S&P 500 Composite (Adjusted for Inflation)

12/31/1820 03/31/1824 06/30/1827 09/30/1830 12/31/1833 03/31/1837 06/30/1840 09/30/1843 12/31/1846 03/31/1850 06/30/1853 09/30/1856 12/31/1859 03/31/1863 06/30/1866 09/30/1869 12/31/1872 03/31/1876 06/30/1879 09/30/1882 12/31/1885 03/31/1889 06/30/1892 09/30/1895 12/31/1898 The Death of Equities Dr. Bryan Taylor, Chief Economist, Global Financial data 2011 has ended with another subpar year for equities. The United States was the only major market in the world that registered any increase in the share prices, and that was very small. The indices of most developed countries remain below the level they were at in 2000 when the Twentieth Century ended. Many investors are worried that stocks will continue to provide inferior returns for years to come. Unfortunately, they may be right. Historical Returns to Stocks and Bonds Equities reflect the present value of future earnings and free cash flow to a corporation. If investors anticipate that future earnings will rise, the stock price rises, but if investors anticipate a decline in future profits, share prices will fall. During the 18 th and 19 th Centuries, the average share price of equities changed little (Figure 1). Most stocks were valued at the same amount they were at the beginning of the century because there was little inflation, investors didn t have to consider the trade-off between income taxes and capital 100 S&P 500 Composite (Adjusted for Inflation) 90 80 70 60 50 40 30 S&P 500 Composite (Adjusted for Inflation) 20 10 0 Figure 1

01/31/1900 09/30/1903 05/31/1907 01/31/1911 09/30/1914 05/31/1918 01/31/1922 09/30/1925 05/31/1929 01/31/1933 09/30/1936 05/31/1940 01/31/1944 09/30/1947 05/31/1951 01/31/1955 09/30/1958 05/31/1962 01/31/1966 09/30/1969 05/31/1973 01/31/1977 09/30/1980 05/31/1984 01/31/1988 09/30/1991 05/31/1995 01/31/1999 gains taxes, and most profits were returned to shareholders. This changed in the 20 th Century. As countries abandoned the gold standard and allowed their paper currencies to inflate, share prices rose (though often accompanied by numerous stock splits). As governments grew in size, so did taxes, and in countries where income taxes on dividends exceeded capital gains taxes, investors benefited from allowing corporations to reinvest profits that generated capital gains. Anticipation of future capital gains could lead to P/E expansion (Figure 2) as investors anticipated rising earnings. Finally, as central banks manipulated interest rates to influence the economy, lower interest rates made equities more attractive contributing to the rise in equity prices. 40 S&P 500 P/E Ratio 35 30 25 20 15 S&P 500 P/E Ratio 10 5 0 Figure 2 At the same time, returns to fixed income investors are at unprecedented low levels. Shortterm treasuries yield almost nothing in the United States while a 10-year bond yields less than 2%. Generally speaking, the long-term yield to fixed income investors equals the coupon when the bonds are issued, so fixed income investors should expect no more than a 2% annual return for the next decade, and if inflation were to pick up, real returns after inflation could be negative. If yields stay at these low levels, fixed-income investors get little or no return, and if yields fall, the situation becomes even worse.

01/31/1950 10/23/1956 10/30/1958 11/09/1960 11/14/1962 11/19/1964 12/01/1966 12/10/1968 12/25/1970 01/16/1973 03/03/1975 04/18/1977 06/06/1979 07/21/1981 09/03/1983 10/22/1985 01/04/1988 05/14/1990 10/26/1992 04/14/1995 09/29/1997 03/22/2000 09/04/2002 03/01/2005 08/15/2007 02/16/2010 If inflation or other factors drive yields up, fixed-income investors face capital losses that reduce their total return. Could the 21 st Century be reverting back to the condition in the 18 th and 19 th Centuries where the capital gains on stocks were minimal or non-existent? Unfortunately, this may be the case. Japan s Two Lost Decades Japan has been in this situation for over 20 years now. From 1950 to 1989 (Figure 3), Japan had one of the best performing markets in the world when the annual return to stocks and bonds was 14.24% per annum. The phenomenal growth in equity returns occurred as Japan s economy caught up with the rest of the world after the devastation of World War II. Since then, stock prices have declined dramatically, showing an annual decline of 4.72%. At the end of 2011, the Nikkei was at the same level it had been at in 1983, almost 30 years with no change in stock prices. Moreover, the trendline on Japanese equities remains down. With Japan s 10-year bond yielding 1% at the end of 2011, bonds provide a poor alternative to equities which provide a 2% dividend yield, and with the Yen appreciating against other currencies, the return from foreign investments to Japanese investors is reduced. Is this the fate of investors in the rest of the world in the century to come? 45000 40000 35000 30000 25000 20000 15000 10000 5000 0 Nikkei 225 Stock Average Nikkei 225 Stock Average Figure 3

