NCPA - National Center for Policy Analysis

STOCK RETURNS AND ECONOMIC GROWTH

July 1, 2005

Some critics of personal retirement accounts have argued that the projected earnings on stock returns are too high, given the projected gross domestic product (GDP) growth rate. They suggest that for consistency, the assumed stock return should be lower. A lower return would make reforms that include stock market investments less appealing.

Is this criticism valid?

According to the Private Enterprise Research Center's Liqun Liu and Andrew J. Rettenmaier, there are two main problems with the critic's argument:

One of their primary assumptions is that the dividend-price ratio will stay at its historical average while GDP growth is assumed to be lower than its historical average:

  • However, since lower projected GDP growth means lower investment, a larger share of earnings will be paid out in the form of dividends.
  • As a result, the dividend-price ratio will rise corresponding to the lower GDP growth.

Second, note that earnings growth is not solely determined domestically:

  • Limiting the extent of earnings growth to domestic GDP growth ignores the international nature of the firms represented in the stock market and the ability of workers to invest in the global economy.
  • Earnings growth of multinational and international firms will reflect international GDP growth, which may well exceed the growth in domestic GDP, particularly if developing countries like China and India are considered in the equation.

Source: Liqun Liu and Andrew J. Rettenmaier, "Stock Returns and Economic Growth," Brief Analysis 519, National Center for Policy Analysis, July 1, 2005.

For text:

http://www.ncpa.org/pub/ba519/

 

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