AgPa #24: Market Capitalization vs. GDP

The big bang: Stock market capitalization in the long run (2022)
Dmitry Kuvshinov, Kaspar Zimmermann
Journal of Financial Economics 145(2), 527-552, URL

This week’s AGNOSTIC Paper is admittedly not very practical. It examines the ultra-long-term and therefore includes a lot of nasty methodological details. However, I believe this perspective and some of the results are today more relevant than ever before. The authors examine the outstanding performance of equity markets since the end of the inflationary 1970s and early 80s. A regime shift that they call the big bang.

Many people contribute the outstanding performance of equities to steadily declining interest rates since the 1980s. As a consequence, some of them now also worry whether this trend got finally broken in 2022. The data and methodology of the paper shows that (as so often in science) the story is not so simple. Of course, equities like low interest rates but there are other, even more important, factors as well…

Everything that follows is only my summary of the original paper. So unless indicated otherwise, all tables and charts belong to the authors of the paper and I am just quoting them. The authors deserve full credit for creating this material, so please always cite the original source.

Setup and Idea

There is not so much to add to the short introduction above. It is a well-known empirical fact that interest rates (and inflation) were relatively low since the 1980s. As a consequence, investors experienced a >40 year bull market for bonds. Despite some crashes and crises, the period since the 1980s was also outstandingly good for stocks and other risky assets.[1]The MSCI World Index delivered a total annualized return of about 8.6% between 01/31/1980 and 09/30/2022. The S&P 500 Index was with 11.5% even better. Due to those outstanding returns and the general economic prosperity, some people also call this period the “great moderation”.

Of course, standing here in 2022, the world doesn’t feel so “moderate”. Inflation is very high, apparently more persistent than thought, and interest rates are rising. Some people therefore ask whether the “great moderation” is finally over and if we enter another gloomy period like the “stagflationary” 1970s. I don’t believe economic forecasts are a worthwhile endeavor, but I am of course interested what such a scenario would mean for equity markets. Of course, we have now all experienced that stock markets neither like unexpected inflation nor rising interest rates. However, the results of the paper offer some hope that even a regime of rising interest rates might be not necessarily the deathblow for equity markets.

Data and Methodology

The authors start with the ultra-long-term database of the “Return on Everything” paper and develop it even further. Dmitry Kuvshinov, one of the authors, was also part of the team that wrote the first paper, so this is a nice follow-up. Specifically, the sample includes annual data on stock market capitalization and corporate fundamentals for 17 developed countries between 1870 and 2016. Such a long time series is of course very cool and the authors mention that some of their data has never been used before. Most of the data comes from archives of stock exchanges or central banks, national libraries, and other researches. So compared what I am doing here in front of my screen, this is real work.

Constructing such a dataset inevitably requires a lot of assumptions and the authors explain their methodology in great detail. They also use many different econometric techniques to derive their results and I will not comment on every single one.[2]Or to be more honest, I am not able to give you more details on every single one. That’s the nice thing about summarizing papers instead of writing them. But for those who are interested, the captions of the charts should include the most relevant information. Overall, the results are in the same ballpark with what I have seen elsewhere. The paper is also published in the Journal of Financial Economics, so the data and methodology should be trustworthy.

Important Results and Takeaways

The Big Bang: market capitalization detached from GDP growth after the 1980s

The first result sets the stage for everything that follows. The chart below shows the ratio of aggregate stock market capitalization to GDP (MC/GDP in the following) for the 17 countries between 1870 and 2016. The line corresponds to the median of the countries, the shaded area is the interquartile range.

Figure 1 of Kuvshinov and Zimmermann (2022).

For the period between 1870 and 1980, MC/GDP was relatively stable and hovered around its long-term average of about 0.3. After the 1980s, however, the ratio detached from its own history and approximately doubled to values between 0.5 and 1. Since the shaded interquartile range also follows this pattern, this is not a regional phenomenon but quite persistent across the 17 countries.

Intuitively, this means that aggregate stock market capitalization outgrew GDP over most of the last >40 years. The point that is really striking, however, is that the previous 100 years were different. So either something has fundamentally changed, or we were just lucky and got a >40 year period with above-ultra-long-term-average returns. In any case, the authors lovingly call this regime shift the big bang.

Most of the Big Bang comes from higher stock prices

The second result also still belongs to the stage-setting phase. To get more aggregate market capitalization you either need higher stock prices, more equity supply, or both. The authors use historic capital gains (higher prices) and net equity issuance (more quantity) to account for those two components. The following chart summarizes the result.

Figure 7 of Kuvshinov and Zimmermann (2022).

The figure clearly shows that most of the big bang comes from capital gains (blue bars), i.e. “higher stock prices”. This is consistent with the (sometimes worried) view that equity returns were above-ultra-long-term-averages since the 1980s. In contrast, net equity issuance (green bars) declined continuously and was almost zero at the end of the sample around 2016. So the big bang and the increase of MC/GDP ratios was clearly driven by higher stock prices and capital gains. Also note that the chart shows again global averages. Except for some outliers, the pattern is therefore also quite persistent across the 17 countries.

