There's no need, because I was agreeing with the values part. I too expect home prices to just keep up with inflation.
protagonist wrote:If earnings and book values kept pace with inflation, their sum should keep pace with inflation,not exceed it, correct? (ax+bx)=(a+b)x , no? (Maybe there is something there I am not understanding.....I'm not a finance person or economist).
No, because returns are compounding. The more appropriate equation, or inequality rather, would have been (a + b)^n > a^n + b^n, because of all those terms in the middle which represent reinvestment.

Specifically, every year your value grows by an inflation factor F; let's assume it's constant to simplify things. But you also get earnings which we said also grow with inflation so we can assume they're a constant fraction Ef of value; you reinvest those into the value, so you get: V1 = V0 x (1 + F) + V0 x Ef

Repeat for n years and the accumulated value is Vn = V0 x (1 + F + Ef)^n. This is much greater than a mere summation of value and present-day earnings, of Vn = V0 x (1 + F) ^ n + V0 x Ef x (1+F) ^ n, which is what your formula looked like (with x the compounded inflation).

To realize this, the landlord would of course need to reinvest rent into new properties. I won't comment on how often that happens with real estate, but it sure happens with stocks, whether internally in the company or externally through dividends and buybacks. Taxes and investment expenses subtract from this, of course, but as long as it's less than earnings you will exceed inflation.

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Re: Why does the stock market beat inflation?

Post by ogd » Tue Oct 14, 2014 6:31 pm

To follow up: it's also the case that even an accumulation of earnings, without reinvestment, will exceed inflation, although I think only by a constant factor. Too lazy for that piece of math right now. Remember, we're talking about unspent earnings from n years not just the last.

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Re: Why does the stock market beat inflation?

Post by LFKB » Tue Oct 14, 2014 6:58 pm

protagonist wrote:

I still am having trouble getting my brain around why stocks increase on the average a massive 8%/year if inflation only increases 2-3%/year on average.
It seems like a fairly simple concept and one that a few posters (myself included) have answered more than adequately in this thread. What is it that you're having trouble getting your head around?

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Re: Why does the stock market beat inflation?

Post by VictoriaF » Tue Oct 14, 2014 7:20 pm

Archimedes said:
"Give me a lever long enough and a fulcrum on which to place it, and I shall move the world."

With the usual physics envy, economics could be tempted to transform this into:
"Give me a time-frame long enough and a starting point for applying the formula, and I shall know the value of my stock holdings."

And in economics, just as in physics, it doesn't work:
Not only a long time-frame does not eliminate risk, but we also don't have a starting point. Is the Ground Zero for the calculation of market returns January 1929? October of 2007? March of 2009? By applying the expected growth rate starting at a market high vs. starting at a market low we would get very different outcomes.

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Re: Why does the stock market beat inflation?

Post by MossySF » Tue Oct 14, 2014 8:07 pm

protagonist wrote:I still am having trouble getting my brain around why stocks increase on the average a massive 8%/year if inflation only increases 2-3%/year on average.
Some of the replies here have hit on half of the idea.

If stock ownership represents ownership of companies participation in a global economy, then the growth of the GDP beyond inflation is your share of returns. Real GDP growth is the expected behavior during our existing societal phase -- Google up "Linear Economic Growth" for some good reading on the days (agricultural society) when the economy grew at the rate of inflation. So let's say world GDP has been growing for 4% while inflation has been running at 2% -- stock ownership means you participate in the 2% over inflation growth.

But then why does stock ownership get 8% if the GDP is only growing at 4%? In a capitalist system, money flows from consumers to investors. Think of a simple scenario where 2 employees at a company both earn the same income. Person A who saves nothing returns his entire income to the economy while person B who invested some part to start/expand businesses/services/products ends up being the beneficiary of the person A's consumption. So while the total pie increased 4%, not everybody's share grows at the same rate.

