Photo: Françoise Garranger. Source: Pixabay. CC0
For as long as I’ve been investing, people have said to put money into the stock market for growth and to own bonds for stability. And generally, that advice has worked out: the US stock market has returned 10% per year over the past 25 years, while the bond market has earned 5%. The stock market is volatile, to be sure, the indices seem to move from the lower left to the upper right.
But why? Markets aren’t magic. If you were a Japanese investor, you didn’t earn much of anything from stocks over the last several decades. The 25-year return from their stock market has been 1.5% per year. Japan isn’t an obscure market no one’s ever heard of. They’re a modern democracy with the world’s third largest economy. What’s holding them back?
Nikkei 225 over last 20 years. Source: Bloomberg
Equities are residual claims on corporate cash flow. Equity holders get paid after everyone else—the bondholders, the employees, the vendors. For the past few decades, earnings at Japanese companies haven’t grown at all. In 2006 they earned 750 yen per share, last year they earned 840. And in the ‘90s their earnings were higher than they are right now. For over two decades, Japanese companies haven’t growth their cash flow at all. So their equity investors have suffered. What’s wrong with Japanese companies? It’s actually pretty straightforward: their economy has been stagnant. In 1996, their economy was actually larger than it is now.
In fact, there’s a pretty strong correlation between long-term economic growth and stock market returns. The more economic growth there is, the more the market advances. This doesn’t work every year—sometimes markets get overvalued and contract despite a decent underlying economy. But over the long haul, markets depend on the economy to generate earnings for shareholders.
The lesson here is clear: if we want the market to generate decent returns, we need to see the economy grow too. But that growth has to be sustainable.