Is it possible for the stock market to beat inflation forever?

Question

Just a few thoughts on the possibility of markets beating inflation in the long, long term (say, hundreds of years). I am a theoretical physicist, not an economist, so please forgive my ignorance.

I was wondering what can we say about a market in the $t \to \infty$ limit if that market beats inflation when averaged over long periods of time.

It seemed to me like market caps would have to just keep rising and rising. And in fact, it is true that for the available data to me (since 1996) the S&S500 market cap has risen at essentially the same YOY rate as the index itself. Meanwhile, P/E ratios have not changed very significantly. This means that to sustain the trend in both stock price and P/E, company earnings must increase YOY by more than inflation.

In a world where the money supply stays constant, this would mean that eventually the earnings of any individual company would have to exceed even the total money supply, as $t \to \infty$. This seems like a very unrealistic situation. And, in fact, M2 has increased just as quickly as the S&P in total! Since 1996, M2's YOY rate is 7.0%, while the S&P grew at 6.7%. Meanwhile M0 grew by a whopping 10.1% YOY.

This leads me to preliminarily conclude that in fact the ever-increasing money supply is providing a mechanism for companies to increase earnings faster than the CPI each year. This suggests the view that the increase in markets faster than inflation is caused by the following phenomenon:

More and more money is created. Yet that new money is unevenly distributed, with much more of it going towards businesses than to consumers. For this reason, the CPI, which only measures a particular cross section of the market, grows more slowly than M2, and also more slowly than business profits. Thus the creation of money is a necessary process to keep markets rising faster than inflation, and if this were to cease, eventually the trend would be over.

I would be interested to hear anyone's thoughts - in agreement or not - with what is outlined above, especially the last sentence.

Answer 1

Is it possible for the stock market to beat inflation forever?

Yes this is theoretically possible. Return on a stock depends on discounted value future value and dividends (and consequently profitability) of a company and there is no theoretical limit to that. So it is theoretically possible.

In a world where the money supply stays constant, this would mean that eventually the earnings of any individual company would have to exceed even the total money supply, as t→∞. This seems like a very unrealistic situation.

No even with constant money supply this is possible. Inflation is change in price level and in long run price level and price level is given by money market equilibrium that can described as:

$$M/P=L(Y,i) \implies P= \frac{M}{L(Y,i)}$$

where $M$ is money supply, $P$ price level (change in which gives you inflation), $L$ money demand that depends on $Y$ (real output), and $i$ interest rates.

Now money demand depends positively on real output $dL/dY>0$ and real output depends positively on profits. So as firms get more profitable (keeping $M$ and $i$ constant) price level $P$ drops leading to negative inflation (also known as deflation).

Recall that stock prices depend on profitability of a firm. Hence it is possible for stock return to beat inflation even with constant money supply because when inflation turns negative you need your returns to be less negative (e.g. when inflation is -10% you only need -9.99% nominal return to beat inflation). So theoretically the quantity of money does not constrain the real returns on market and to beat inflation you just need any positive real return.

Thus the creation of money is a necessary process to keep markets rising faster than inflation, and if this were to cease, eventually the trend would be over.

No this is not true as explained previously. There is however a kernel of truth in it. Small inflation has positive effects on economy because prices are sticky downwards and inflation thus helps economy to adjust whenever prices need to drop in real term. For example, it is much easier to lower real wages of workers via inflation than for each company individually negotiating new contracts with workers.

Inflation depends on money supply as equation above shows, so without ever expanding money supply we would end up with negative inflation (as Y increases over time thanks to technological progress and expansion of human activity). Hence without growing money supply we would be in a deflationary world, that requires perpetual downward adjustments in prices and wages, and since this is difficult to do it would hurt the economy leading to unnecessary high unemployment and underutilization of other factors of productions (such as capital) which will also hurt profitability. Nonetheless, even in such deflationary world economy should not completely collapse and so even though it would be perpetually working below full capacity there should be possibility for perpetual growth in factor returns (e.g. profits or wages) in real terms.

Of course, in nominal terms wages and profits and returns decline but nominal terms are irrelevant. Nobody would be upset to earn half of their salary if they can buy 4 times more goods and services than on the older salary.

Answer 2

A simpler example is possible: suppose the real output of firms grows by 1% every year (due to population growth and/or wealth accumulation), while pretty much everything else (prices, capital share of income, P/E ratios, etc.) is unchanged. Then inflation is 0%, while stock prices grow by 1% per year.