Here's a very simple math model to demonstrate how a capitalistic system is skewed towards capital owners. Assume we have a 80/20 population where 80% has a 100% consumption rate. Their share of the GDP growth will remain constant at inflation since they are pegged 100% to wage & price changes.

Total GDP --> 100% x 4% growth = 400 points
Consumer Pie Slice --> 2% growth
Total Consumer Pie --> 80% x 2% inflation = 160 points
Total Investor Pie --> 400 - 160 = 240 points
Investor Pie Slice --> 240 points / 20% = 12% growth

The system has corrective mechanisms (taxes on CG/dividends/interest/etc) to avoid this imbalance from permanently tipping the system over but you can see an obvious example in the most recent "jobless recovery" phase.

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Re: Why does the stock market beat inflation?

Post by Kevin M » Tue Oct 14, 2014 8:22 pm

You might be interested in reading "Capital in the 21st Century". I don't have it in front of me, since I borrowed it from the library, but here are a couple of things I recall that are relevant to this discussion.

The long term return on capital has been about 5% (in real terms).

Inflation is largely a phenomenon of the 20th century. Prior to that prices were relatively stable over long periods of time.

Of course these aren't the main points of the book, but I think they are the points that are relevant here. I may not have the numbers exactly right, but I think that's the gist of it.

So if I'm remembering these points correctly, your question could be re-framed as "why has there been a long-term positive real return on capital?"

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Re: Why does the stock market beat inflation?

Post by VictoriaF » Tue Oct 14, 2014 8:42 pm

MossySF wrote:Here's a very simple math model to demonstrate how a capitalistic system is skewed towards capital owners. Assume we have a 80/20 population where 80% has a 100% consumption rate. Their share of the GDP growth will remain constant at inflation since they are pegged 100% to wage & price changes.

Total GDP --> 100% x 4% growth = 400 points
Consumer Pie Slice --> 2% growth
Total Consumer Pie --> 80% x 2% inflation = 160 points
Total Investor Pie --> 400 - 160 = 240 points
Investor Pie Slice --> 240 points / 20% = 12% growth

The system has corrective mechanisms (taxes on CG/dividends/interest/etc) to avoid this imbalance from permanently tipping the system over but you can see an obvious example in the most recent "jobless recovery" phase.
MossySF,

This is a very instructive example. Thank you. Here is a follow-up question.

If capital ownership is advantageous not in isolation but in relation to the consumption part of the economy, would not capital owners want to reduce the size of their "club"? However, what we observe is that stock owners want all others also to own stocks. If everyone buys and holds stocks, the value of stocks is higher. Is there a contradiction?

Victoria
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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 8:56 pm

VictoriaF wrote:
Bob K posts as bobcat2 and is worth paying attention to. Some of the key concepts I've learned from are as follows:
- Equities are risky, period. If you don't want to run out of money, have safe sources of income that satisfy your needs, such as Social Security (maximiized), TIPS ladder, and alike.
- Liability Matching is matching safe income to the times when you have liabilities. For example, if you need money for a house, college, or retirement income (i.e., various "liabilities"), have TIPS that mature at the time when you encounter these liabilities.
- Consumption smoothing is avoiding large disparity in spending during different periods of one's life. Thus, it's foolish to starve for years in order to become a rich retiree.
He sounds like a smart Kookie. I agree with all the above.
protagonist wrote:I put very little faith in expected market returns (hence the "why?"- I want reason not faith) or safe withdrawal rates.
VictoriaF wrote: What will you do if you don't find a satisfactory answer?

Victoria
Don't worry. Nothing desperate.

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Re: Why does the stock market beat inflation?

Post by VictoriaF » Tue Oct 14, 2014 9:06 pm

protagonist wrote:
VictoriaF wrote:
protagonist wrote:I put very little faith in expected market returns (hence the "why?"- I want reason not faith) or safe withdrawal rates.
What will you do if you don't find a satisfactory answer?

Victoria
Don't worry. Nothing desperate.
I would worry if you found a satisfactory answer [for an assured 8% return],

Victoria
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Re: Why does the stock market beat inflation?

