If you’re a Canadian investor with a fairly long time-horizon, there’s really only one chart that you need to understand to successfully make money over the long-run. Now, the relationship expressed in the following chart may not necessarily be intuitive at first glance, but investors who take the time to fully grasp its underlying meaning will almost certainly find it well worth their time. Understanding the relationship laid forth will make holding risk-assets infinitely more comfortable for long-term investors, reduce “short-termism” and other behavioral mistakes, give investors both the courage and confidence to hold riskier assets through periodic market turmoil, and intuitively allow the average investor to grasp the iron-clad arithmetic behind why risk-assets must increase in value, relentlessly, over the long-term.
Without further ado, let’s take a look at the single most important chart for Canadian investors:
Illustrated above is the total dollar value of Canadian equities overlaid with the outstanding liabilities of non-financial borrowers. The point of the above chart is to show that, in the long-run, the total dollar value of Canadian equities increases at roughly the same general rate as the amount of outstanding debt in the country. Now the fact that stock prices increase over the long run is hardly controversial, but why exactly should the value of equities in Canada follow the same approximate growth profile of total outstanding debt? Well, it turns out that the “secret sauce” underpinning this relationship comes from the insight that the total value of financial liabilities held by real economic borrowers actually equates to the total value of cash and bonds held by the average investor. This was explained in detail by the brilliant blogger Jesse Livermore (pseudonym) in his 2013 piece “The Single Greatest Predictor of Future Stock Market Returns”1.
The reason that the amount of debt in the country equates to the amount of cash and bonds held by investors is, quite simply, because in a modern economy all cash and bonds arise from debt. In the case of cash (ie. bank deposits), a simple example will suffice. Let’s suppose that Ben takes out a $100k loan from Bank A. At the end of the transaction, the change to the balance sheets of Ben and Bank A will be as follows:
Change in assets = +$100k (new deposit at Bank A)
Change in liabilities = +$100k (loan now owed to Bank A)
Change in net worth = None
Change in assets = +$100k (the loan, now owed by the borrower)
Change in liabilities = +$100k (the borrowers new deposit)
Change in net worth = None
While the net worth of both Ben and Bank A remains the same, Ben now has an additional $100k in cash to spend within the economy. This is new money created as a direct result of the loan, meaning that the amount of new cash injected into the economy is exactly equal to Ben’s new $100k liability. If we therefore ignore Bank A, and count only the liabilities of real economic borrowers (Ben, in this case), we can measure the total amount of cash created through bank loans by simply looking at the outstanding liabilities of real borrowers such as Ben.
Of course, all loans aren’t made through banks, which is what happens when corporations and governments issue bonds to investors. In this case, corporations and governments create bond assets and supply them to investors in exchange for existing money. At the end of a bond issuance to raise $100k by a corporation or government, for example, the change to the balance sheets of the lender and borrower appear as follows:
Government or Corporation (Borrower):
Change in assets = +$100k (borrowed money)
Change in liabilities = +$100k (the funds now owed to the lender)
Change in net worth = None
Private Sector (Lender):
Change in assets = +$100k (newly acquired bond), -$100k (cash paid to government)
Change in liabilities = None
Change in net worth = None
Again, while the net worth of both the lender and borrower are unchanged, we can see that a bond was created as a result. The private lender simply sent $100k of existing cash to the borrower, and was given a $100k bond that the borrower created in return. Again, we can therefore measure the total value of bonds in existence by simply looking at the total outstanding liabilities of real economic borrowers that issue debt securities. In this case, the loan to a government or corporation resulted in a new $100k liability for the government or corporation, which matches dollar-for-dollar with the new $100k bond created as a result.
So, we can now see through these simple examples that the dollar value of total liabilities among real economic borrowers in the country is the same as the total dollar value of cash and bonds in the economy. In other words, what the above chart shows is that, in the long run, the total value of Canadian equities held by investors tends to increase at roughly the same pace as the value of cash and bonds in the economy.
The reason for this is quite simple. As the total value of debt expands within the economy, the newly created cash and bonds that result from the increasing debt must be held at all times by all investors collectively. If the total dollar value of equities did not expand in line with the total dollar value of cash and bonds, then investors in aggregate would end up with an ever-growing proportion of their assets allocated towards cash and bonds. If we assume that investors collectively want to hold a similar percentage of their assets in stocks as they have historically, then the dollar value of stocks must rise proportionally with the amount of cash and bonds in existence. As the Livermore piece (referenced above) points out, because a corporation issues new shares at a relatively slow pace, the primary means by which the total dollar value of corporate equity can increase is through an increase in the prices of existing shares.
