You're making a weird distinction by saying "mass-market finance" as if the fundamentals of asset classes change radically depending on how they are marketed.
Stocks, as an asset class, have been around a lot longer than the 1970s, and they have on average grown a lot faster than GDP over that time.
That makes sense since stock prices measure a form of wealth, and GDP measures income. Big difference.
"as if the fundamentals of asset classes change radically depending on how they are marketed"
More like the fundamentals of asset classes change radically depending on how they're regulated & taxed, who is willing / able to buy them, what the composition of that asset class is, and how much money there is flowing in and out of that asset class.
And we're not even really talking about "fundamentals", since there is so much path dependency, especially in the context of drawing-down of those assets to finance retirement. A rise in variance would be bad enough.
Stock prices in the long run represent a time-discounted income stream (as do all securities) (plus a bundle of legal rights, which is mostly irrelevant for individuals). It is not mathematically possible to have the stock market growing by 4% and GDP growing by 2% ad infinitum; you would have the value of the stock market exceed the discounted value of all future economic activity.
There is a cogent argument that the inflation in stocks has been due to 1) more economic activity falling under the umbrella of publicly traded corporations (private blacksmith displaced by Ford), 2) capital inflows driven by privatized retirement savings, interest rate manipulation, etc. 3) a legal & economic regime that encourages "paper assets" in general.
> It is not mathematically possible to have the stock market growing by 4% and GDP growing by 2% ad infinitum
Yes, it is.
First, because there is no necessary mathematical relationship between the aggregate market cap of firms and economic output (future or otherwise). There are rational expectations that can be stated, but those aren't actual constraints, since irrationality is a real thing.
Second, the economic universe from which the stock market draws value is not limited to the domestic economy, so even if there was a constraint based on economic output, it wouldn't be GDP.
"Maybe the future will be perpetually irrational about asset prices" is not really a compelling economic story. There is indeed a mathematical relation between long run asset prices and the income generated by those assets. In the short run you can do whatever you want, but the long run constraint is predictably enforced by arbitrage.
(it is left as an exercise to construct the most entertaining arbitrage play in a world where stock prices diverge indefinitely from the value produced by the underlying assets via some magic.)
> "Maybe the future will be perpetually irrational about asset prices" is not really a compelling economic story.
Perhaps, but then we are getting into rational expectations and not mathematical constraints. (Though, really, given that rationality requires perfect knowledge of future utilities, "the future will be perpetually irrational about asset prices" is pretty much guaranteed to be true except for intermittent times when it isn't momentarily largely by chance; even a consistent divergence in a particular direction from rationality isn't surprising, given what we the particular ways in which people tend to be deviate from economic rationality in practice.)
> There is indeed a mathematical relation between long run asset prices and the income generated by those assets.
No, there is a mathematical relation between reasonable asset prices and expected income streams that the assets will generate.
> In the short run you can do whatever you want, but the long run constraint is predictably enforced by arbitrage.
"In the long run, we're all dead" -- Keynes
Even granting your point for the sake of argument, what must ultimately be true in the long run assuming an infinite time horizon need never actually be true in the physical universe we inhabit. Irrationality in prices can be maintained indefinitely, even though not infinitely -- but then, the market can't actually exist infinitely, anyway.
I am talking about a long run relation between two long run quantities, which either fluctuates in a certain band around equilibrium, or allows the economic equivalent of perpetual motion.
You seem to be predicting a diverging trend in that relation towards infinity, which is insane, as infinities tend to be.
I conclude from this you're misunderstanding the notion of "long term equilibrium" as stronger than it is in reality. Construct a model that simultaneously allows infinite divergence between securitized asset prices and their associated incomes, and disallows easy arbitrage, or we have nothing to talk about.
Every fool digs up that Keynes quote when his model is wrong.
Betting that the market reverts to 'rational' pricing in any short time frame is a risky bet, but I'll claim it's much, much more reasonable than assuming that irrationality persists indefinitely.
OTOH, there's another story to why equity returns are higher than GDP returns: equity investors are being compensated for the higher risk.
> OTOH, there's another story to why equity returns are higher than GDP returns: equity investors are being compensated for the higher risk.
This gets mentioned very often in such debates, but the implied causal connection is wrong: There is no guarantee that higher risk leads to higher returns. It's not like the stock market says "We should keep up increasing stock prices so that equity investors are being compensated for their risk."
Over long timespans, stock prices are coupled to the performance of the underlying companies (mostly their income streams), not to risk. So far, there has been a correlation, but there has never been a guaranteed causal relation between risk and stock returns.
> There is no guarantee that higher risk leads to higher returns. It's not like the stock market says "We should keep up increasing stock prices so that equity investors are being compensated for their risk."
The mechanism is much simpler: asset prices of risky assets today will fall because willing buyers demand a higher return for the risk.
E.g. you have a stock and a bond both at $100 with the same expected return. Investors aren't happy with that, so they refuse to buy the stock until its price falls and its implied return rises.
