In a recent study of the effect of the retirement of Baby Boomers on the price of equities, the GAO based its conclusions on the assumption that equities will provide real returns of over 7% over the next decades, stating:

	Implanting False Hope

“Returns on investment are important in helping many Americans accumulate sufficient savings throughout their working lives to meet their retirement needs. From 1946 to 2004, U.S. stocks have returned an average of 8.0 percent annually, adjusted for inflation.”

“According to a recent study surveying the literature, such simulation models suggest, on the whole, that U.S. baby boomers can expect to earn on their financial assets around half a percentage point less each year over their lifetime than the generation would have earned absent a baby boom.”

The GAO conclusions were dependent upon investors earning at least 7.5% per year on equity holdings, after inflation, for the foreseeable future.

Is this projection reasonable and is it based on fact?

And, why is this important?

Where Expectations of Market Returns Come From

The $14.9 trillion market value of US domestic equities (Q1 2006) is predicated upon common expectations of future returns on stock investments. The GAO figure of between 7 and 8% (real returns) is representative of current market consensus.

If this general expectation were to be significantly reduced, a loss of several trillion dollars of market value would almost inevitably follow. Holders of US equities would become much poorer should there be a substantial reduction in commonly projected long-term returns on equities.

A reduction in this widely-accepted projection would also impact heavily on defined-benefit pension funds and the savings plans of millions of households.

So how is it that millions of investors have come to believe that investing in stocks will produce long-term real returns of over 7% per year? After all, no one knows what the future holds.

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Periodic reports and analyses of Federal Reserve Flow of Funds Accounts are published on the Financial Markets Center website, which I believe should be of interest to our readers.

These published reports are directed by financial economist Jane D’Arista, a leading expert in flow of funds accounts and author of the “Flow of Funds Review and Analysis” newsletter from 1998 to 2003. (Back issues of this review are available on the Financial Markets Center website.)

Capital flow analysts will find the following reports published regularly on this site:

1. Changes in Household Net Worth;
2. Analytical Measures for Nonfarm Nonfinancial Corporations;
3. Foreign Holdings of U.S. Financial Assets;
4. Foreign Lending in U.S. Credit Markets;
5. Composition of Household Assets;
6. Shares of Financial Sector Assets; and
7. U.S. Credit Market Debt as Percentage of GDP.

In March 2004, news tickers reported a larger trade deficit. The Fed announced its decision to raise short term interest. Bond traders, crowded elbow to elbow on their communal desks, alerted by blaring bull horns, were quick to react. Intermediate and long bond prices fell sharply.

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