By way of example, let’s say that the total amount of liabilities was to suddenly increase by 10% tomorrow. If no new shares of equity were issued by corporations over the same time period, then the price of existing equity shares must increase by 10% in order for investors to maintain the same equity allocation that they have today. Now of course, there’s nothing to prevent investors from suddenly altering their asset allocation preferences tomorrow to reflect an actual desire to hold a smaller proportion of their portfolio in stocks – they certainly might. Many macroeconomic factors can drive investors to collectively want less exposure to equities, and this has certainly been the case historically, even over long periods of time.
The point, however, is that even if investors were to suddenly bid down stock prices as a consequence of wanting to decrease their equity allocations, the constant creation of cash and bonds within the economy provides equity investors with an enormous tail-wind that serves to relentlessly push up the prices of stocks over time. Unless you think that Canadian investors will want to hold a continually decreasing share of their portfolio in equities over time, then it’s a near-certainty that stock prices will continue to be driven higher as total debt in the system expands.
The reality is that with interest rates hovering near rock-bottom levels, stocks form an essential part of the average investor’s asset allocation in the current investing environment. While current investor equity allocations may of course decline in the future due to things like concerns over inflation or periodic recessions, the odds highly favor stocks remaining a core staple of investor asset holdings for years to come. Even if investor allocations towards stocks were to suddenly and permanently fall by, say, 5%, the corresponding 5% decline in equity prices would eventually be recouped as total debt expanded and investors became increasingly over-allocated to cash and bonds once again. They would eventually need to bid up stock prices as their equity allocations were driven lower and lower by ever-expanding cash and bond holdings within investor portfolios. Again, there is nothing to say that stocks can’t decline significantly irrespective of total cash and bond holdings, but regardless of what happens to prices in the short term, the constant stream of new debt issuance will serve to push equity prices up over time.
Of course, this merely begs the question as to why, exactly, one should expect that the total amount of debt in the economy will continue to rise over time. The reason is simple – in a modern economy, economic growth is predicated on an ever-increasing amount of debt. If you expect that economic growth will continue well into the future, you can’t help but also expect that the total amount of outstanding debt will increase as well. To illustrate this point, the following chart shows the total amount of debt in the economy since 1990. The graph is shown in log scale such that each increment on the y-axis represents a doubling of the amount of debt in the economy. This visualization allows us to see the steady growth rate of debt that has been occurring over the last 30 years.
The relationship between increasing debt and economic growth isn’t especially hard to grasp. For example, let’s suppose that Ben wants to build a widget-making factory, borrowing $100k from the bank to fund his endeavor. The bank will subsequently create a new $100k bank deposit for Ben, which he will eventually spend into the economy in order to build his factory. The expectation, of course, is that Ben will ultimately produce widgets from this factory which he can then sell for a profit. Thus, through the loan, Ben will increase the real amount of goods in the economy since he will be producing real things (widgets) that real people actually want to own. He will unquestionably have grown the economy as a result of the loan.
It’s true that the newly created money that Ben spends to build his factory will tend to drive up prices relative to the scenario where the loan had never been made at all. After all, as a result of the loan, there will now be more spending in the economy bidding on the same amount of real goods and services that existed prior to the loan. This, of course, will tend to be inflationary in nature. However, because Ben will eventually increase the quantity of real goods and services as a result of the loan (he will be making widgets for people to buy), inflation generally won’t run rampant as a result. Yes, it’s true that new debt immediately increases the amount of financial wealth in the private sector for people to bid on a finite supply of real goods and services, but this ignores the fact that the loans themselves result in a constantly increasing supply of goods and services (if the loans are productively invested).
Turning now to the subject of economic downturns, what would happen if economic growth were to be suddenly curtailed via a recession or, perhaps, even a depression. Indeed, under this scenario one would certainly expect the pace of debt to contract on an economy-wide basis. After all, if borrowers no longer want to borrow and instead actively attempt to pay down debt, and lenders turtle up and no longer wish to lend, surely debt will have to contract as a result, mustn’t it? Looking at the previous chart, however, we can see that this has historically not been the case. While debt has contracted in some small manner on various occasions over the last 30 years, economic downturns have generally not caused the overall stock of debt to contract significantly. The recent experience with COVID is case in point – the total amount of debt not only failed to contract at the beginning of 2020, but it actually accelerated sharply higher.
