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STOCKS FOR THE LONG RUN

Eastern Mediterranean UniversityDr. Korhan Gokmenoglu

Mohamad Kaakeh 137618Masimba Mutuke 118198Victoria Adedayo oni 128123

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The impact of Economic growth

on market valuation and the coming age wave

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GDP growth and stock return

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GDP growth and stock return

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GDP growth and stock return

• Real GDP growth is negatively correlated with stock market returns.

• Why does this occur?• price is the present value of future dividends • Would economic growth positively impact future

dividends and increase stock prices? • the determinants of stock prices are dividends and

earnings on a per share basis, although economic growth influences aggregate earnings and dividends favorably, economic growth does not necessarily increase the growth of per share earnings or dividends.

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GDP growth and stock return

• Why?• Economic growth requires increased capital

expenditures, this extra capital is financed by debt (loans, bonds,..) or equity (issuing new shares) and the added interest costs (debt) and the reduction of earnings (equity) reduce the growth of per share earnings.

• growth can occur in the short term without capital expansion by using the existing plant more intensely. But the long run historical evidence strongly suggests that capital must be expanded to support higher growth.

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The Gordon Dividend Growth Model

• d is the next period dividend per share• r is the discount rate • g is the constant rate of future growth of

dividends per share

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Economic growth and stock returns

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Factors that raise valuation ratios

• Expected rate of returns on equities

• The Equity-Risk premium

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Factors that impact expected returns

• the reduction in taxes on equity return due to the reduction in marginal and capital gains tax rates and inflation.

• the reduction in transactions costs

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The Equity-Risk premium

• given the standard models of risk and return that economists had developed over the years, one could not explain the large gap between the returns on equities and fixed-income assets found in the historical data.

• economic models predicted that either the rate of return on stocks should be lower, or the rate of return on fixed-income assets should be higher, or both. In fact, an equity premium as low as 1 percent or less could be justified.

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More stable Economy• Attempts to justify the 3 to 3 1⁄2 percent risk

premium found in the historical datao Some of these are based on very high aversion by

individuals to lowering their consumption.o Others on those who dislike taking short-term losses on

their investments even when they have substantial long-run gains.

• Increasing stability of the real economy is the reason why premium might narrow in the future.

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More stable Economy

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New justified P-E Ratios

• Average historical P/E ratio may no longer be appropriate

• If inflation stays low, the tax policy remains favorable for equities, and the business cycle remains muted, one can justify price-to-earnings ratios in the low 20s for the equity market.

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The Age Wave• Inflation, tax policy, macroeconomic stability, and

the drop in transactions costs are important factors influencing the valuation of equities.

• Many are expecting a long and comfortable retirement by relying on government and private pension plans as well as tax supported medical services.

• Unless we can exploit the change in demographic and economic changes then we may face a poorer future.

• This forecast is not based on an unpredictable future but on events that have already transpired.

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Demography is Destiny

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The Bankruptcy of Government and Private

Pension Systems

• Although it is widely known that our Social Security and Medicare programs are threatened by these demographic trends, there are many who believe that they have accumulated sufficient private wealth to fund their retirement.

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The Bankruptcy of Government and Private

Pension Systems• But this may not be so. The same crisis that

strikes the public pension programs can overwhelm private pensions as well. Since there will not be enough workers earning income, there will not be enough savings generated to purchase the assets the retirees must sell to finance their retirement.

•  Reasons why retirees cannot turn their savings into consumption

• In a modern economy, wealth does not represent “stored consumption,”

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Reversal of a Century-Long Trend

• Implication of less demand and more supply • Social Security was passed in 1935, the average

retirement age was 69. That age fell to 67 by 1950, and to 62 today. In 2003, for the first time, more Americans chose the reduced Social Security benefits at age 62 than the full benefit that starts at 65. Despite improving health, surveys indicate that the bulk of Americans and Europeans want to retire earlier, not late.

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Reversal of a Century-Long Trend

• But that will not be possible. Because of our aging population, it is most likely that future increases in the age of retirement will actually exceed the increase in the life expectancy and will cause—for the first time in history—an absolute reduction in the number of years in retirement.

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The Global Solution: An Opportunity to Make a

Trade

• There is no easy solution. Nevertheless there is a solution that can help aging economies. This solution is call GLOBAL SOLUTION to the age wave

• How effective is this solution will be?• Growth rate in the developing world• Degree to which world trade and capital market

are kept open.

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The figure below shows how crucial the growth rate of the developing world is to future retirees

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Attraction of U.S. Capital

• Why would the developing world wish to acquire our capital when their countries are expanding so rapidly?

• that end, U.S. capital markets have many attractive attributes. Our country is still viewed as the fountainhead of innovation, discovery, invention, and entertainment, and our institutions of higher education are second to none.

• For these capital movements to occur, we must be viewed as receptive to international capital.

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CONCLUSION• faster economic growth in no way guarantees

higher returns.• there are persuasive reasons why future valuation

measures may be higher. Lower transactions costs, lower taxes, and increased economic stability.

• the aging of the population is a critical issue impacting financial market returns. We cannot escape from our demographic realities. But we can take actions that will lead to a much brighter outcome.

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Thank you for your attention

Any questions?

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questions• Why GDP growth and stock returns as shown in

the historical data are negatively correlated?

• Why the growth of earnings and dividends per share is higher since World War II than before even though the GDP growth is lower?