Okay, so let's assume that the stocks are traded with a 10% risk discount ($90). Ten years later, the bonds are about to mature and are valued at $150 (50% profit). The company belonging to the stocks has also become 50% more valuable (because its fundamentals improved, e.g. 50% higher revenue and profit), but its stocks are still just as risky and still trade at a 10% discount, for a price of $150 * 90% = $135 (also 50% profit).
So despite the higher risk, and despite the fact that the stock's price is discounted, the investor did not make more profit from the stocks than from the bonds.
In practice, companies should grow faster than bonds (because they can reinvest their profits to increase their profit – although many companies fail at that), yielding higher returns. My point is, that those higher returns result from the different mechanisms underlying different security types, not from differences in risk.
You arbitrarily fixed the bond return to match that of stocks, but that's not how bonds get their prices set.
Bonds are fundamentally less risky than stocks because in the event of bankruptcy bondholders are paid first. Real recovery rates are around 40% usually.
> Ten years later, the bonds are about to mature and are valued at $150 (50% profit)
No, the value of of the bond is mostly independent of how much the company's future revenues are (as long as they don't go bankrupt). There are few future paths where someone will pay you $150 in the future for a bond that you bought for $100 today.
Bonds mostly have downside risk (you can lose everything), but limited upside participation. OTOH, equity has worse downside risk (if a company has $700m in debt and $300m in equity, it only needs to lose $300m in assets to go bankrupt--but in that case, bondholders would still get paid), but full upside participation.
Another way of looking at this is that if a company triples in size, your equity stake also triples because you now own the same percentage of a much larger company, but the bond cashflows did not change because bonds do not have that upside.
Why are you fixated on bonds? My argument is mostly independent of bonds, I only included them because you mentioned them originally.
Your reasoning was:
> The mechanism is much simpler: asset prices of risky assets today will fall because willing buyers demand a higher return for the risk. [...] Investors aren't happy with that, so they refuse to buy the stock until its price falls and its implied return rises.
I showed that this is not a valid argument, because if the market discounts the price of a stock by x% due to higher perceived risk, then it will discount its price by x% ten years later as well (unless there was a major change in the company's fundamentals, which is another story and not relevant here), meaning that the discounting of risk did not result in higher profit (compared to the return on stocks of a company which is deemed less risky).
Bonds are the natural comparison because bonds represent relatively riskless cashflows. Bonds tell you how much you get paid in the future, stocks don't.
Otherwise, how can you measure the return to risk?
> then it will discount its price by x% ten years later as well
That doesn't follow because you're missing a free parameter. Let's say a piece of stock ought to be worth $110 in 1 year if people weren't risk averse (based on how we think the company will do, etc.), but it'll only be worth $100 because of the risk. It can still be worth $91 today, implying a 10% return, for example.
For any path of future expected equity values, regardless of what future discount you apply, there is a price today that will imply an equity risk premium.
FYI, people have empirically measured the implied equity risk premium over long periods of time. The general consensus is that equity returns around 5-10% more per annum that a risk-free asset, but it varies greatly from decade to decade:
> Betting that the market reverts to 'rational' pricing in any short time frame is a risky bet, but I'll claim it's much, much more reasonable than assuming that irrationality persists indefinitely.
Rational pricing requires perfect knowledge of future income streams. Unless you have such knowledge, you can't even know what concrete position reflects a bet that the market "reverts" (a misnomer, because it assumes that rationality is a normal state that is only in exceptional circumstances deviated from) to rational pricing.
It's not even that "irrationality persists indefinitely", it's that it increases towards infinity.
Equity > GDP as a return to risk would require you to be able to "invest in GDP" in a relatively variance-free way. Social Security or seizing control of the government (or at least its taxing power) is about as close as you can get, but neither is really securitizable.
> Equity > GDP as a return to risk would require you to be able to "invest in GDP" in a relatively variance-free way
Technically no, it just requires one to be able to construct a basket that approximately returns GDP growth (along with GDP variance).
Note that total returns to equity include dividends, so you can easily have equity give outsize returns without total market cap approaching 100% of assets.
Stock-market-returns are almost always going to be higher than GDP growth, by a significant margin. A GDP growth of X% implies that companies revenues/profits are going to be ~X% higher next year.
But your return-on-investment isn't driven purely by the X% profit growth. It's also driven by the baseline profits that companies make. If you buy a share for $10, and it has an EPS of $0.50, you're immediately getting an ROI of 5%, even in a flat-GDP world. If GDP grows by 2%, and the company's projected-future-profits grow by 2%, you'll get the benefit of that 2% profit growth, in addition to the baselines ROI of 5%.
The PE ratio gives a pretty good indicator of long-term ROI baseline. Given the current PE ratio of 25, which is certainly worryingly high, it still implies a baseline ROI of 4%. Any GDP growth we happen to get, is simply gravy on top of that baseline.
> It is not mathematically possible to have the stock market growing by 4% and GDP growing by 2% ad infinitum; you would have the value of the stock market exceed the discounted value of all future economic activity.
The value of future economic activity is perpetually hypothetical, so when would the reckoning arrive?
Stocks, as an asset class, have been around a lot longer than the 1970s, and they have on average grown a lot faster than GDP over that time.
That makes sense since stock prices measure a form of wealth, and GDP measures income. Big difference.