Theoretical question about markets

[toddf]

Hi,

I've been lurking on these boards for a while, and I've learned a lot. I realize that a forum dedicated to short-term investing may not be the best for my question (which deals with the long-term), but I don't know where else I can ask as many intelligent people.

Popular opinion holds that the major stock markets make for good long term investments. Everyone talks about how they have historically returned more than 10% per year, and they assume that this long-term trend will continue.

I am not yet very knowledgable about stocks, so there is almost certainly a flaw with the following reasoning. My challenge to you is to point out the flaw!

It seems to me that it is impossible for the stock market to continue outpacing inflation forever. Why? Well, to make the math simple, let's set the inflation rate to 0 and suppose that stocks return 10%. Let's also make another simplifying assumption that doesn't have any effect on my main point: The only holders of money are individuals, and the only corporations are publicly traded. In other words, private companies, governments, and other types of organizations do not exist. Got it? Good.

Now, suppose that there is $1 billion in our sample economy. Since inflation is 0, this number remains constant forever. Let's say that, in the beginning, the combined market cap of all of the corporations is $100 million. Alright. No problems there, right? Let's fast forward 10 years. The stock market has been increasing in value by 10% every year, so now the stocks have a total value of about $260 million. Still no problems. OK. Let's fast forward 100 years from the starting point! Uh oh. Now all of the stock is worth $1378 billion. This is a problem, since only $1 billion in actual money and/or purchasing power exists. Several corporations would be worth more than the combined net worth of all of the people in the world! I cannot imagine that any company could truly produce enough value to justify being worth several times more than the net worth of the world.

 

[cakulev]

Quote from toddf:

Hi,

I've been lurking on these boards for a while, and I've learned a lot. I realize that a forum dedicated to short-term investing may not be the best for my question (which deals with the long-term), but I don't know where else I can ask as many intelligent people.

Popular opinion holds that the major stock markets make for good long term investments. Everyone talks about how they have historically returned more than 10% per year, and they assume that this long-term trend will continue.

I am not yet very knowledgable about stocks, so there is almost certainly a flaw with the following reasoning. My challenge to you is to point out the flaw!

It seems to me that it is impossible for the stock market to continue outpacing inflation forever. Why? Well, to make the math simple, let's set the inflation rate to 0 and suppose that stocks return 10%. Let's also make another simplifying assumption that doesn't have any effect on my main point: The only holders of money are individuals, and the only corporations are publicly traded. In other words, private companies, governments, and other types of organizations do not exist. Got it? Good.

Now, suppose that there is $1 billion in our sample economy. Since inflation is 0, this number remains constant forever. Let's say that, in the beginning, the combined market cap of all of the corporations is $100 million. Alright. No problems there, right? Let's fast forward 10 years. The stock market has been increasing in value by 10% every year, so now the stocks have a total value of about $260 million. Still no problems. OK. Let's fast forward 100 years from the starting point! Uh oh. Now all of the stock is worth $1378 billion. This is a problem, since only $1 billion in actual money and/or purchasing power exists. Several corporations would be worth more than the combined net worth of all of the people in the world! I cannot imagine that any company could truly produce enough value to justify being worth several times more than the net worth of the world.

There are a couple of flaws.
First, the mentioned rate of 10% is not inflation adjusted. It’s around 7-8% real return.
Where does this return comes from? There are two components:
1) Real economic growth. Surely you agree that the GDP of US (inflation adjusted) is much greater than the one 100 years ago. It’s called wealth creation.
2) Survival bias. The 10% rate is the rate of an stock index. If you look at the DOW 80-90 years ago, only GE is still there. So obviously if you invested in THOSE blue chips 80-90 years ago, you probably wouldn’t get 10%.

We do not have fixed amount of money. The money supply is constantly increasing. Part of it goes into real growth, part of it into inflation. Every central bank is debasing its curency over time.

 

[telozo]

Quote from cakulev:

There are a couple of flaws.
First, the mentioned rate of 10% is not inflation adjusted. It’s around 7-8% real return.
Where does this return comes from? There are two components:
1) Real economic growth. Surely you agree that the GDP of US (inflation adjusted) is much greater than the one 100 years ago. It’s called wealth creation.
2) Survival bias. The 10% rate is the rate of an stock index. If you look at the DOW 80-90 years ago, only GE is still there. So obviously if you invested in THOSE blue chips 80-90 years ago, you probably wouldn’t get 10%.

We do not have fixed amount of money. The money supply is constantly increasing. Part of it goes into real growth, part of it into inflation. Every central bank is debasing its curency over time.

I was going to point out the same thing. When you say market increases by 10% a year, you usually refer to an index, and index components change, so it is quite possible to obtain that growth for ever.

 

[kubilai]

You forget about the reason people invest in the first place. They invest so they can sell the shares later and spend it.

- People take money out to retire
- People die and a huge chunk of shares must be liquidated to pay for estate taxes
- They take money out to support their charity
- They take money out to pay for toys

If people can get gain in excess of inflation, do you calculations, I'll bet over time they take more money out of corporations than they put in.

