The disconnect between economic growth and stock returns

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Conventional thinking says that higher rates of economic growth will lead to higher stock returns for investors. Conventional thinking is wrong.

Although the connection between economic growth and stock returns might seem intuitive and obvious, there is not necessarily a direct correlation. Investors who make allocation decisions based on this shaky premise may be disappointed.

The experience of China over recent decades is illustrative. Over the past 30 years, China’s economy has grown at a much higher rate than the U.S. economy, at times by as much as 10% annually. Over the same period, China’s stock market returned an average of just over 2% annually, far less than the U.S. stock market. That’s because stock returns do not correlate squarely with economic growth.

Consider the example of Greece nearly a decade ago. In 2012 Greece was mired in an economic depression and a multi-year debt crisis. Even so, the Athens Stock Exchange was the best performing stock market within the European Union that year, up over 33% and far outstripping the rest of Europe.

An abundance of academic research confirms the disconnect between economic growth and stock market returns. The correlation between long-term economic growth and long-term stock returns is weak. Economic growth by itself is not a reliable predictor of stock returns. This conclusion holds across developed and developing markets.

One study compared the developing economies of Latin America with those of Asia. Over a 20-year period (1985-2005), economic growth in Asia was much higher at 7.4% versus 2.9% for Latin America. However, the returns on Latin American stocks were twice as good at 14% annualized versus 7% for Asia.

Another study of emerging markets found little difference between those economies with high rates of growth versus those with low rates of growth. The study split emerging market economies into two groups: one-half with the highest rates of growth and one-half with the lowest rates of growth. Stock returns for the two groups over the period covered (1990-2005) were virtually identical at 16%.

A 2010 study by Vanguard found virtually no correlation between long-term GDP growth and long-term stock returns. Their study covered the major equity markets over the past 100 years as well as emerging markets over the past several decades. A study out of the London Business School covered the same time-period and reached the same conclusion. In fact, the London Business School study found that the economies with the highest rates of growth had the lowest stock returns. Over the period studied, stock returns from the lowest growth economies were double the returns from the highest growth economies. How is that for counter-intuitive?

There is no clear relationship between economic growth and stock market performance. Why is that and what does it mean for investors? Here are some possible explanations.

First, price matters. The price an investor pays for expected growth is critical. Expectations for higher economic growth very quickly get built into the price of stocks. Economies with high growth potential represent a good investment opportunity only if stock valuations are low. As the author of the London Business School study noted with respect to investment in China, “You’re paying a price that reflects the growth that everybody can see.” If the growth potential for any economy is high but the stock valuations are even higher, then expected returns from stocks may be lower than investors had hoped.

Second, fast growing economies may suffer what the authors of one study referred to as the “dilution effect.” This study argues that in economies experiencing a high rate of growth, companies finance their growth by issuing large amounts of new stock. Speaking about the assumption connecting GDP growth and stock returns, the authors noted, “per share earnings and dividends keep up with GDP only if no new shares are created. Entrepreneurial capitalism, however, creates a ‘dilution effect’ through new enterprises and new stock in existing enterprises. So, per share earnings and dividends grow considerably slower than the economy.”

Third, the publicly traded stock markets do not reflect all economic growth from business. The authors of the study noted immediately above point out that, “an often overlooked, but unsurprising, fact is that more than half of aggregate economic growth comes from new ideas and the creation of new enterprises, not from the growth of established enterprises. Stock investments can participate only in the growth of established businesses; venture capital participates only in new businesses.”

It may be that economic surprises may matter more than growth itself. Economic growth that is better than the consensus expectations has a much stronger correlation with subsequent market returns. This may explain, for example, the outperformance of Latin American stocks relative to Asian stocks in the study noted previously. Latin American economies began the 1980s with very low expectations. Even though they underperformed the Asian developing economies over the next 20 years, the fact that Latin America performed better than expected economically helped to produce better stock returns. Latin American stocks also started out undervalued relative to the developing markets of Asia.

Economic growth by itself is not a reliable indicator of future stock returns. Returns that are expected get built into the price of stocks. Returns that are better than expected are the reward to investors from outcomes that are unexpected.

Investors should be cautious about over-allocating to high growth economies, such as emerging market economies, based on a flawed premise that does not stand up to scrutiny.

David Peartree JD, CFP® is an investment advisor with Brighton Securities Capital Management. This column is a collaborative work by David Peartree and Patricia Foster, Esq. Patricia Foster is a securities law attorney with substantial experience advising members of the financial services industry. The information in this article is provided for educational purposes and does not constitute legal or investment advice.