The Rules, Part XII

Growth in total factor outputs must equal the growth in payment to inputs.  The equity market cannot forever outgrow the real economy.

This is the “real economy rule,” and was listed first in my document, but i have not gotten to it until now.  It is very important to remember, because men are tempted to forget that financial markets depend on the real economy.  If the global economy grows at a 3% rate, well guess what?  In the long run, payments to the factors — wages, interest, rents, and profits will also grow at a 3% rate.  Maybe some of the factor payments will grow faster, slower, or even shrink, but you can’t get more out of the system than the system produces year by year.

  • The value of equity is the capitalized value of the profit stream.
  • The value of debt is the capitalized value of the interest stream.
  • The value of property, plant and equipment is the capitalized value of the rent stream.
  • The value of a slave/employee is the capitalized value of the wage stream.

Hmm, that last one doesn’t sound right.  We no longer capitalize people, as if one could legally own a person today.  Contracts for labor are short-term, and employees typically can leave at will.

But, there can be bubbles in property, debt and equity markets.  We just happen to be the beneficiaries of a situation where we have simultaneously had bubbles in all three.  Think of late 2006 — high values for residential and commercial real estate, low credit spreads, and high P/Es (relative to future profits).  Market participants expected far more growth than the overindebted economy could deliver.

Important here are the discount rates.  By asset class, relatively low discount rates relative to swap or Treasury yields indicate complacency.  It is one thing if stocks move up because profits are rising rapidly, and another if the discount rate is declining.  Similarly, it is one thing if stocks are rising because GDP is growing rapidly, and thus revenues are rising, and another thing if it is due to profit margins rising, and profit margins are near record levels, as they are today.

Extreme profit margins invite competition.  Extreme profit margins tend not to last.

In many asset classes, investors were fooled.  Home buyers bought thinking the prices could only go up.  They ignored the high ratio of property value relative to what they would currently pay.  Commercial real estate investors bought at lower and lower debt service coverage ratios.  Collateralized debt investors accepted lower and lower interest spreads at higher and higher degrees of leverage.  With equity, investor assumed that growth in asset values in excess of growth in GDP would continue.  The stock market does grow faster than GDP, but the advantage is less than double GDP growth.

Thus after the long rally, with no appreciable growth in the economy, I would be careful about equities, and corporate debt as well.  Some yields are high relative to long run averages, but the risk is higher as well.

The main point is to remember that the real businesses behind the financial markets drive performance in the long haul, even if adjustments to the discount rate do it in the short run.  To be an excellent manager, focus on both factors — likely payments, and rate at which to discount.  But who can be so wise?


  • Very useful perspective.

    And independent confirmation: EconomPic Data recently had a striking scatter plot of the long term relationship between (1) the ratio of the S&P 500 index to nominal GDP, and (2) ten-year forward capital returns. When I first started reading his post, I thought, ‘Come now, there is no reason for this set of 500 companies, changing over time, to maintain a constant relationship with GDP’. But … R^2 = 0.73.

  • IF says:

    I know it would take away from your point, but you are omitting population growth and, you know, money printing. It would be nice to see this discussed as well. I think one should use them to normalize the real economy to get to your model described here.

    That said, one thing that still confuses me is what I would call “leakage”. Share dilution via options, fund fees, other rents. Everything that removes from the big payment streams. Clearly leakage is not part of a zero-th order model, but leakage is still part of the real world economy (just like black economy is). If we have constant leakage one should not expect a drag on yearly GDP growth. But what if leakage changes over time? Does it matter only to the share holder, or does it also matter to GDP growth?

  • rjs says:

    add that growth in the real economy is constrained by the laws of physics…only fools and economists believe growth can go on indefinitely…

  • @rjs:
    I don’t agree with you. Economic “growth” can occur by an increase in the education level of a segment of market participants. For instance – as more market participants are able to conceptualize and then internalize the idea that environmentally friendly practices sometimes have economic value, actual value is created that wasn’t there before. Outside of the developing economies, most “growth” will come in this form in our lifetime. “Growth” is about more abstract ideas now that we have strip malls on every patch of land in the US and suburb neighborhoods out our ears. Another example of an abstract idea that actually provides real “growth” is eating food without preservatives. As folks realize that preservatives may cause them to get cancer and/or detract from their long-term health in many ways, the production and delivery of products with no preservatives is “growth” fueled by an increase in the general level of research and education.