Via Brad Delong, Marty Feldstein critiques Dean Baker’s and Mark Weisbrot’s stance on equities.

[Baker and Weisbrot’s] basic point is that "the 6.5-7.0 percent real returns assumed by advocates of investing in the stock market are inconsistent with the 1.5 percentage growth rate for the economy and profits assumed by the Social Security Trustees" (News from Preamble, February 22, 1999).

As a matter of basic economics, this is simply wrong. There is no necessary relation between an economy’s growth rate and the rate of return earned on capital in general and equity capital in particular.

I have not read Baker or Weisbrot on this issue. However, the point I’ve tried to make is that in the long run profits cannot grow faster than the rate of growth of the overall economy.

This implies that if there is any upper bound on the P/E ratio then stock prices also cannot grow faster than the economy for long. Now, price increases are not the only return to equity. There are dividends.

Indeed, assuming that the P/E ratio is bound and that the stock market is a representative sample of American business, the rate of return of equities will be essentially the growth rate of the economy plus the dividend yield.

In fact the stock market is almost certainly not a representative sample of business in the long run.  In the long run, many businesses that will dominate American industry have not even been created yet, so they cannot be listed in a stock index.

Thus the long run return on the equity market is somewhat lower than the growth rate plus the dividend yield. 

All of that having been said, the question is, is 6.5 – 7.0 percent an implausibly high return? I think so.

Right now the dividend yield on the S&P 500 is just under 3%. The long run growth rate of the economy is somewhere around 2.5%. Thus the long run return on equities should be something short of 5.5%.

In the past dividend yields were higher and the economy was growing faster. Both of these effects could be attributed to demographics. With a fewer workers entering the workforce, there is less labor supply. With more workers looking towards retirement there is more capital supply. This drives down the growth rate for the economy and the dividend yield.