Conventional wisdom holds that equity market returns are linked to GDP growth. Supply-side models assume that GDP growth of the underlying economy flows to shareholders in three steps.
First, it transforms into corporate profit growth.
Second, the aggregate earnings growth translates into earnings per share (EPS) growth, and finally EPS growth translates into stock price increases. If this theory holds true one would expect an exact match between real price increase on the stock market and real GDP growth. This theory is simple and makes intuitive sense. But is it true in practice? (MSCI Barrra)
Is GDP Growth Important for Successfully Investing?
Indeed are many market pundits truly obsessed with economies and stock markets of countries that have shown significant past economic growth.
Past economic growth is extrapolated into the future making market participants believe that those countries exhibit good long- term growth prospects. Investing in emerging markets, with apparently good future growth, is widely viewed as very attractive. Those countries and themes are wholeheartedly embraced by "Investors", while countries like Japan, with prolonged periods of low growth that are expected to persist, are neglected and ignored.
The hype surrounding buying into prospective growth countries was at plain sight when investing in BRIC countries and other emerging economies was all over the media and the latest party talk of the time.
It was not going unnoticed by Wall Street and the City of London. They vigorously marketed, enticed and flooded the public with financial products that facilitated investing in these countries.
At the same time major international banks were packing their bag and leaving Tokyo, as the country was mired in stagnation and no prospect of future growth was at sight. This behavior was definitely good for the commissions of the investment bankers, but was it good for investors?
Do empirical findings support the view that economic growth always—or even generally—benefit stockholders? If so, there should be a stable relationship between economic growth of a country and excess return on the respective stock market!
But, maybe surprisingly to many, such a positive relationship does not exist! Even worse! Not only is the answer a clear no on both theoretical and empirical grounds, but the shocking truth is that the cross-sectional correlation between returns and the growth rate of per capita gross domestic product (GDP) is negative. (Dimson et al.) Those findings beg the question why this might be so. Some arguments concerning the irrelevance of GDP growth in investing will be presented in the second part.
On the Irrelevance of GDP Growth: The Empirical Findings
As far as I am aware, the first who mentioned the negative cross-country correlation between real per capita GDP growth and real stock returns was Jeremy Siegel. In the second edition of his book "Stocks for the Long Run" Siegel (1998) noted that: „Investment advisors often select foreign markets on the basis of the country's prospects for economic growth. But economic growth is no guarantee of superior stock market returns. The results are quite surprising: except for Singapore, over the past 27 years there has been a negative correlation between economic growth and dollar stock returns. (...) a negative correlation between growth and stock returns also applies to developing or emerging world economies. (...) (p.130-131)"
Those findings must have been a shocker to the investment community. Siegel not only was claiming that there is no robust relationship between investing results and the GDP growth rate, but that the relationship is rather negative! It suggests that investing into high growth countries increases the likelihood of underperformance.
However, Siegel's finding was based on data that went back only as far as 1970's. So it might be that the 30 year period investigated were rather an outlier. But apparently that is not the case! Dimson (2002) reported a negative correlation since 1900 between growth in real GDP per capita and real equity returns. He noted in his book "Triumph of the optimist" that: "(...) somewhat surprisingly, high economic growth was not associated with high real dividend growth—if anything, the relationship was perverse with a correlation of -0.53 (...) (p.156)”
Although groundbreaking findings they went almost unnoticed by the public. Maybe this was because it was so diametrical to common sense, which suggests that what is good for the economy is good for companies, and vice versa.
It took 12 years till the public picked up on the findings of Dimson et al. In 2014 the Economist was puzzled by the fact that: " An oft-quoted argument for investing in emerging markets is their superior economic growth. But (...) economic growth and equity returns are not correlated at all (...)." I would argue that Dimson el al.'s findings are not only puzzling but rather flabbergasting. Not only could they not identify any robust positive relationship between equity returns and GDP growth but rather it was negative.
Dimson and its research team are always good for shockers. In 2014 they showed that instead of growth being a contributor to stock market performance it is rather a distractor and a contrary indicator. " (...) Contrary to many people’s intuition, investing in the countries that have recently experienced the lowest economic growth leads to the highest returns – an annualized return of 28% compared with just under 14% for the highest GDP growth quintile (...) (p.14)"
To sum it up. Being aware of past economic growth of a specific country does not only not increase investment return it decreases it. Thus, you would be best placed investing in the slowest-growing economies of the past, not in the fastest. Japan anyone?!
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On the Irrelevance of GDP Growth: Explanation Attempts
Concerning the findings that past high GDP growth is irrelevant for future stock returns begs the question why this might be so. Several arguments have been brought forth. Some more convincing than others.
