If Economic Growth Falls to 1.4%, What Happens to the Stock
By: John Mueller
The National Press Club, October 14, 1997
1. When Can We Use the Past to Forecast the Future?
Those who seek to end pay-as-you-go Social Security often compare past
returns on financial assets with projected future returns on pay-as-you-go
In the past, the "privatizers" agree, the average return on
Social Security -- about 9% -was much higher than the average returns on
common stocks.1 But future returns on Social Security, the "privatizers"
argue, will be far lower than in the past. Therefore, they say, future
retirees would be better off if pay-as-you-go Social Security were
abolished and replaced with financial savings accounts.
If we believed that the future will resemble the past (apart from
random variations), then past returns on financial assets would be our
best guide to future returns. In that case, we would have to conclude that
Social Security will outperform financial assets in the future, because it
always did so in the past.
But the "privatizers" insist that the future will be very
different from the past. First, they point out, Social Security's
extraordinary returns in the past were partly due to the startup of a
pay-as-you-go retirement system, which will not be repeated. Second, they
say, the retirement of the Baby Boom will result in a sharp decline in the
ratio of workers paying taxes to retirees receiving benefits. Finally,
they point out, in a mature pay-as-you-go retirement system, the average
return of benefits from paying payroll taxes is equal to the rate of
economic growth -- but the projected demographic bust implies much slower
If we accept these assumptions, we can no longer assume that the
average future returns on financial assets will equal average returns in
the past. Otherwise, we would have to make at least three peculiar
assumptions: first, that Social Security is affected by the rate of
economic growth, but financial assets are not; second, that the return on
Social Security is affected by demographic changes like the Baby Boom, but
financial assets are not; finally, that the return on financial assets is
unaffected by the return on alternate investments like Social Security.
2. The Systematic Behavior of Financial Markets
Using past returns to forecast the future requires certain basic
assumptions, which are squarely contradicted by the assumptions just
described. This renders useless certain techniques (like "Monte
Carlo" simulations, which are much in vogue at the moment), because
the basic requirement for projecting past financial returns into the
future is that the past variation in returns must be random. Although
there is a great deal of randomness in day-to-day and month-to-month
variations in asset returns, the longer-term behavior of financial assets
over the past century has been quite systematic. This is obvious, for
example, when we consider asset returns in 20-year periods. (The typical
family has an average of about 20 years in which its retirement savings
can earn a return on investment.3
Since 1900, the 20-year average annual real change in the stock market
was negative about one-third of the time. And this did not occur randomly,
but in four periods of several years each. The 20-year average real total
return (that is, the return if all dividends are reinvested in the stock
market) fell to about zero during three 20-year periods in the past
century -- from 1901 to 1921, from 1928 to 1948, and from 1962 to 1982. In
each case, these lows were interspersed with periods in which stock
returns peaked at rates about twice the long-term average -- again for
several years at a time. In other words, there is evidence of a pronounced
stock market cycle.
We see a similar non-random pattern in bond returns. Since 1945, the
20-year average annual real return on long-term government bonds was
negative almost exactly two-thirds of the time -- in fact, for 33 straight
years. During the same half-century, the 20-year average real total return
on long-term corporate bonds was negative almost exactly half the time --
for about 25 almost uninterrupted years. Measured net of management fees
(but before taxes), corporate bonds also yielded a negative return for 33
years straight. It's curious that the "privatizers" now ignore
all this. Martin Feldstein used to remark rather often about the
inordinate length of these financial losing streaks.4
Before projecting the past into the future, therefore, we must first
account for this systematic behavior. The current paper will show that the
non-random long-run return of the stock market is largely a function of
three factors: the rate of economic growth, the relative size of
subsequent generations, and the stock market's volatility -- precisely the
three factors which the "privatizers" ignore. If future economic
growth and demographic trends are as adverse as projected, so will be the
performance of the stock market. In the future as in the past,
pay-as-you-go Social Security will continue to outperform financial
3. Economic Growth and the Stock Market
Measured by its "standard deviation," the stock market has
been about four times as risky as the economy since 1926. Because of
people's natural aversion to risk, this higher volatility is the main
reason why the risk-adjusted return on the stock market has been much
lower than the rate of economic growth.
