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Facts

Why?

Many people suggest to move your money of your bank, which is maybe paying 1.5% APY, and into index funds so that your money is not depreciating. I agree with this advice because the math is simple: 1.5% < 2% < 10%. But I'd feel more comfortable if I knew why I was following the advice. Why does S&P 500 grow faster than inflation?

To play devil's advocate, I'm throwing out two counter examples below to the 10% growth. By no means am I a skilled economist, so I will not be offended if you correct me.

Spread of Wealth

I think the companies in the S&P 500 grow by selling more products. When their profits grow, investors have more faith in the company and buy their stock. Buying stock bumps up their NAV. But why would consumers only buy from these 500 USA companies? Aren't they also buying from the thousands of other companies in the world?

Competition

Google and Apple are both in the S&P 500. Let's say someone buys an iPhone from Apple. They would be unlikely to buy an Android phone and thus Google's operating system is unused. This is just one example of competition. Many other pairs of competitors exist in the S&P 500. The bottom line is when one company succeeds, their competitor may fail. So the net success of the two companies should remain neutral. The net will not grow 10% a year.

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  • 1
    "The bottom line is when one company succeeds, their competitor may fail. So the net success of the two companies should remain neutral." This is a faulty assumption. As new markets are created, multiple participants may find a profitable niche in them. Twenty years ago there were no smart phones, now a significant fraction of the planet owns one. Apple created the market for the new device, but both Google and Apple are currently making money on it. Older players like Nokia may withe away, but the overall size of the new market dwarfs the size of the older one. – Charles E. Grant Sep 2 '18 at 0:52
  • @Charles E. Grant: And there are dozens, if not hundreds, of companies that make money upstream and downstream of Apple/Google/Samsung/ASUS and everyone else that sells finished phones & tablets. Chip makers, Corning selling tons of its "Gorilla Glass", all the apps sold to run on the them, &c. – jamesqf Sep 2 '18 at 16:47
  • "Aren't they also buying from the thousands of other companies in the world?" What in the world makes you think they're not? – Beanluc Sep 6 '18 at 0:04
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The answer boils down to, are publicly-listed companies able to grow earnings faster than the rate of inflation? If the answer is "yes", then no surprise that the S&P500 grows faster than inflation.

And the answer is unequivocally "yes". According to this CNBC article from July for example, we're currently in the midst of an earnings boom with earnings growing by as much as 20% - way more than 2% inflation. Of course this kind of boom will not last, but on average you can see that the big get bigger and the 500 current biggest US companies historically grow earnings by ~10% a year.

To address the two situations you gave:

I think the companies in the S&P 500 grow by selling more products. When their profits grow, investors have more faith in the company and buy their stock. Buying stock bumps up their NAV. But why would consumers only buy from these 500 USA companies? Aren't they also buying from the thousands of other companies in the world?

Because these 500 USA companies - like any other good company, including those from elsewhere in the world - have some kind of competitive edge. For example, if you want a Big Mac, you have to buy it from McDonald's. You don't have an alternative! This advantage, known as a "moat", means that a new upstart company can't just enter the burger market and displace McDonald's by offering a better, cheaper burger. In principle, it can be done. In practice, McDonald's brand name is such that the new competitor will need a fantastically superior product to displace McDonald's.

Google and Apple are both in the S&P 500. Let's say someone buys an iPhone from Apple. They would be unlikely to buy an Android phone and thus Google's operating system is unused. This is just one example of competition. Many other pairs of competitors exist in the S&P 500. The bottom line is when one company succeeds, their competitor may fail. So the net success of the two companies should remain neutral. The net will not grow 10% a year.

This assumes that the smartphone market overall doesn't grow, which is certainly not the case. 10 years ago there were much fewer smartphones in the world than today. The market is bigger now, which of course leads to both Apple and Google making more money.

There're other factors as well. For example, Apple makes a lot more money per phone sold than Samsung (Google doesn't sell many phones directly). So if people buy iPhones, Apple's profits grow by more than Samsung's profits drop.

  • Earnings rising faster than inflation implies that money velocity increases, right? Is this a consequence of higher consumer debt? – not_a_comcast_employee Sep 4 '18 at 6:09
  • @not_a_comcast_employee: Not necessarily. In theory (assuming a healthy labor market) higher earnings could translate into higher wages and therefore higher purchasing power, which if matched with higher productivity would mean inflation is kept in check. In the current US context, however, increased earnings do not translate into higher wages; the whole increase is captured by share owners. Higher US earnings are indeed driven by debt; not just consumer debt but also government debt. – MSalters Sep 4 '18 at 8:36
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Buying stock bumps up their NAV.

Well, individual stocks do not have a NAV, so you're either referring to a company's balance sheet (assets) or market capitalization (market value of equity) Companies to not benefit directly from public buying and selling of stock (other than initial offerings), so their assets are unaffected. It increases their market cap, which is just a measure of how much equity is in the open market.

I think the companies in the S&P 500 grow by selling more products.

More than who? You seem to think that the S&P 500 companies are the only ones that are growing at 10%, and that others are just growing at 2% or less, which is not the case. The S&P 500 is supposed to be an indication of the market overall, not just the best-performing companies.

But why would consumers only buy from these 500 USA companies? Aren't they also buying from the thousands of other companies in the world?

Absolutely. What makes you think that they don't? The companies in the S&P 500 are not the only companies growing at 10% or more. In fact, many "small-caps" grow MUCH MORE than the "large-cap" S&P 500 companies. But many also fail, so there's much more risk involved.

The bottom line is when one company succeeds, their competitor may fail. So the net success of the two companies should remain neutral. The net will not grow 10% a year.

Not true. Look at reality. Apple and Google are both "growing" (in market cap terms) at more than 10%. In reality, it's more accurate that some companies grow at 40% or more, and some fail, and the average is around 10% (using the S&P 500 as a benchmark).

Think of it this way. The S&P 500 is just a sample of the US market as a whole. The entire market is growing at more than 2%. Remember that inflation is NOT a measure of economic growth. It has to do completely with the amount of money in circulation and the decline of the purchasing power of that money. It is only a benchmark of economic growth, not a direct measure of it.

What causes S&P 500 to grow faster than inflation?

Economic growth is certainly one factor, but another factor is increased investment in the equity market through 401(k) savings and other means of investment. Every year there is more and more money in the equity market, which naturally causes it to grow. Because equities are very liquid (easy to trade), there is also a natural "survival of the fittest". As companies do well, more investors buy their stock. As companies decline, their stock is sold and loses value. Since successful companies survive and losing companies die off, there is a natural tendency for the market to grow overall (certainly there are periods of loss, but I'm referring to long-term patterns more than short-term bull or bear markets.

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