What went wrong? Why have stocks performed so poorly in Japan during the past 20 years? Part of the explanation is the bubble in stocks that occurred in Japan in the late 1980s, pushing share prices to unsustainable levels, just as Internet stocks increased in value in the 1990s. However, while other indices may stabilize after the bursting of an equity bubble, Japan remains in a downtrend. But why would it take over 20 years to recover from an asset bubble? The more important long-term factor is Japan s Nominal GDP which in 2011 is at the same level it had been at in 1991. No increase in GDP means no increase in profits and no increase in stock prices. Whereas GDP had been rising in Japan from the end of World War II until 1990 allowing profits to increase and stock prices to rise, the end to rising GDP not only kept profits from growing but led to the compression in the PE Ratio and lower stock prices. Moreover, the Japanese population has declined during the past 10 years and has hardly changed over the past 20 years. The Japanese population has been aging, reducing the number of people of working age and in the labor force, further reducing the ability of GDP to grow. As the dependency ratio between workers and non-workers increases, the cost of supporting retirees rises, further limiting the growth in profits and thus share prices. This trend is reflected in the fact that labor force participation in Japan has fallen from 64% in 1970 to 59% today. Although the size of government in Japan is smaller than it is in the rest of the developed world, government expenditures represent about 40% of GDP, leaving only 60% of the economy for the private sector to generate the growth needed to provide the future corporate profits that will allow share prices to increase. Could Japanese share prices be the same 20 years or 100 years from now as they are now? Yes. If the profits of Japanese corporations fail to grow then stock prices will stay where they are now. With no inflation, no growth in population, a shrinking labor force, a low dividend yield, a low yield on government bonds, rising government debt, an increase in the dependency ratio as the population ages, and a stronger yen, this remains not only a possibility, but a probability. People talk of Japan s lost decade. Could it be a lost century? More importantly, is this the fate that awaits the rest of the developed world? America s and Europe s Lost Decade Although the US Stock market was the only developed market in the world that provided positive returns to investors last year, it remains below the level it was at when the 21 st Century began. This has occurred despite a 50% increase in nominal GDP since 2000. Unfortunately, this is true of the rest of the world. MSCI s EAFE Index remains below the level it reached at the end of 2000 as does the European index. Most of the factors that have kept share prices from rising in Japan are also present in Europe and the United States. Europe s population is shrinking in some countries and stagnant in others, though population in the United States is rising due to higher population growth and immigration.

However, both the United States and Europe face aging populations with rising dependency ratios. Labor force participation peaked in the United States in 2000 and has declined since then while labor force participation in Europe has been declining since the 1990s. A large portion of the increase in labor force participation at the end of the 20 th Century came from women joining the workforce, but women s share of the labor force has stabilized since the 1990s. Many governments have tried to spend their way of the Great Recession through running large budget deficits from increases in government spending and declining government taxes; however, the deficits these policies have produced are unsustainable and have led to austerity programs in countries facing fiscal crises. A second response has been to expand the Central Bank s balance sheet as a way of providing liquidity to the private sector. These policies have also sent interest rates to unprecedented historical lows reducing returns to fixed income investors. One important thing to remember about fiscal and monetary policy is that they can help the economy to avoid problems, but they cannot generate growth. Fiscal policy can redistribute income to avoid large drops in aggregate demand, but true GDP growth comes from increasing productivity and the amount of resources allocated to economic activity. Monetary policy can be used to control inflation, or the Central Bank can act as a lender (or bond purchaser) of last resort to prevent a financial meltdown, but monetary policy cannot generate change productivity or the amount of economic resources. Only the private sector can generate the economic growth needed to increase corporate profits and equity prices. In one important way, Europe and the United States are in a worse position than Japan. In many European countries, the government represents half of GDP. Although the government, federal state and local, represents about 40% of GDP in the United States, if you add in the portions of health and education, which are largely state provided in Europe, which are provided by the private sector in the United States, the government, health and education represent about 50% of GDP in the United States as well. This leaves only 50% of the economy to the private sector. At the beginning of the 20 th century, government represented around 10% of the economy when countries were not at war, leaving 90% of the economy in the for-profit sector to generate profits for investors. That is no longer true. In addition to government expenditures, the cost of transfer payments and the impact of government regulations must also be considered as factors that limit the growth in corporate profits. So in a world where the non-profit government sector represents half of GDP, where populations are stable and labor force participation is shrinking, where populations are aging and the dependency ratio of non-workers on workers is rising, where inflation is low or stable, where nominal GDP is stable, where the catch up growth that occurred in Japan and Europe after World war II has come to an end, where governments have built up large debts, sometimes exceeding GDP, where these governments have even larger future liabilities for retired workers which will have to be borne by workers and corporations, how can investors anticipate the increase in profits necessary to generate higher stock prices?

