David Peartree, The Daily Record Newswire
The connection between economic growth and stock returns seems so intuitive and obvious that most investors never question it. They should if only to prevent themselves from making decisions about their investment allocation based on a shaky premise.
Conventional thinking says that higher rates of economic growth should lead to higher stock returns and lower economic growth should lead to lower stock returns.
Alas, it doesn’t quite work that way. There is a connection between economic growth and stock returns, but nothing so direct or immediate as often assumed.
Take the case of Greece. Here is a country in an economic depression and mired in a multi-year debt crisis. Yet, the Athens Stock Exchange was the best performing stock market within the European Union in 2012. It was up over 33 percent, far outstripping the rest of Europe, which returned a bit over 19 percent. Who would have guessed the outcome for either, but especially Greece based on its dismal economic performance?
Consider also the economic growth in the U.S. over the past several years and the performance of the S&P 500. GDP growth for the past several years has barely averaged 2 percent and has continued to disappoint expectations. And yet, the market has been on a four-year rally and last year returned about 16 percent.
There is simply no evidence that economic growth in any year reliably correlates with the performance of stocks. The stock market, using the S&P 500 as a proxy, is one of the 10 standard leading indicators of economic growth. Many investors incorrectly assume just the opposite, that economic growth is a lead indictor for stock market performance.
Unfortunately, it is not. Although economic data junkies are constantly trying to anticipate the market and trying to get a jump on other investors, economic growth by itself is not a reliable predictor of stock market returns.
There is no evidence that the direction or degree of GDP growth is a reliable indicator of the direction or degree of future stock market performance. In addition to observable recent history, a slew of academic research confirms this conclusion.
A study out of the London Business School published in 2010 concluded that there was no clear relationship between changes in GDP of the major developed economies and their stock market performance over the period 1900-2009. In fact, the correlation was actually slightly negative.
Other studies have found that this conclusion holds true across both developed and emerging markets.
This is not to say that economic growth is not relevant for investors. Strong economic growth is undoubtedly a good thing, but nothing says it has to benefit investors exclusively or even primarily. It should benefit workers and consumers by means of rising incomes and a higher standard of living. And some significant portion of economic growth should funnel through corporate earnings and provide investors a return through the stock market.
But the reason the connection between economic growth and stock returns is less direct and obvious than commonly assumed is that factors other than economic growth also have a significant impact on stock returns. A study by The Vanguard Group makes this point.
First, valuation is a major determinant of stock returns. The price at which an investor buys into the market or, as the Vanguard study puts it, “the price investors pay for a market’s expected growth,” is critical.
Expectations for higher economic growth quickly get built into the price of stocks, and buying overvalued stocks leads to disappointing returns. Economies with high GDP growth potential present a good investment opportunity only if equity valuations are low. Even economies with low GDP growth potential can provide good investment returns if the market is fairly priced.
Second, the Vanguard study concludes that economic surprises, good or bad, seem to matter more than absolute growth. Economic performance better or worse than consensus expectations seems to have a much stronger impact on subsequent market returns.
Economic forecasting is just not that good. John Kenneth Galbraith, a prominent economist from the last century, once said, “the only function of economic forecasting is to make astrology look respectable.” Even if investors could reliably predict turns in the economy, that information wouldn’t necessarily translate into superior investment returns.
Because economic performance by itself is not a reliable indicator of subsequent stock returns, investors should be careful about making investment decisions based on their expectations for what the economy may do.
Far better to maintain a strategic, long-term allocation and change it only as circumstances or objectives changes.
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David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, NY 14625; email david@worthconsidering.com.
