Thursday, February 03, 2005
Rising to the Baker/Krugman challenge
In his latest column about the coming plunge in stock market returns (but surely not his last) Paul Krugman wrote:
Mr. [Dean] Baker has devised a test he calls "no economist left behind": he challenges economists to make a projection of economic growth, dividends and capital gains that will yield a 6.5 percent rate of return over 75 years. Not one economist who supports privatization has been willing to take the test.Not being an economist, I shall now go where they fear to tread and take that test!
First, a recap of the conditions set for it in that column as covered here as long ago as yesterday:
We utilize the Baker/Krugman-column-version model that states domestic profits are a steady portion of GDP in the long run, and thus increase only as fast as GDP does, with GDP growth stated to rise an average 2% annually in the US for the next 50 years. Also, stock prices can increase only as fast as profits, as modified by change in the P/E ratio, which can't get ridiculous. Thus to get a 6.5% future return with today's 3% dividend payout we need 3.5% annual appreciation in stock prices, in spite of only 2% domestic growth, without getting P/E ratios of 100+ from the disparate rates of compounding. OK...
Pausing to get empirical for a moment, one notes that the S&P 500 over the last 55 years through the end of 2004 has appreciated 0.9% a year on average faster than GDP, for a total increase of 64% relative to GDP.
About half that is due to the increase in P/E ratio from 15 to 20, which as Jeremy Siegel has noted is reasonable in light of reduced risk to corporate investors (better management, much easier diversification for investors) and accounting factors (due to the increased reliance on intellectual assets, etc.) The rest comes from ... somewhere.
Taking this as our lead we take on the challenge that economists flee:
With 3.5% real annual appreciation in stock prices required, our target stock valuation is 5.6 times greater than today in 50 years.
With the stipulated 2% growth we get stock prices 2.7 times greater than today in 50 years.
Add an increase in the P/E ratio over the next 50 years that matches that of the last, ocurring for the same reasons, and we obtain a stock price of 3.6 times today.
Then we've still got to boost profits a bit somehow.
Hey, it's not illegal for US firms to earn profits abroad!
Note this is one area where past experience really is not indicative of likely future performance. Apart from the various historical episodes of the 20th Century that made it impossible-or-impractical to invest abroad in most of the world for most of the century, capital controls also often made it outright illegal right into the 1970s. But that's all entirely different going forward!
With more than 4 billion mostly young people today in economies in Asia, South America and Eastern Europe (and dare we hope Africa?) that expect to be grow a lot faster than 2%-a-year well into the forseeable future -- and we'd better hope they do, for the world's sake -- is it unreasonable to imagine profits earned abroad will grow in proportion to total profits over the next 50 years, as US economic growth slows?
Say there is such growth so that total future corporate profits come two parts from the Baker/Krugman 2% domestic growth rate plus one additional part from abroad (that is, one part in three, one-third) and there we are, bingo! We've got profits enough for our 5.6x valuation, or 96+% of the way to it.
(Alternatively, of course, we could have the P/E ratio rise less and profits from abroad rise more for the same result).
Now are profits earned abroad on this scale 50 years in the future entirely implausible in light of the likely course of future world economic development?
If not, please have Mr. Baker contact me about where to send the trophy and prize check. (I hope I'm not disqualified for talking 50 years instead of 75.)
BTW, if sometime in the next 50 years I'll be able to invest directly in China or India -- or in the Vanguard Greater China and India Diversified Growth Fund -- as their GDPs come to exceed that of the US, then I really won't care whether or not staid old US stocks can appreciate only 2% year.