On the contrary, it would be quite easy to argue that it is because of these conditions that the expectations of future corporate profitability has fallen and that equities have shown no increase in price over the past decade. This also means that unless the conditions cited above change, equity prices could be the same at the end of the 21 st Century as they were at the beginning. The problem this creates is obvious. Workers directly or indirectly through their pension plans save for their retirement. Providing a sufficient amount of money to cover personal expenses after retirement has become dependent on high returns to equities and fixed income. However, if equities once again become like bonds and show little capital appreciation, and dividends and bonds only return 2-3% per annum, there will be less money available for retirees. Many governments have created pension plans and retirement income dependent upon rising government revenue generated by a rising workforce and/or high returns on their investments. If either of these events fail to materialize, governments will have to cut back on the benefits they provide. Less money available to retirees means less expenditures, which means less profits for corporations, which creates a vicious circle sustaining the absence of capital appreciation in equities. The Death of Investing Investors in the 21 st Century may face the worse of all possible worlds. Fixed income provides little or no returns, and if yields rise, fixed-income investors will face capital losses. Equity investors may also face a similar situation. Rising equity returns are dependent on rising corporate profits. But if government represents 50% of GDP and provides substantial transfer payments, the share of the economy that allows corporate profits to grow is limited. Even within the for-profit sector, the opportunity for growth is limited. Increases in profits depend solely on productivity increases due to innovations, not applying existing technology to benefit from catch up growth, or increasing labor force participation either through an increase in the working age share of the population, bringing more women into the workforce, or shifting workers from agriculture into industry and services. In most developed countries, services represent 2/3 of GDP making productivity increases more difficult. If nominal GDP remains stagnant and labor force participation declines, it is difficult to see how investors can anticipate the rising profits necessary to sustain capital gains in equities. What profits are generated will be transferred to the aging population instead of being reinvested to increase future profits. If the returns to equities fall, investors could focus on timing the market, but this is a zero-sum game. Investors in the developed world could move more of their investments to developing countries where these conditions are not yet present, but such a move would create problems of its own. Many developing countries have their own barriers to or controls on foreign investment. Although there are still many opportunities for catch up growth in emerging markets, they also face the problems of lower population growth, rising dependency ratios, and growing populations dependent upon pensions and other retirement benefits. Because of China s one child policy, the country is aging quickly and by the 2020s, the median age in China will be greater than in the United States. Most Asian and Latin American countries have already reached the point where population growth has stabilized.