It might seem, then, that any change in the rate of economic growth
would cause the stock market to decline or accelerate by some multiple.
But this is not the way things work. Short-term fluctuations of the stock
market are a multiple of variations in economic growth. But the long-term
influence seems to be almost exactly 1 for 1. We will therefore begin by
dividing the total return of the stock market by gross domestic product.
This index will show how the stock market performs relative to the
economy. It also has the advantage of telling us how the stock market
performs relative to pay-as-you-go Social Security.6
Apart from the pronounced waves which we are trying to explain, the
stock market's total return rises relative to the economy at a constant
rate of about 2-1/2%. This rate is precisely equal to the risk premium of
the stock market vs. the economy, during relatively quiet periods -- the
average volatility in stock returns since 1880, excluding the turbulent
years between the start of the Great Depression and the end of the Korean
Since the Korean War, the annual stock market total return fluctuated
about 12 percentage points above or below average; while growth of the
economy fluctuated about 3 percentage points from the average. This
difference in "normal' volatility implies that, for the median
investor -- someone who is neither terribly conservative nor overly
speculative -- the "risk premium" in the total return of the
stock market, compared with the economy (or with Social Security), is just
This is interesting but also curious. Standard portfolio theory assumes
that higher stock market risk8 is rewarded by a higher return. That
implies that the average rate of return on the stock market ought to be
proportional to the average volatility of returns. If so, stock market
returns ought to have been higher when the market was more volatile, and
lower when the market was less volatile. Exactly the reverse is true. The
return on the stock market has been sharply lower, immediately after
20-year average volatility was higher than average, and the return was
sharply higher, immediately after volatility was lower than normal.
This means that the stock market rewarded investors for what we might
call "normal" risk, but penalized those who assumed
"abnormal" risk by remaining fully invested in stocks.
The principle is essentially the same as the difference between "systematics"
and "unsystematic" risk in the theory of equity diversification.
In portfolio theory, the "unsystematic" risk assumed by an
investor as the result of failing to diversify his equity holdings (among
different companies and different sectors) is not rewarded with a higher
return, because such risk could have been avoided. Only the
'systematic" risk to which a diversified stock portfolio is subject
is rewarded, in this theory.
But the same is true to a certain extent of the stock market as a
whole, because equities comprise only one of several alternate classes of
financial investments. Exposure to abnormal variations in stock market
risk could be avoided by holding less risky assets.
We can get an idea of this shifting among asset classes, in response to
perceived changes in stock market risk, by comparing the 20-year average
volatility of stock market returns with the short-term interest rates (in
this case, the yield on high-quality 6-month commercial paper). Whenever
stock market volatility rose above the "normal" average, the
commercial paper rate declined, and whenever stock market volatility fell
below the "normal" average, the commercial paper rate rose.
We will consider the effect of "abnormal risk shortly. For now, we
note that when we adjust for GDP growth and for "normal" stock
market risk, we find that the total return of the stock market fluctuates
in waves compared with the economy. Most of these waves are associated
with demographic changes.
4. Demographics and the Stock Market
This brings us to the second remarkable assumption of the "privatizers":
that the stock market is not affected by the differing sizes of
The omission is curious, because the "privatizers" also argue
that the future return on Social Security will be adversely affected by
the relative size of the "Baby Boom." With more retirees and
fewer workers, they argue, the system will not be able to support growth
of benefits at the same rate as in the past.
What they don't explain is why the stock market is not affected by
exactly the same demographic changes. After all, there will be fewer
workers producing profits, but more retirees trying to live on those
profits -- and, later on, there will be fewer investors to sell their
remaining assets to. We can view this demographic reality by comparing the
relative size of subsequent generations. A convenient way to do this is to
compare the ratio of 44-year-olds to 22year-olds.9
If we compare the risk-adjusted return of the stock market, relative to
the economy, with the relative size of successive generations, we find
that there is, on average, a one-for-one relation between the two. A
smaller generation receives a stock-market return higher than the rate of
economic growth, and a larger generation receives a return that is lower.