So much to the big bang and its underlying mechanisms. In the remaining paper, the authors now examine different explanations why MC/GDP ratios are higher than during the first 100 years of the sample. For this purpose, they present a simplified discounted cash flow model and identify three fundamental drivers: the profit share of listed firms, the expected growth of these profits, and the expected return to discount those profits to the presence. I will not cover the role of expectations, as the authors discard that one rather quickly. Therefore, let’s start with interest rates.

Falling interest rates are surprisingly not the main driver

After the inflationary 1970s, interest rates declined steadily to de-facto zero in the 2010s and early 2020s.[3]It is hard to imagine, but the 10Y US Treasury rate peaked at close to 16% in 1981. I don’t want to open the discussion of whether this trend now reverses but many people still argue that the outstanding equity performance over the last >40 years was mainly driven by falling interest rates. And that makes sense because if you discount dividends or cash flows at lower rates, their value increases.

However, the authors show that this is not so simple for equities. Risk-free rates are only one part of the expected return on equities, the other one are risk premiums. Interestingly, as the chart below shows, the decline in risk-free rates was balanced (sometimes even overruled) by widening risk premiums. There are of course also countries where the effect of falling interest rates prevailed, but overall, expected returns on equities didn’t fall too much.[4]As you can see in the chart, the largest decline are about 4%-points for Spain. For the US, the decline is with about 1%-point quite modest. Declining risk-free rates are therefore unlikely the main driver of the big bang.

Figure 14 of Kuvshinov and Zimmermann (2022).

One important note to those results. Risk premiums and expected returns on equities are theoretical concepts (they are not directly observable) and there are different ways to estimate them. The results therefore depend on many methodological details. However, the results of the authors are quite in line with other studies. For example, Damodaran (2022, Figure 13) also finds that the expected return on US equities decreased after the 1970s but still remained around the pre-1970s levels over the 1990s and 2000s. The mechanisms are again widening risk premiums that balance the effect of declining risk-free rates.

Higher profitability of listed firms is much more important

After discarding the effect of expectations and falling interest rates, the authors finally turn to the third mechanism: the profit share of listed firms. Using data on dividends and earnings, they find a “historically unprecedented” corporate profit boom after the 1980s and argue that this was the main driver of the big bang. The following chart illustrates this over time: the ratio between listed earnings and GDP increased steadily and this is consistent across various data sources. The pattern is also quite similar for dividends.

Figure 15 of Kuvshinov and Zimmermann (2022).

We have already seen that net equity issuance was very low since the 1980s, so in aggregate, there were not many new firms that contributed to the profit boom. The results therefore suggest that the existing listed firms became more profitable. In further analyses, the authors indeed show that the profit boom was primarly driven by higher margins and increasing dominance of large incumbent firms.

However, the question what enabled this boom is still remaining. And there are finally some good news for all who believe that low interest rates turbocharged equity returns and that we are due for disappointing years ahead. The authors show that a substantial part of the higher profit margins come from lower taxes and, wait for it, lower interest expenses. So yes, falling interest rates ultimately mattered for the big bang, but much more indirectly via profit margins than directly via the discount rate.

Conclusions and Further Ideas

To be honest, this week’s paper was one of the most intense I did so far. It is full of methodological details, data descriptions, and economic theory. What I presented here is therefore just the tip of the iceberg and the authors provide much more details. Therefore, like my first post on the long history of markets, this one is again cherry-picking from someone mainly interested in finance.

With respect to the results, I really like the structure of the paper and I believe the insights are valuable. Yes, equity markets posted above-ultra-long-term-average returns since the 1980s. Yes, interest rates were falling steadily over the same period and contributed to lower expected returns. But no, this is not the full story. Most of the outstanding equity returns (and the corresponding increase of MC/GDP ratios) actually came from higher profits of listed companies. Lower interest rates still contributed to this development via lower interest expenses in firms’ income statements, but this is a much more indirect effect than thought. The second important driver of this profit boom were falling corporate taxes and increasing dominance of listed firms.

By and large, I think those results go in a positive direction. They suggest that the last >40 years were not just a giant “falling-interest bubble” but that fundamental factors (higher profits of listed firms) somehow supported the strong performance of equities. Of course, you can still argue that this was only possible because of lower interest rates. However, I think the ability of listed companies to translate such a supportive environment into “historically unprecedented” profits is valuable in itself and deserves somewhat higher returns.

On the other hand, I don’t want to be misleading. Higher interest rates are not the ideal setup for equity markets[5]Does someone really question that after 2022? and the results of this paper are certainly no reason to relax in the current environment.[6]There is a lot of evidence that the investment outlook for the next years is rather muted. More on that, for example, in Antti Ilmanen’s latest book.[7]For example, you can also make the argument that corporate debt currently stands at historical highs and higher interest expenses (due to rising rates) will return the trend of expanding profit margins. The only point I want to make is that an increase in interest rates does not automatically mean that we are heading back to more gloomy periods like before the 1980s. Time will tell and I am already looking forward to the follow-up after the next 40 years in 2062…

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