The Globalization Argument
For Siegel (1998) one explanation concerning the lack of correlation between economic growth and stock returns is that even if multinational corporations are headquartered in a particular country, their profits depend on worldwide economic growth. This is particularly true of economies whose firms are oriented to export markets. (Siegel)
Thus, part of the difference among countries may be explained by the different level of openness of the economies, and by the disparities in the proportion of listed companies. Especially in an ever more globalizing economy, corporations operate in several locations throughout the world. Consequently, parts of the production process for these multinational firms are not reflected in the home country’s GDP. This can create a discrepancy between the company’s performance and the local economy. (MSCI Barrra)
But, although it is true that international operations could plausibly lower the correlation between per capita GDP growth and stock returns, Ritter (2012) notes that it is hard to see how international operations would cause a negative correlation between growth and stock market return. Thus, the globalization argument is unsatisfactory. The Valuation and Behavioral Argument
A more convincing assertion concerns the valuation of growth markets. Siegel (1998) points to the analogy to the discussion concerning growth vs. deep value investing. When the expected growth in a stock is already factored into the price of the underlying, growth stocks do not necessarily have higher returns than value stocks. The same phenomenon is true on a country basis. Those countries with high expected growth rates, such as the supercharged Japanese economy of the late 1980s, have overly optimistic P-E ratios than lower-growth countries. (Siegel) The expected economic growth is already impounded into the prices, thus lowering future returns.
A more recent example would be China. In China, the combination of high economic growth (over 9% on average) with low stock returns (-5.5% per year) is remarkable. At numerous times since 1993, the price-earnings (P/E) multiples of Chinese company stocks reached extraordinary heigts. Often those high valuations were followed by earnings disappointments and low reported returns on capital.
Like in Japan during the late 1980's, and more recently China, the general tendency for markets appears to assign higher P/E and price-to-dividend multiples when economic growth is expected to be high. As a corollary it means that companies must produce higher growth in earnings and dividends per share in order to meet investors’ expectations and to justify the current prices paid. Furthermore, it must be achieved by increased investing in positive-NPV projects, because only then will the earning yield be increased. Only if earnings and dividend growth eventually turn out to be at least as high as expected, then overall shareholder returns will not be negatively affected. (Ritter)
Dimson et al. (2014) seem to approve on the abovementioned viewpoints. They also try to explain the lack of correlation between growth and stock market performance by past growth fully factored into market valuations. But they note that this would only imply neutral performance from the highest growth countries, whereas the "perverse result" of their studies show outright underperformance to low growth countries.
For explaining the outperformance of the stock markets of low growth countries over high growth countries other factory must be at play. Could it be that those factors are specific features of the low growth stock market? Their thesis implies that weak growth countries, often accompanied by a weak currency, are often distressed and thus a higher risk market.
Hence, investors demand a higher risk premium and real interest rate. The higher returns that follow would than simply be a reflection of those facts. The not trivial problem with this explanation, which is not going unnoticed by the authors, is that the market outperformance of low growth over high growth persists even after standard risk adjustments. Dimson et al.(2014) note that: "(...) If this risk argument is correct, then our risk adjustments are failing to capture the nature of the risks involved. (...)"
Especially for advocates of the CAPM model and the efficient market hypothesis, not known for having a weakness for empirical work, the results should be more than disturbing. Firstly, because their work suggests that excess return is possible only by taking on more risk. This is obviously not the case when investing into low growth countries.
Furthermore, their theory implies that such a mispricing should vanish instantly, because they offer arbitrage opportunities that any rational investor would immediately exploit. The strategy involved would be to buy equities in distressed markets and to short-sell securities in fast-growing markets, thus eliminating any risk adjusted valuation discrepancy in a timely manner. But that is apparently not the case. They fail to recognize that short-selling can be costly and a risky endeavor, and sometimes outright forbidden by certain regulatory agencies. (Dimson et al.)
This brings forth an additional (behavioral) argument trying to explain the negative correlation between the growth of an economy and respective stock market returns. As mentioned before short selling involves several obstacles and the absence of short selling, and hence the impossibility of arbitraging, would allow relative valuation differentials to persist. In combination with investors having the tendency to avoid distressed countries, or demand a too high risk premium for investing in them, while meanwhile enthusiastically overpaying for growth markets, would suggest that mispricing not only persist but even get more pronounced over time. (Dimson et al)
In developed markets it is well known that portfolio performance is impacted by investment style. Especially the long term outperformance of value over growth investing is evidenced by numerous empirical studies. The supremacy of value over growth investing is the longest established and best documented regularity in equity markets. (Dimson el al.)
Consequently, for explaining the outperformance of the stock markets of low growth countries over fast growth countries Dimson et al. (2014) also concentrate on the evaluation of a value rotation strategy. They compared the portfolio of high dividend yield stocks to low dividend yield stocks and showed a large premium. In contrast to other, more sophisticated empirical studies concerning value strategies, they found the value rotation strategy to have a higher standard deviation of 41% per year versus 33% for the lowest yield quintile. However, the Sharpe ratio (reward to volatility) of the “value” quintile was still a massive 0.88 versus 0.44 for the “growth” quintile.
