Weak Growth Doesn't Mean Weak Stock Returns

By John P. Reese

While gross domestic product increased at a solid 3.1% rate in the third quarter of 2012, the U.S. growth since the Great Recession ended has been far from gangbusters. In the 13 quarters since turning positive in mid-2009, GDP has grown by an average of just 2.25% per quarter -- well below the 3% to 4% growth to which the country had become accustomed in past decades. And, many analysts are expecting more of the same in 2013.


No, I'm not heavily short on stocks. And I'm certainly not rooting against the United States. I'm simply looking at history, and history has shown that, while many investors and pundits fret and hyperfocus on every GDP report and revision, GDP growth actually matters little in terms of long-term stock returns.

Take, for example, the work of Elroy Dimson, Paul Marsh, Mike Staunton, and Jay Ritter. In their book Triumph of the Triumph of the OptimistsOptimists: 101 Years of Global Investment Returns, Dimson, Marsh, and Staunton looked at stock market return data from 16 developed countries from 1900 through 2000 (and Ritter updated their work in 2002). One issue they examined was how those returns correlated with per-capita GDP growth. Their findings: GDP and stock market returns were, if anything, negatively correlated. That's right -- higher GDP growth was actually associated with lower stock returns.

In a 2004 paper titled "Economic Growth and Equity Returns" (PDF: Pacific-Basin Finance Journal), Ritter also looked at similar data for 19 developed countries from 1970 to 2002, and from 13 other countries, mostly emerging markets, from 1988 through 2002. He found that there was a negative correlation between GDP and stock returns for the 19 developed countries, and a slightly positive correlation for the 13 other countries. On the whole, higher growth did not mean higher returns.

Ritter says all of this doesn't mean that economic growth is bad, of course. And he notes that there's an asymmetry to the data: "If a country has negative growth, this is probably bad for stocks," he writes. "But for positive rates of long-term growth, whether the growth rate is 3% or 7% should not matter."

So, what gives? After all, stocks are essentially pieces of businesses, and the economy is made up of businesses, so shouldn't rising GDP mean more corporate profits and higher stock prices? Well, several factors get in the way of that logic, not the least of which is expectations. "A possible reason for a negative correlation [between stock returns and GDP growth] is that optimistic investors will bid up stock prices, lowering the dividend yield," Ritter writes. "Because investors must then put up more capital to receive the same dividends, the return is lower. If countries with high economic growth rates consistently have stocks priced at higher multiples, this effect could explain the negative correlation."

In a 2009 paper (PDF) that reviewed Dimson, Marsh, Staunton, and Ritter's work, Vontobel Asset Management's Rajiv Jain and Daniel Kranson offered several other explanations.

For one thing, they note that globalization -- an ever-increasing trend -- alters the relationship between GDP and stock returns. When a U.S. firm has overseas operations that are bringing in lots of sales and profits, it's good for the company and should impact its shares -- but it's not included in U.S. GDP.

In addition, GDP takes into account the value of goods and services produced in a country -- regardless of the margins being earned on those goods. If a company cuts prices and margins to boost sales, it will be adding to GDP, but not doing much for profits, which drive share prices.

Other sources of divergence between GDP and stock returns, Kranson and Jain say, include dilution (a company that issues new shares decreases the value of existing shares, while having no effect on GDP) and the fact that the stock market doesn't include all the businesses of a country (private firms, government-owned businesses, and newly formed firms can have their profits count toward GDP, but not show up in the stock market's returns).

Given all of this, I don't get too concerned when a new round of growth forecasts reveals that America is projected to grow, say, 0.3% faster or 0.4% slower than previously thought (though such minor differences can have a big impact on investors' short-term behavior). What I'm more interested in is the broader expectations that are embedded within those projections. Right now, for example, the meager growth projections indicate people are pretty pessimistic on the U.S. economy in 2013. And, because many assume GDP and stock returns go hand-in-hand, they therefore have low expectations for stocks. In the process, they ignore bullish signs, like the attractive valuations at which many shares are currently trading. That creates bargains for savvy, long-term investors, and I plan to take advantage of those bargains in 2013.

John P. Reese is founder and CEO of Validea.com and Validea Capital Management, LLC. He is the author of “The Guru Investor: How to Beat the Market Using History's Best Investment Strategies” and runs The Guru Investor blog. John, a graduate of Harvard Business School and MIT, is considered an expert in the systematic investing strategies based on the methods and principles of Warren Buffett, Peter Lynch, Benjamin Graham and other investing greats.




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