Of course, it takes no great insight to understand why debt increased rapidly at a time when the economy was effectively shuttered due to pandemic restrictions. In modern economies, when people no longer want to borrow and banks no longer want to lend, the government is there to back-stop the economy as the “borrower of last resort”. Large-scale deficit spending is simply part and parcel of the government’s response to modern-day economic downturns. When the pandemic struck the government borrowed huge sums of money in order to increase transfers to Canadian households and businesses. While the economy may have contracted rapidly in the early stages of the pandemic, overall debt in the system clearly did not.
Recall that in the early days of COVID, stock markets fell dramatically only to stage a remarkable rally that took equities well above their pre-pandemic highs. This was at the same time that GDP and spending contracted rapidly, illustrating a sharp divergence between equity markets and the real economy. Many investors choose to believe that the rally in stocks was merely the market front-running the impending recovery. However, unless investors actually wanted to permanently hold a significantly lower portion of their portfolios in equities, the large-scale increase in cash and bonds due to government deficit spending served as the fuel for the coming stock market rally. If we assume that investor preferences hadn’t been permanently altered by the pandemic, then at some point a large-scale equity rally should have been entirely expected. Canadian investors, suddenly over-allocated to cash and bonds, sought to re-establish their old stock allocations by shifting a portion of their portfolios from cash and bonds back into equity markets. Investors simply held too much cash and bonds relative to stocks. They held too many riskless assets relative to risk assets.
It can be helpful to think of the relationship between debt and equity prices along the same lines as a pet-owner walking his dog down the street. The leashed dog can scramble off in any direction in the short term, but in the long run the dog is going to end up roughly where the owner takes him. Investors with a long-term view ought to be paying attention to the owner and not the dog, focusing instead on the continuous growth of credit rather than the short-term gyrations of the stock market. In the long run debt will continually expand as the economy grows. Conversely, when the economy goes through periodic recessions, investors would be wise to realize that the government will be there to expand debt even in the face of private sector credit contraction. Given the apparent success of fiscal stimulus in the aftermath of the COVID pandemic, do investors really believe that the government won’t be there with more debt-driven stimulus when the next recession eventually rolls around? To be completely frank, the likelihood of this scenario occurring is so remote as to not even be worth considering.
Yes, things like GDP, productivity, and inflation still matter. All of these things can impact the stock market allocation preferences of Canadian investors. The prospect of high inflation and low growth can certainly make investors less enthusiastic about holding stocks in the future, and downward adjustments in investor equity allocations can take place suddenly and last for years, if not an entire lifetime. But investors still need returns, and they aren’t going to get those returns with their portfolio increasingly allocated to cash and bonds instead of risk assets. At the end of the day, the constant and relentless increase in debt provides a steady upwards pressure on equity prices, regardless of what happens to future stock market valuations. Investors who insist on avoiding equity markets because they’re currently “frothy” or because they’re “waiting to get in at a better price” need to be careful that they don’t limit their exposure to an asset with a huge tail-wind at its back.
The point is, for the average retail investor, short-termism is a real portfolio killer. By far, the best thing that most investors can do is take a long-term view of markets, manage their risks, keep costs low, and boringly dollar-cost average into their positions for as many decades as possible. The real issue that investors face is behavioral, in the sense that they almost never have the fortitude to just patiently sit there and watch their portfolio grow over the long term when the short-term is punctuated by huge swings to the downside. Trying to market-time and constantly selling out at the market low is probably the most destructive thing for long-run portfolio performance, but it happens time and time again during every steep market correction like clockwork.
So what, then, is the true underlying meaning behind this chart? It’s really that the pet-owner matters more than the dog; that the signal matters more than the noise. It’s understanding the upwards directional bias of equity markets and knowing that you’re on the right side of the trade, even as you admit to having no earthly idea what’s in store for the market tomorrow or even next year. It represents the courage to hold onto your risk positions for the long term, because sometimes the important thing to know isn’t the timing, but the direction. If you have the vector right, the returns will take care of themselves.