They conclude that the outperformance from investing in value-oriented markets is thus robust to standard forms of risk adjustment. In addition, Dimson el al. (2014) also examined another rotation strategies showing that equity returns tended to be higher following periods of currency weakness with annualized return from the quintile of the weakest currencies being 34%, while the return from the strongest currencies was 18%. Again, this outperformance is robust to standard risk adjustments. They conclude that the most likely explanation is that a period of low economic growth for a country, or a period of currency weakness, is simply another proxy for the value effect.
To sum it up. Contrary to many people’s intuition, investing in the countries that have recently experienced the lowest economic growth leads to the highest returns. Once again, standard risk adjustments, and thus the CAPM model, do not explain this finding. The Dilution and Wasteful Spending Argument
Stock dilution and wasteful spending by companies are other compelling arguments brought forward in order to explain the "perverse" relationship between economic growth and stock market return.
Concerning the first point, economic growth is not a panacea for investors, since its benefits are offset by the dilution arising from the need for capital. New investors who create or buy into the new businesses that accompany economic growth will increase growing countries’ market capitalizations. (Dimson et al.)
China is a point in case. Its stock market grew from almost nothing in 1993 to a market value of approximately $3 trillion at the end of 2011. But much of the growth in China’s aggregate market cap is attributable to the expansion of the number of listed companies, resulting in part from several thousand initial public offerings (IPOs). (Ritter) But those new stocks do not represent wealth creation that can be shared with current investors (Dimson el al.)
For the U.S dilution mainly takes place through large grants of employee stock options. (Ritter) Those dilutions cause the growth in EPS available to current investors to be lower than growth in aggregate earnings of an economy.
Hence, Countries can grow rapidly— and for considerable periods of time—by applying more labor and capital, but without the owners of capital earning high returns. Ritter (2012) notes that the dilution argument is much the same story than with economic growth due to technological advances. Unless technological change comes from companies with some kind of pricing power, the resulting improvements in productivity typically end up contributing mainly to higher standards of living for workers and consumers, and not to higher returns to the shareholders.
Finally, and more importantly to the stock market investors, is the fact that, like GDP can grow without providing commensurate benefits to its citizens, a company can grow without the shareholders benefitting. In the case of GDP growth examples would be major public projects. Investments that are subsequently terminated, or abandoned like unwanted infrastructure or bubble era housing like in Spain or Ireland. Expenditures on these wasteful projects are still counted as additions to aggregate GDP. But it does not enhance the overall standard of living.
Unfortunately, also many companies keep expanding with pursuing low, or even worse, negatively yielding projects. Consequently, they fail to convert bigger revenues into higher aggregate earnings. (Dimson el al.)
Not a few companies have wasted massive amounts of investor capital. Especially in misguided attempts to maintain sales in declining businesses or by getting into unfamiliar ventures in order to increase sales growth. In the U.S., for example, some industries have consistently invested in negative NPV projects, causing significant losses for their shareholders. Examples for industries that have experienced remarkable sales growth during the last century include airlines and automobiles. On the other end of the spectrum are stagnating or even declining industries such as tobacco.
Not only have the shareholders of the former (growth) industries not gotten rich during the last 45 years, but rather did they ofthen have to see many billions of dollars poured into value-destroying negative-NPV projects. Investors in low growth industries (or even declining ones like Tobacco), on the other hand, have done very well. In the case of tobacco companies this was despite hundreds of billions of dollars paid out to settle lawsuits. (Ritter)
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Why do Companies Overinvest?
I regard the overinvestment argument as the most intriguing explanation why high growth country portfolios tend to underperform those of low growth countries.
One explanation for overinvestment is political and social pressures. Take the case of Japan. For an extended period of time Japanese policymakers were committed to growth and full employment. It resulted in officials pressuring corporate Japan on using their assets to preserve growth and employment instead of returning cash to the shareholders. (Ritter)
But, as policymakers in Japan hopefully have begun to recognize, the shareholder losses resulting from this pursuit of growth at all cost have arguably played a major role in the country’s relatively poor economic performance since the 1990s. (Ritter)
But even without political pressure corporate manager's are biased towards excessive retention and overinvestment, including overinvestment in acquisitions. The reason is mainly behavioral. Both successful—and unsuccessful—entrepreneurs and top corporate executives tend to be overly optimistic and confident about their own abilities and are inclined to overinvest. They take on projects that fail to earn their cost of capital. Mostly because of their tendency to emphasize on what can go right, while downplaying the potential downside risk. (Ritter)
In addition, not a few corporate managers have a penchant for empire building. Their social prestige in the business community correlates with the size of the corporation. Hence, they an incentive to pursue high risk/ low profit ventures in order to grow the company in size. Unfortunately, most often to the detriment of the owners of such a company.
