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The Effects of Government Intervention on Equity Returns

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History shows that after nearly every major economic downturn, questions arise as to whether the free market system remains an appropriate way to organize and direct the nation’s resources.

Many individuals may be surprised to learn that government intervention can play a key role in free market systems. Milton Friedman, widely known as the most vocal proponent of the free market system cited that the true cause of the Great Depression was the US government’s failure to act swiftly to inject capital into the failing banking system.

"The Federal Reserve stood idly by when it had the power and the duty and the responsibility to provide the cash that would have enabled the banks to meet the insistent demands of their depositors without closing their doors," Friedman stated in “Free to Choose 3: Anatomy of a Crisis.”

The video presentation below discusses the impact of historical government interventions on stock returns.  

[ Click here to play ]

The chart below shows the relationship between equity returns and economic freedom rank. Economic freedom rankings data from Heritage Foundation awards their rankings in consideration of 10 specific elements.

As the chart shows, the US ranks very high in the area of economic freedom, while France came in significantly lower. It would be widely determined then, that the equity returns of a more Socialist-leaning France would be lower than those of the US. The reality, however, is quite different (the returns are very close). The chart’s vertical axis measures the equity returns of the countries. It shows that higher returns over the entire period were not always delivered to the countries with the highest degrees of economic freedom. Notoriously socialist-leaning countries relative to the US include Norway, Sweden, Japan, the Netherlands, France, Belgium, and Germany. The annualized returns of each of these countries defy the presumption that increased returns come from increased economic freedom.

The figure directly below depicts the annualized standard deviation, or the Risk, of each of the above countries, plotted against their annualized return, the Reward, over the entire period.

The bar chart directly below depicts the returns for the entire period shown in the figure above.

The bar chart below shows the 10-year returns for countries based on their economic freedom rankings, as well. As you can see, in both long-term and short-term data, economic freedom indicators dispute the commonly held belief that government intervention hampers returns.

While the data presented here may seem surprising, the explanation is very straightforward. Just as value investments demand a higher return relative to growth investments to compensate for the higher risk associated with them, so too should investments in countries with increased government intervention demand higher expected returns to compensate investors for the increased perceived risk of investing in them.

This research, once again points to the simple and profound truth that investment returns come from investment risk, proving once again that there is no free lunch — even for perceived free market economic systems. Ken French talks about this subject and more in this interview.

The global history of the size and value effect on stocks is made even clearer by reviewing the figure below. Next, the table below provides a thorough analysis of many indexes from 1928 to present. Both the chart and table indicate that over the entire period, small-value has outperformed the S&P 500 and large-cap growth. Also, it is clear that value has had higher returns in international and emerging markets, even though available data only dates back to 1975 for international and 1989 for emerging markets.