The Lost Century Will the 21 st Century be a Lost Century for investors in which the world returns to a situation in which capital gains are rare and investors live off of the dividends and interest payments provided by the shares and bonds that they own as occurred in the 18 th and 19 th Centuries? If the 21 st Century is one in which populations are stable or declining, labor force participation declines, the population is aging, increasing the dependency ratio between the working and the nonworking, government, health and education represent a substantial and rising portion of GDP leaving less opportunity for corporations to grow profits, and nominal GDP remains stagnant as the service sector dominates the economy and the opportunities for productivity growth are limited, then this remains a high probability. Some of the solutions are non-starters. Demographics are unlikely to improve. The trend of an aging population with a rising dependency ratio is unlikely to change. Higher inflation would only change nominal not real returns and trying to trade the market s fluctuations is both difficult and ignores the fact that this is a zero-sum game. Shifting investments to emerging markets may provide some short-term relief, but may only delay the inevitable day of reckoning. Is there anything that can be done to avoid having finance join economics as a dismal science? The only way to allow future profits to increase at a higher rate is to allow the private sector more opportunities to generate profits. This would mean shrinking both the size of government and the role of government in the economy at every level. This would include reducing the level of government expenditures, eliminating the corporate income tax and tariffs, simplifying the tax system, reducing government regulation, eliminating activist monetary policy, and allowing the role of the private sector to increase at every level of the economy. What is needed is more private sector stimulus and public sector austerity rather than the other way around. The 21 st century need not be a lost century, but unless the role of government in the economy changes, it very well could be.

GFD File ID (Symbol) Current Series _SPXD _N225D File Description (Name) S&P 500 Composite Price Index (w/gfd Extension) Nikkei 225 Stock Average (w/gfd Extension) Periodicity (dates) Monthly From Aug 1791 To Jan 1918 Weekly From Jan 1918 To Dec 1927 Daily From Jan 1928 To Jul 2012 Monthly From Jul 1914 To Oct 1946 Weekly From Nov 1946 To May 1948 Daily From Jun 1948 To Sep 1948 Monthly From Sep 1948 To Dec 1954 Daily From Jan 1955 To Jul 2012 SYUSAPM S&P 500 P/E Ratio (As Reported Earnings) Monthly From Jan 1871 To May 2012 NOTICE AND DISCLAIMER This document and all of the information contained in it, including, without limitation, all text, data, graphs, charts, and tables (collectively, the Information ) is the property of Global Financial Data, Inc. or its subsidiaries, parent companies, and/or affiliates (collectively, GFD ), or GFD s licensors, direct or indirect suppliers, or any third party involved in the making, compiling, or creation of the Information (collectively with GFD, the Information Providers ) and is provided for informational purposes only. The Information may not be reproduced or re-disseminated in whole or in part without prior written permission from GFD. The Information may not be used to create derivative works or to verify or correct other data or information. For example, without limitation, the Information may not be used to create indices, databases, risk models, analytics, software, or in connection with the issuing, offering, sponsoring, managing, or marketing of any securities, portfolios, financial products, or other investment vehicles utilizing or based on, linked to, tracking, or otherwise derived from the Information or any other GFD data, information, products, and/or services. NONE OF THE INFORMATION PROVDERS MAKES ANY EXPRESS OR IMPLIED WARRANTIES OR REPRESENTATIONS WITH RESPECT TO THE INFORMATION (OR THE RESULTS OBTAINED BY THE USE THEREOF), AND TO THE MAXIMUM EXTENT PERMITTED BY APPLICABLE LAW, EACH INFORMATION PROVIDER EXPRESSLY DISCLAIMS ALL IMPLIED WARRANTIES (INCLUDING, WITHOUT LIMITATION, ANY IMPLIED WARRANTIES OF ORIGINALITY, ACCURACY, TIMELINESS, NON-INFRINGEMENT, COMPLETENESS, MERCHANTABILITY AND FITNESS FOR A PARTICULAR PURPOSE) WITH RESPECT TO ANY OF THE INFORMATION. Without limiting any of the foregoing and to the maximum extent provided by law, in no event shall any Information Provider or their employees, officers, and directors have any liability regarding any of the Information for any direct, indirect, special, punitive, consequential (including lost profits) or any other damages even if notified of the possibility of such damages. Information containing historical information, data, or analysis should not be taken as an indication or guarantee of any future performance, analysis, forecast, or prediction. Past performance does not guarantee future results. None of the Information constitutes an offer to sell (or a solicitation of an offer to buy), any security, financial product, or other investment vehicle for any trading strategy. Any use of or access to products, services, or information of GFD requires a license from GFD. GFD and its parents, subsidiaries, and affiliates brands and product names are trademarks, service marks, or registered trademarks of GFD or its parents, subsidiaries, and/or affiliates in the United States of America or other jurisdictions, as applicable. Nothing contained herein or the Information is intended to transfer, assign, mortgage, pledge, or otherwise provides a license for you to use GFD s, its parents, subsidiaries, and/or affiliates trademarks, service marks, or registered trademarks.