GDP was recently reported to be 2% for the third quarter of 2012. The result was higher than the Bloomberg consensus estimate of 1.8%, but still too low, according to most experts, to make a meaningful impact on the labor market. Meanwhile, investors seem to be shying away from equities because of the expectation that GDP growth may be impacted by the fiscal cliff, the results of the election, and a variety of other factors.
But the fact of the matter is that GDP growth and stock market returns have very little correlation, and investors shouldn't be weighing on GDP to make an allocation decision whether to increase or decrease equities. There are still risks, no doubt, such as the European crisis, instability in the Middle East, hurricanes, and the like. In our opinion, however, equities look compelling, and focusing too much on GDP growth to drive that decision may be misleading.
GDP vs. Stock Market Returns
Both Vontobel Asset Management and BNY Mellon have published pieces that study the relationship between GDP and stock market returns. Their conclusions were similar: there is no relationship. In fact, in the period shown in Chart 1 below, from 1900-2002, the relationship between GDP/Capita and Real Equity Returns was negative!!
So one might argue that the markets have changed considerably in the last few decades, and that perhaps this relationship has changed during more recent periods. Well yes, it has changed. We can see from Chart 2 below that while the relationship is still negative, the slope of the line has actually flattened somewhat. But there is still no evidence of a relationship between GDP and stock market returns.
Source: Vontobel Asset Management
Finally, let's evaluate the most recent period shown in Chart 3, which is from 1988-2002. Once again, the slope of the line is flatter, but the conclusions are all the same. There is no relationship.
Source: Vontobel Asset Management
What comes first? The chicken, or the egg?
The concept that we feel most investors find difficult to grasp is the myth behind the idea that the economy drives the stock market. Unlike the chicken or the egg dilemma, we could use hard data to determine the relationship between economic growth and stock market returns without getting into some deep philosophical discussion.
There are certainly economic conditions that are conducive to revenue and profit growth for businesses, but is it truly the economy that drives the stock market? Or as BNY Mellon asks in its Viewpoint piece, "Stock Markets vs. GDP Growth: A Complicated Mixture":
" Does the economy drive the stock market,…or Do Stock Markets Simply Reflect Expectations About the Economy?"
What BNY found to be evident is that Consumer Confidence and stock market returns are highly correlated. (See exhibit below). Doesn't this make sense? If GDP is made up of approximately 70% consumer spending, then it would certainly make sense that if the consumer is confident, the consumer will spend, driving up revenues and profits, and the consumer may even invest in the stock market. Only after consumers feel confident enough to spend and invest do we then begin to witness GDP growth, right? According to BNY, without positive consumer confidence, there can be no rising market in the world's leading stock exchanges.
So how does consumer confidence look? Well, it has been on a relatively steady rise since June/July of this year, rising from the mid 50s to 82.6 at the end of October, according to the University of Michigan Survey of Consumer Confidence Sentiment.
How have the markets performed since then? The SPDR S&P 500 ETF Trust (NYSEARCA:SPY) -- which tracks the performance of the S&P 500 Index -- is up 8.64%, including dividends. Without dividends, SPY was still up 7.52%. The Dow Jones Industrial Average, on the other hand, was up 5.67%.
If consumer confidence continues to improve, the equity markets may rise even further. We read the news about slowing revenue growth and the challenges that some companies face to further reduce costs. With slow revenue growth, cost reduction has been an increasing area of focus for most companies if they expect to increase profits. At some point, however, cost reductions will be limited, and revenues will have to grow for profits to grow. Still, valuations are very compelling at current levels, and it's not a secret that companies are awash with cash. Whether they invest that cash in activities that generate economic profit, or acquire other companies, or return it to shareholders in the form of share buybacks, special dividends, or increasing current dividends, we think there are good opportunities in equities.
We are not suggesting to load up on equities overnight if you are currently underweight. What we do suggest is to set a target allocation that you feel comfortable with in equities, and begin to slowly average in to that long-term strategic position.
While we do prefer to invest directly in individual stocks, using a well-diversified ETF can provide you with exposure to the broad market as you evaluate individual stock opportunities to pursue. Two great options are SPY and the iShares Core S&P 500 ETF (NYSEARCA:IVV).
Don't be sidetracked by the talk of slowing GDP growth -- invest in equities.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.