Hurrah, the economy is picking up! This must be great news for equity markets, right? Unfortunately, it is not. There is an increasing amount of research that indicates that the relationship between GDP growth and stock returns is not so harmonious. And yet, many investment decisions are still based solely on economic growth.
A couple of years ago Morgan Stanley did some interesting research on this topic. Using the 'Triumph of the Optimists' database compiled by Dimson, Marsh & Staunton (2001), which contains over a hundred years of economic and market data for nineteen different countries, they concluded that the relationship between stock markets and GDP growth was predominantly negative. Their findings are irrespective of the time horizon over which this relationship is measured. Analysis of both shorter and longer intervals demonstrates that economic growth and equity returns are negatively correlated.
In a similar study, using the same database, Goldman Sachs related GDP growth to actual returns. They calculated that, if you had invested only in those countries with the highest economic growth, your return would, on average, have been 3% per year lower than if you had invested in the countries with the poorest growth. Interestingly enough, if you only look at the emerging countries from the data sample, the 'slow growers' would have earned you as much as 5% more per year.
Low growth, high return
One of the best examples of this negative relationship between stock markets and GDP growth is China. Since 1992, China has outgrown the United States by a whopping 8% per year on average. But, it is the investor who put his money in the US stock market who actually made the best return. While lagging China by a mile in terms of economic progress, US equities outperformed Chinese stocks by roughly 8% per year. More evidence that the relationship between economic growth and equity returns is not a match made in heaven.
Why do investors so often incorporate economic growth in their views on the stock market? Well, theoretically, it is possible for GDP growth and equity-market movements to go hand in hand. Imagine a closed economy (no foreign trade) with only local companies listed on the stock market. In that case the relationship between growth and return is perfectly positive if:
- Earnings growth matches GDP growth, and
- Growth in earnings per share matches earnings growth, and
- Equity returns match growth in earnings per share.
Of course, most economies are by no means closed, but it is useful to go through every step individually, to find out where the relationship breaks down. Let's start by looking at the relationship between GDP growth and earnings growth. This is illustrated below using data from the Bureau of Economic Analysis. I think it is fair to conclude, with a little imagination, that GDP and earnings have historically grown at about the same rate.
But does this earnings growth also lead to the same growth in earnings per share? This is of course what really matters for investors. Unfortunately, the Bureau of Economic Analysis doesn't keep track of earnings per share. But MSCI does. MSCI calculated that between 1969 (the start of the MSCI indices) and 2010 the growth in earnings per share lagged earnings growth by a hefty 2.3%.
The reason for this is dilution. On average, companies issue more shares than they buy back, resulting in earnings dilution. And, while, the MSCI research only goes up to 2010, looking at a Bloomberg terminal will tell you that this dilution has continued in the years that followed. Whenever a company needs to raise equity capital, earnings will be diluted. Ritter (2005) argues that dilution will also occur, because some of the gain of capital investment will flow to new companies, instead of existing shareholders.
Although it is already evident in this second step that the relationship derails, it is still well worth looking at the final step. Here, the growth in earnings per share should be equal to the return on the share itself. This can only be the case if the valuation of the company, measured by the price-to-earnings ratio, stays the same. If a company doubles its earnings, its price must also double if its PE ratio is to remain unchanged.
Valuation, valuation, valuation
This is of course not the case. Valuation changes every day as investors try to establish which stocks are cheap or expensive. Every day, new information is incorporated in these valuations. But also consider periods like the tech bubble at the end of the '90s, in which valuations rose enormously. Moreover, it is exactly this change in valuation that explains why equity returns have been so solid over the last decades despite the dilution in earnings-per-share growth. Since 1948 valuations have roughly doubled, creating additional returns for investors.
So why is the above interesting for investors? As mentioned before, the decision to invest in equities is often almost solely based on the growth data from the Bureau of Economic Analysis. How common is it for investors to start buying equities once GDP growth has already picked up and vice versa? However, the research described above indicates that there is no positive relationship between GDP growth and equity returns. If anything, it is the other way around, invest one growth is low. But, taking into account that fundamental factors like dilution and valuation frustrate the relationship, investing purely based on economic growth is probably not the most profitable strategy, anyway.
Does this mean economic growth is totally irrelevant? Perhaps not, as investors tend to react to changes in expectations about future GDP growth. There could be some value in growth projections, but these are notoriously volatile. Having an insight into earnings growth, dilution related to corporate actions and valuations may be of more use when deciding to invest in equities or not. Also, there is certainly no shortage of information about these factors at an index level as well. From this angle investing in a single company is not that different from investing in stocks in general. Except of course for the fact, that getting your equity timing right is much more important than getting the company right. Leave the GDP growth for the economists.
Elroy Dimson, Paul Marsh and Mike Staunton, Triumph of the Optimists: 101 Years of Global Investment Returns, 2002, Princeton University Press, Princeton.
Jay R. Ritter, Economic growth and equity returns, Pasific-Basin Finance Journal 13 (2005) 489 -503
MSCI Barra, Is There a Link Between GDP Growth and Equity Returns?, May 2010.
Goldman Sachs, Outlook 2011 - Stay the course, Investment Strategy Group, January 2011.
Morgan Stanley, Downunder Daily: Growth: Who Cares?, March 2011.