Post by protagonist » Tue Oct 14, 2014 9:09 pm

MossySF wrote:
protagonist wrote:I still am having trouble getting my brain around why stocks increase on the average a massive 8%/year if inflation only increases 2-3%/year on average.
Some of the replies here have hit on half of the idea.

If stock ownership represents ownership of companies participation in a global economy, then the growth of the GDP beyond inflation is your share of returns. Real GDP growth is the expected behavior during our existing societal phase -- Google up "Linear Economic Growth" for some good reading on the days (agricultural society) when the economy grew at the rate of inflation. So let's say world GDP has been growing for 4% while inflation has been running at 2% -- stock ownership means you participate in the 2% over inflation growth.

But then why does stock ownership get 8% if the GDP is only growing at 4%? In a capitalist system, money flows from consumers to investors. Think of a simple scenario where 2 employees at a company both earn the same income. Person A who saves nothing returns his entire income to the economy while person B who invested some part to start/expand businesses/services/products ends up being the beneficiary of the person A's consumption. So while the total pie increased 4%, not everybody's share grows at the same rate.

Here's a very simple math model to demonstrate how a capitalistic system is skewed towards capital owners. Assume we have a 80/20 population where 80% has a 100% consumption rate. Their share of the GDP growth will remain constant at inflation since they are pegged 100% to wage & price changes.

Total GDP --> 100% x 4% growth = 400 points
Consumer Pie Slice --> 2% growth
Total Consumer Pie --> 80% x 2% inflation = 160 points
Total Investor Pie --> 400 - 160 = 240 points
Investor Pie Slice --> 240 points / 20% = 12% growth

The system has corrective mechanisms (taxes on CG/dividends/interest/etc) to avoid this imbalance from permanently tipping the system over but you can see an obvious example in the most recent "jobless recovery" phase.
This is the best explanation I have seen so far. I don't know if it is the "why?", but given the history of 20th-21st century capitalism, it makes sense in the current era/climate. Thanks.
How sustainable such a system is , that is another question.

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Re: Why does the stock market beat inflation?

Post by MossySF » Tue Oct 14, 2014 9:23 pm

VictoriaF wrote:If capital ownership is advantageous not in isolation but in relation to the consumption part of the economy, would not capital owners want to reduce the size of their "club"? However, what we observe is that stock owners want all others also to own stocks. If everyone buys and holds stocks, the value of stocks is higher. Is there a contradiction?
I'm not an economist so here's my rough amateur thoughts on it:

Making the club more exclusive increases your share of the total pie. But there is some threshold where expanding the club makes the total pie grow bigger -- more investors generating more economic activity so your smaller share might still be better. You can't tilt this to where everybody is a crazy investor -- look at China where the average savings rate is 50% and the people simply have no good place to put their money.

Now it seems like the stock game doesn't have much to do with the underlying economy. I sell you some Apple shares -- you sell me back some Google shares -- and the Apple/Google employees ride their spiffy WIFI buses to work ignoring our trading activity. Luckily, most companies (founders/CxOs/treasury shares/etc) keep some percentage of the ownership. And over the long-term as increased participants in the market drive stock prices up, that in turn increases the amount of money the company has to increase their economic activity (borrowing against stock, selling stock, buyouts using stock, etc.).

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Re: Why does the stock market beat inflation?

Post by Ged » Tue Oct 14, 2014 9:45 pm

Well, one way of looking at it is it beats inflation because it has to.

Nobody would invest in stocks if there wasn't some compensation for the risk of investment. Businesses would not be able to attract capital if their operation did not propose to generate returns greater than inflation. Otherwise people would just invest in some hard asset like aluminum billets or land that aside from market fluctuations would be pretty likely to match inflation.

Financial analysts working in the corporate world do evaluations of business opportunities based on what they call discounted cash flow analysis. The discount is the assumed rate of inflation. If the analysis does not show a healthy return above the discount rate the project just does not proceed; the funds (investor's capital) are simply not invested.

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