Morgan Stanley sent a big note to clients this morning in an attempt to resolve the huge debate sparked by Bill Gross and Jeremy Siegel recently over the relationship between stock market returns and GDP growth.
In the note, Morgan Stanley economist Gerard Minack featured a chart breaking down the drivers of stock market returns: dividends, changes in earnings per share, and changes in the price-to-earnings valuation ratio.
Photo: Morgan Stanley
Minack writes that while both earnings and valuations tend to revert to average levels after periods of outperformance and underperformance, the mean reversion can take a very long time to occur:
Several factors can drive a wedge between GDP and equity returns. Exhibit 3 shows a long history of equity returns in the US. The returns are calculated over a rolling 10-year period, adjusted for inflation, and including reinvested dividends. Returns are driven by two factors: dividends and changes in share prices. The change in share prices can be attributed to either change in earnings per share or changes in valuation.
It is clear that historically valuation changes account for much of the variation in returns. Valuation changes routinely add to, or subtract from, trend returns for periods of 10-20 years. Earnings changes – which often reflect the rise or fall in profits relative to GDP – can likewise affect returns for extended periods.
This is important. For sure, on a very long view, both valuation and profit share tend to mean-revert – or, put another way, over a long time horizon, the net contribution from valuation and profit share changes should be zero. But the key is ‘on a very long view’. These deviations can persistently affect returns through the entire investment career of an individual investor.