 

[kubilai]

Now I have a question, out of all the things you can own in the world, which ones are expressly designed to make you more money?

- government bonds?
- cars?
- houses?
- corporations?
- gold?
- collectible art?
- commodities?
- forests?

Anything I forgot?

 

[jamis359]

Quote from toddf:

Popular opinion holds that the major stock markets make for good long term investments. Everyone talks about how they have historically returned more than 10% per year, and they assume that this long-term trend will continue.

This is due to the fact that the American stock markets have been in a secular bull market since 1945. Look at a yearly chart of the Dow. It's a definite uptrend -- the "bear markets" of the 1970's was really just a pullback when you look at the truly long picture. Ironically, the buy-and-hold crowd's mantra that the markets "will always give you an average 8% return" is just data-fitting over a long period of time.

This long-term bull market mirrors the growth of the United States. The question is how much longer can this growth continue. I don't know the answer. If the U.S. empire slowly declines, just like England's did, then I expect the markets to reflect that. At that point the expectation of an average 8% return will no longer be fulfilled.

 

[toddf]

Thanks for your responses, everyone.

To those who pointed out the survival bias and turnover on the major stock indexes: Thanks! This answers my question perfectly!

To jamis359: I was just thinking the same thing! It seems to me that there may still be plenty of room for future growth during all of our lifetimes, but I can't see how the rate of American growth could outpace the rate of growth of the rest of the world over a timespan of thousands of years. If that happened, America would control more than 99.999% of the world's wealth!

To those who were talking about inflation, real economic growth or talking about selling your valuable stocks to make money: I am not sure you understood my example economy and the paradox it produced. That's probably my fault. It was not easy to precisely convey what I meant, and terms like "total value" probably mean different things to different people.

In my economy, the combined value of EVERYTHING as measured in dollars was $1 billion. Stocks, real estate, cash, cars, whatever. All of that added up to $1 billion. In this economy, stocks can only be worth $1 billion total at most, and that only happens when everything else is worth $0. I suppose stocks could technically be worth more than $1 billion if people decided that things like real estate had negative value, but that is quite silly.

If the rate of growth of the total value of stocks outpaces the rate of growth of the total supply of money/value, then eventually, the value of stocks becomes higher than the value of everything (including stocks!).

Whether there is actual economic growth or not doesn't matter. The problem is still that the total value of stock (as measured in dollars) eventually grows higher than the value of everything including stocks (as measured in dollars).

Whether there is inflation or not also doesn't matter. The paradox just takes longer to occur if there's inflation. For example, starting from a total money/value supply of $1 billion and stock value of $100 million with 0 inflation and 10% stock growth rate, it takes 25 years for the paradox to occur (the money/value supply is still $1 billion, but stocks alone are worth $1.08 billion). If inflation is 5% instead of 0%, it takes 50 years instead of 25, but it still happens. After 50 years, the total money/value supply is $11.47 billion, but stocks alone are supposedly worth $11.74 billion).

Anyway, all of this is academic, as there is no way invest in a "true" index fund - one that includes every corporation in the world, public or private. And, as the others have pointed out, that's the kind of investment you'd need to have for this paradox to be able to happen.

 

[MorganSys]

Quote from toddf:

Now, suppose that there is $1 billion in our sample economy. Since inflation is 0, this number remains constant forever.

This is a problem, since only $1 billion in actual money and/or purchasing power exists.

Hello,

The above is the error. Total purchasing power goes up over time because of real economic growth (as others have stated). Hence, the $1 billion increases despite no inflation.

cakulev answered well.

Quote from cakulev:


1) Real economic growth. Surely you agree that the GDP of US (inflation adjusted) is much greater than the one 100 years ago. It’s called wealth creation.

I doubt survivorship bias was not taken into consideration when studies released long-term stock market return figures of x%. However, when people expect continued growth to be similar to the U.S. history, it's not neccessarily realistic. Check out other countries. The U.S. is a bit of an anomaly.

 

[cakulev]

If you have a fixed money supply over a long priod of time, the value of money will increase. This is because money is scarce , while the output grows.
The economy would have experienced massive deflation, with deflation more or less equal to real GDP growth.

In this case, there would be no nominal positive rate of return (there would be real return). But in this case why would anybody invest in risky assets since he can get a decent return by stashing cash under mattress (tax free). Furthermore due to deflation, the cost of business is high. At least now, when getting a loan, corporations can speculate it will be easier to be paid by raising prices/output at faster rate than interest rates.

I don’t think there was a fixed money supply that allowed long term growth. Even the ancient countries were increasing the supply by mining gold/silver, and by trade.

 

[5yrtrader]

I believe you forgot about the money creation affect too. If you have $1billion dollars in an economy, know one wants to actually hold on to it they want to loan it out, so that original $1billion is multiplied many times over, therefore the net value of the market will be worth much more than $1billion.