Even the year-to-year correlation between the two has been remarkable
since about 1960. From 1962 to 1982, the risk-adjusted stock market
underperformed the economy by more than half -- almost exactly the same
proportion in which the ratio of 44to 22-year-olds was falling. Since
1982, the stock market (adjusted for risk) has risen about three times as
fast as the economy -- almost exactly the proportion by which the ratio of
44- to 22-year olds was rising.
Generation size, therefore, explains the rest of the trend of the stock
market's riskadjusted total return, relative to GDP. Apart from changes in
generation size, the stock market return, adjusted for "normal"
risk, has on average been about the same as the growth rate of the
However, this still leaves part of the stock market's ups and downs
unexplained. The remaining variation is smaller and has no trend, but is
not completely random: it has remained above or below average for several
years at a time. Can we explain why?
5. Abnormal Stock Market Volatility and Stock Market
The main reason -for the remaining variation in the stock market's
total return becomes apparent when we compare this "demographically
adjusted" pattern with earlier changes in the volatility of the stock
So far we have assumed there is such a thing as a "typical"
stock market investor, and that the volatility of the market remains about
the same. But in fact investors are not required to invest in stocks, and
as we have already seen, the volatility of the market is not constants. In
fact, investors enter or leave the stock market systematically, and out of
or into other investments, in response to changes in "perceived
risk" -- approximated by stock market volatility during the preceding
We can see that the market trades at a premium immediately after
periods of lower-than-average volatility, and trades at a discount
immediately after periods of higher-than-average volatility. Investors who
are not normally in the stock market enter the market when perceived risk
is below normal, while the "typical" stock market investor tends
to leave the market when perceived risk is above normal.
For example, inexperienced investors flooded into the stock market
during the 1920s when its relative volatility was at an all-time low.10
But even "typical" stock investors left the stock market during
and after the Great Depression, when perceived risk hit an all time high.
During the 1990s (as in the 1960s) below-average volatility has drawn more
risk-averse investors into the stock market. But such investors, by
waiting to buy until volatility had already fallen, have therefore paid a
premium proportional to their degree of risk aversion. This implies that,
should stock-market volatility rise back even to normal levels, such
investors will again be willing to sell at a discount to avoid the rise in
6. 75-Year Stock Market Futures
By combining the factors we have examined -- economic growth,
generation size, and stock market volatility -- we can devise a simple
model that can tell us about the stock market's likely future performance
relative to the economy.11 Such a model seems able to explain most of the
stock market's past variation.
The evidence suggests that the tremendous rise of the stock market
since 1980 is due primarily to the relative rise in the number of Baby
Boomers saving for retirement. This has bid up stock prices to the benefit
of their parents' generation, which bought stocks while prices were
relatively low. A smaller but still significant part of the rise is due to
the below-average volatility of the stock market during the last
generation. Just as in the 1920s, this decline in volatility has attracted
more risk-averse investors into the stock market, because they perceive
stock market risk to be lower than the historical norm.
What does this analysis imply for the future performance of the stock
market? The same factors imply that the stock market's total return will
peak relative to the economy before the year 2000, and decline sharply
thereafter. Even if volatility remains at current below normal levels,
demographic projections suggest that the stock market will under-perform
the economy by about one-third for the first two decades of the 21st
century. If volatility rises above normal, the decline will occur more
Based on current Census Bureau projections of generation size, the
stock market's risk-adjusted relative return should then fluctuate around
the lower level -- that is, once again keep pace with the economy -- until
at least the year 2050.
From 1926 to 1996, common stocks yielded an average real return of
about 7.4%, while real GDP grew at about a 3.2% rate. The Social Security
Administration's actuaries project an average real GDP growth of about
1.4% over the next 75 years. Consistency with these assumptions requires
that the stock market's real total return should average about 3.2% over
the next 75 years. But for the first 20 years, the average real return on
the stock market would be much lower than this -- about 1.5%. This is
because most of the adverse demographic trends are concentrated in this
Our analysis also allows us to construct an investment
"frontier" -- the probable combinations of average real return
and average risk on various investments -consistent with the Social
Security actuaries' assumptions. For any set of consistent assumptions
about future growth of GDP and future demographic trends, there must also
be a unique and consistent relationship among the returns and risks on
different investments, including stocks, bonds and Social Security.
