An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today. – Laurence J. Peter
Our last article explained why the economy is not relevant to investing – short term. If you want to forecast the stock market this year or next year, the economy is essentially irrelevant – because the stock market forecasts the economy, not the other way around.
More surprising for investors, however, is that even the long term growth of the economy is not relevant to investing!
Most investors mistakenly believe that, over the long run, stock prices rise because of growth in profits brought on by the economy. Specifically, the belief is that the long run stock market growth = economic growth + change in multiple (normally expressed as P/E, or Price/Earnings multiple).
This is widely believed, even though it is obviously false when you look at the numbers! The actual stock market growth in most countries is many times the economic growth long term (see chart below).
A related “conventional wisdom” is that countries that have a strong economy will have a strong stock market. This sounds perfectly logical – it’s just not true. In fact, the opposite may be true!
For example, many news stories gloat about the high growth of the economy of China at about 10%/year. This is used to claim that investing in China will be a good investment. Recently, other news stories speculate that the US and Canada may have slower growth for a few years, and this is used to suggest that the stock market returns may also be lower.
However, in-depth studies comparing countries with high growth economies show this does NOT translate to higher stock market growth. In fact, if anything the opposite is true!
The most in-depth study we have seen is in the classic investment book on global stock markets “Triumph of the Optimists”, Dimson, Marsh & Staunton. They analyzed the correlation of GDP growth to the stock market in 17 major countries from 1900-2000 and found:
Correlation of GDP Growth to Stock Market
|Time Period||Correlation||What it Means|
Note that “negative correlation” means that they tend to move in opposite directions – higher GDP growth generally resulted in lower stock market growth, and vice versa. Higher GDP does NOT mean it is a better place to invest.
“Since 1900, low-growth economies have superior stock market performance. Historically, buying into equity markets with a high GDP growth rate has given a return that is below the return of markets with a low GDP growth rate. There is no apparent relationship between equity returns and GDP growth.” – Global Investment Returns Yearbook 2005, Dimson, Marsh and Staunton.
Figure: Higher stock markets generally were in countries with lower GDP growth in their economy. Source: “Triumph of the Optimists”, Dimson, Marsh & Staunton.
In another study, Jeremy Siegel compared GDP growth to stock markets from 1970-97 and came to the same conclusion:
Correlation of GDP Growth to Stock Market
|Type of Country||Correlation||What it Means|
|17 developed countries||-.32||Negative correlation|
|18 emerging markets||-.03||No correlation|
Jeremy Siegel also did a 107-year study from 1900-2006 with the same conclusion:
“The results are striking. Real GDP growth is negatively correlated with stock market returns. That is, higher economic growth in individual countries is associated with lower returns to equity investors.” – Jeremy Siegel, Stocks for the Long Run.
Ken Fisher (star fund manager and columnist for Forbes) in his myth-busting book, “The Only Three Questions You Need to Ask” explains:
“A major error investors make in foreign investing – developed countries as well as emerging markets – is assuming a country with a growing GDP must have good stock returns. By the same logic, a flat or negative GDP is often assumed to lead to poor stock returns. This easily debunked Question One myth has been a major cause for investor interest in China over the past few years.”
This myth is popular because people like to have very simple methods of understanding what is going on and because human beings are wired to see correlations whether or not they exist. Economic data is widely covered in the news with many news stories trying to relate it to the stock market. For investors that do not have an in-depth knowledge of stock markets and market history, the economy provides a simple way to talk about the market in broad generalities.
Bottom line: Countries with lower GDP growth generally have better stock markets.
The economy and the stock market are different like “chalk and cheese”. The reasons that slower growing economies generally have higher stock market growth are not fully understood, but here are the most likely reasons:
1. Expectations of the economy are built into prices of stocks:
Jeremy Siegel believes it is because the higher economic growth is built into stock market prices ahead of time and that it is often overly-optimistic. The price investors are willing to pay for a stock or mutual fund includes their expectations for how good an investment it will be. Therefore, investments in countries or sectors that are expected to perform well will tend to be at over-valued – which means their future returns will likely be lower.
2. Companies have many ways to grow profits:
Our opinion is that companies are able to adjust their operations to continue to grow their profits, whether or not the economy is growing strongly. Management is focused on annual targets to grow their profits and can do this in many ways – cost cutting, more efficient systems, new products, new technology, selling unprofitable divisions, buying competitors, gaining customers from competitors, new marketing/advertising programs – or replacing the management. Management is expected to grow profits regardless of the economy.
3.The economy is based on gross and the stock market is 15 times net:
As an accountant and a finance guy, it is easier to see why they are not a proper comparison. The economy is related to the “total output” of the country, which includes the sales or income of companies (and governments, etc.), while the stock market is normally based on a multiple of the profits or bottom line of companies (typically 15 times).
A comparison to your personal budget could be that the economy is like your salary (your gross), while the stock market is like 15 times the money you have saved/invested or have left over at the end of the month (your net).
When you think of them this way, you can see why they may grow completely differently for many reasons. For example, if you get a 10% raise, does that mean you will have 10% more money left over at the end of the month? Maybe/maybe not. If you reduce an expense (pay off a loan or buy a cheaper car), your bottom line soars (especially when you multiply it by 15), even though your salary/income did not change.
This is why the formula is false: stock market growth (15 times net) = economic growth (1 times gross) +/- change in multiple. You can’t compare 1 times gross to 15 times net!
4.The stock market is linked to the total of all shares, not to the average price per share.
Jeremy Siegel also believes that “economic growth influences aggregate earnings and dividends favourably, economic growth does not necessarily increase the growth of per share earnings or dividends. This is because increased growth requires capital expenditures…” (Stocks for the Long Run). He believes that it costs money to support higher growth. This is either borrowed, which lowers profits, or financed by issuing new shares, which lowers the profit per share.
5.The economy and the stock market are like “chalk and cheese”.
Companies and the economy are just different. For example:
- Ken Fisher, “The Only Three Questions You Need to Ask” explains: “Prices are determined by shifts in supply and demand, which may or may not parallel whether GDP growth is strong, weak, or nonexistent.”
- Some factors affect them differently. For example, high unemployment is clearly bad for the economy, but is arguably good for companies in the stock market. It means that some consumers are less likely to spend money, but on the upside, it also means that there is an available workforce, less pressure to increase wages, and that they are more likely to keep their best employees.
- The stock market is not the same companies over time. Obsolete or unprofitable companies are replaced by more profitable, innovative companies, especially in a slower economy.
The economy is not really relevant to stock market investing – short term or long term.
I realize this belief is very ingrained in the thinking of many investors, who may find it difficult to understand the stock market without thinking of the economy. However, a growing body of evidence continually confirms that economic growth is not necessary for good stock market returns – and in fact lower economic growth may promote good stock market returns.
The stock market does what it does – grows significantly long term with 1 or 2 bear markets per decade – generally regardless of what happens in the economy.
If you are an investor, your limited time is best spent on things that are definitely relevant, such as understanding stock market history and researching the quality of your investments. Forecasts and conjecture about the short or long term economic outlook or growth rates for the economy, sector or country may amount to just “market noise” or distraction to be avoided in your investment decisions.
Since the reasons that slower growing economies tend to have faster growing stock markets is not fully understood, which of the 5 explanations do you believe is correct (or do you still believe that growth of the economy is necessary for the stock market to grow)?
About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching. If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com. You can read his other articles here.