If the rate of economic growth and the average yield of the stock
market decline, the yield of every other class of financial investment
should also decline. However, the relative risks and returns of the
various investments available should not change. Treasury bills over the
next 75 years are unlikely to yield more than common stocks, for example.
Since the actuaries' projection does not envision another Great
Depression, double-digit average inflation, or a world war, we will
(perhaps optimistically) assume that the average volatility in the economy
and in financial markets will be "normal" -- much lower than
from 1926 to 1996, and resembling the much quieter period since about
1950: 3% average volatility for real GDP, and 13% for the
inflation-adjusted stock market (in both cases, the lowest risk for the
longest period ever observed).
Graph 15 shows the investment "frontier" from 1996 to 2075
under these assumptions. As Graph 16 shows, steady-state Social Security
still increases the future return on retirement saving for the typical
investor, compared with the choices that would be available under a
"privatized" retirement system.
7. Conclusion: Keep Social Security Pay-As-You-Go.
It may seem strange to speak of the stock market's performance over the
next 75 years. Yet, as we have seen, it is easier to explain the long-term
effect of fundamental changes than to predict year-to-year market
fluctuations -- precisely because the long-term changes are systematic,
while the short-term changes are more random.
Moreover, a 75-year stock market forecast is necessarily contained in
the argument for "privatizing" Social Security. But the
forecasts of the "privatizers" are internally inconsistent:
their projections for the stock market do not agree with their projections
for the economy.
The evidence argues against privatizing Social Security. For those
already retired, the benefit "return" on Social Security
contributions has been much higher than the return from the stock market.
In the future, as long as our assumptions are internally consistent, the
total risk-adjusted return on U.S. retirement saving will be higher if the
Social Security retirement program is maintained on a pay-as-you-go basis,
than if Social Security were "privatized."
1. Duggan et al. (1993).
2. As we noted in two separate papers, the "privatizers" also
ignore volatility risk and the existence of "human capital."
Their argument also assumes that people are forward- looking in their
expectations about Social Security, but backward-looking in their
expectations about financial assets.
3. For someone who begins saving at age 25, saves an equal amount each
year for 40 years, and retires at age 65, savings will earn a return for
an average of 20 years. For most people, most of the saving occurs between
the ages of 45 and 65, after children are grown, which shortens the
average considerably. On the other hand, part of the saving earns a return
after age 65 until it is spent. Hence a 70-year average rate of return
would make sense only for someone who retired at age 165, not age 65.
4. As Martin Feldstein observed in 1979: "Last year, the National
Bureau of Economic Research released a study of the impact of inflation on
the taxation of capital gains. In this study, Joel Slemrod and I looked
first at the experience of someone who invested in a broad portfolio of
securities like the Stardard & Poor's five hundred securities in 1957,
held it for twenty years and sold it in 1977. An investor who did that
would have been fortunate enough to have his investment slightly more than
double during that time. Unfortunately, the price level also doubled
during that time. In terms of actual purchasing power, the investor had no
gain at all on his investment. And yet of course the tax law would hold
him accountable for a tax liability on this nominal gain." Feldstein
5. The 1926 starting date is often chosen because the current Standard
& Poor's 500stock index dates from that year. However, a comparable
series going back to 1870 was compiled by the Cowles Commission. Where
necessary (for example, in calculating "perceived" risk), this
paper uses the full series.
6. The point that the return on a mature pay-as-you go retirement
system like Social Security is linked to the growth of the economy was
first made by Samuelson (1 958) and confirmed by Aaron (1966). It is
accepted by "privatizers" like Feldstein (1994) and Ferrara
(1985). A pay-as-you-go pension like Social Security is linked to labor
compensation, which grows at almost exactly the same rate as the economy.
However, the return is also affected by changes in aggregate contributions
and benefits as shares of the economy and by the relative number of
workers and beneficiaries. For an evenhanded discussion of the influence
of economic and demographic assumptions, see General Accounting Office
(1997). The volatility risk for Social Security is a bit lower than for
the economy. Social Security is tied to labor compensation, which grows at
the same average rate, but vary less than the rest of national income.
7. This calculation treats post-Korean War average volatility of
nominal GDP (about 3.1 %) and stocks (about 11.9%) as "normal."
The "normal" stock risk premium, compared with the economy (or
with Social Security), is therefore about [.5(l.119²) + .5/(l.l19²)] -
[.5/(l.031²) + .5/(1.031²)] = 2.35%. This applies to the
"typical" stock market investor, though the average risk premium
for all investors must be higher, because many are more risk-averse and
don't invest in stocks.
The standard deviation of annual returns on common stocks (measured by
the Standard & Poor's 500 stock index) has averaged about 20% since
1926, which would yield a risk premium for the typical investor of about
7%. That by itself would explain the entire difference in return between
the stock market and the economy.
However, as we will see, this is not the way the stock market actually
works. The 20% standard deviation includes the extremely high volatility
during and after the Great Depression. But the stock market has not in
fact rewarded abnormally high volatility with abnormally high returns. On
the contrary, returns have been abnormally low after volatility was
abnormally high, and abnormally high after volatility was abnormally low.
The stock market rewards "normal" volatility, but not abnormal
variations above or below this level. A reason for this is suggested
below: investors systematically alter their portfolios in response to
changes in perceived risk, measured by volatility over the previous
8. Actually, the theory distinguishes between "systematic"
and "unsystematic" risk. What is being discussed here is
"systematic" risk, which means risk that cannot be removed by
diversifying one's portfolio. "Unsystematic" risk is risk that
can be avoided through diversification, so the market does not reward
someone who takes on more "unsystematic" risk -- for example,
putting all his money into a single stock -- because such risk could be
avoided by holding a number of different stocks, as well as stocks of
9. The reason for choosing 22 years is that this is the median age of
marriage for women in the past century. The age has fluctuated between 20
and 24 with no apparent long-term trend. Twenty-two years is therefore
approximately the biological length of a generation. When women are about
age 22, households are formed. From age 22 to age 44, parents devote their
resources to raising children. At about age 44, children begin to leave
home and parents begin saving for their own retirement. At about age 66,
parents begin to retire -- though the retirement age is rising with
increases in longevity. Apart from the varying number of births in each
year, the relative size of generations is affected by changes in life
expectancy and net immigration.
10. The relative volatility declined, not because the volatility of the
stock market was lower before the Depression than since the Second World
War, but because the volatility of the economy was higher. This is
presumably because the economy has diversified over time from agriculture
and manufacturing toward services.
11. The model extrapolates the risk-adjusted return of the stock
market, measured relative to the economy, based on its past relations to
generation size and perceived risk (proxied by actual stock market
volatility in the previous 20 years). The fit is good. In technical
jargon, the R squared is about .85, the t-statistics are highly
significant, and the unexplained residual shows relatively little
autocorrelation. Assumptions about future generation size are based on
current Census Bureau projections, while volatility in the stock market is
assumed to remain at current (below-average) levels.
Aaron, Henry J. (1966), "The Social Insurance Paradox," Canadian
Journal of Economics and Political Science, vol. 32, Augus, 371-77
Duggan, James E., Robert Gillingham and John S. Greenless (1993),
"Returns paid to Early Social Security Cohorts," Contemporary
Policy Issues vol. XI, October, 1-13.
Feldstein, Martin (1979), "Inflation and Saving: The Role of
Texas," remarks presented to the annual meeting of the national
Association of Manufacturers, March 29.
Feldstein, Martin (1994), "Fiscal Policies, Capital Formation and
Capitalism," NBER Working paper 4885, National Bureau of Economic
Research, Cambridge, Mass., October.
Ferrara, Peter J. and John R. Lott Jr. (1985), "Rates of Return
Promised to Today's Young Wrokers," in Social Security: Prospects
for Real Reform, Ferrara, ed., Cato Institute, Washington, DC.
General Accounting Office (1997), "Retirement Income: Implications
of Demographic Trends for Social Security and Pension Reform," GAO,
Ibbotson, Roger G. and Rex A. Sinquefield (1997), Stocks Bonds
Bills and Inflation: 1997 Yearbook, Ibbotson Associates, Chicago.
Samuelson, Paul A. (1958), "An Exact Consumption Loan Model of
Interest with or without the Social Contrivance of Money," Journal
of Political Economy vol. LXVI no.6, December, 467-482.
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