What is Important in Investing?
One of the best researched, most notable and stable patterns when it comes to superior stock returns is the strong association between high dividend growth rates and high overall stock returns. Such positive correlation is not surprising in that growing dividends tend to reflect increases in earnings per share. To make the point the real GDP growth rate of the U.S during the 1980's was significantly less than those of Japan. But in the U.S. the growth rate of real dividends per share had a positive showing of 2.3%. Japan, on the other hand, had an average growth in dividends per share that has actually been negative in real terms (-2.4% per year).
Moreover, stock repurchases, another important tool to let investors participate in the economic success of a company, were forbidden in Japan until 1995. (Ritter) In contrast to Japan, U.S. corporations have paid out large amounts of cash to shareholders by repurchasing shares. The reduction in the number of shares outstanding affects the growth rate of dividends per share. (Ritter)
Furthermore, compared to the U.S. M&A activities in Japan are limited in scope and scale. Under the assumption that cash is used by one company to acquire another publicly traded company, an M&A transaction is equivalent to a share repurchase in distributing cash. Although it does not affect the number of shares outstanding of the acquiring company, it is basically using company A’s cash to retire company B’s shares. Thus, for the aggregate stock market of a country such transaction have the same effect as a share repurchase. (Ritter)
Finally, concerning dividends, there is likely to be another, non-arithmetical, effect at work here, especially when it comes to liberal dividend pay- outs. A high dividend pay- out ratio limits the aforementioned “overinvestment problem,” or the pursuit of growth-for-growth’s sake. (Ritter) A liberal (but prudent) payout policy limits the discretionary cash available to management, potentially spent on value destructive investments. Thus, dividends enhance the corporate governance of the respective stock market. They work like an automatic stabilizer concerning financial discipline. Here the self- governing, e.g. non-discretionary aspect, is what make dividends so important.
Jason Zweig puts it this way: "(...) most managers are wrong when they say that they can put your cash to better use than you can. Paying out a dividend does not guarantee great results, but it does improve the return of the typical stocks by yanking at least some cash out of the managers' hands before they can either squander it or squirrel it away." (Intelligent Investor; p.506)
Given the aforementioned reasons it should not come as a surprise that the Japanese stock market has performed so poorly when compared to the U.S.
Conclusion
Many investors and commentators have ignored and/ or misunderstood the evidence on economic growth and equity performance.
Of course is there ample evidence that unexpected changes in economic growth affect stock prices. Stock prices fall when the probability of an economic recession increases, and prices rise when the probability of economic recovery increases. Recessions are definitely bad for corporate profitability. And there is no doubt that cyclical recoveries are good. (Ritter)
Thus, while there may be no consistent long term positive correlation between equity returns and actual GDP growth, a significant relationship has been found between equity returns and expected GDP growth. This is unsurprising given the link (via a discounting mechanism) between stock prices and expectations regarding both earnings and interest rates (and thus GDP growth). (Wade et al.)
Why then has it been so difficult to make money by buying the stocks of countries that have been improving their economic position? Regarding that question Dimson et al. (2014) note that: "(...) buying the equities of economies that are going to have high growth over the years ahead would have generated a far higher annualized real return than buying into economies that are going to suffer poor growth.(...)"
The corrallity of this observation is that not accurate statistics of historical economic growth is important. It is rather the accurate prediction of future economic growth that would be of much greater value.
Unfortunately, not only are such forecasts incredible difficult, but also do stock prices impound anticipated business conditions in a timely manner. When the economic environment is expected to improve, investors on average factor into the stock prices the likelihood of improved cash flows in the future and/or the lowering of investment risk. When the economic environment is expected to deteriorate, investors on average price into the stock market the likelihood of worse cash flows in the future and/or a need to apply higher discount factors to reflect increased uncertainty and investment risk. Thus, the average investors’ decision-making process and action tends to, at least partially, anticipate the economy’s changed circumstances. (Dimson et. al)
Empirical evidence supports this claim. Hence, stock market fluctuations predict changes in GDP, but movements in GDP do not predict stock market returns. To use public information to try to predict the market is to bet against the consensus view set by a multitude of other smart and informed global investors. If true that stock prices are a leading indicator of future GDP growth then a perfect forecasts of GDP growth would be indeed invaluable. Unfortunately, such a perfect forecast is technically not feasible. (Dimson el al.)
Source:
Elroy Dimson, Paul Marsh, and Mike Staunton; The Growth Puzzle; CREDIT SUISSE GLOBAL INVESTMENT RETURNS YEARBOOK 2014
Elroy Dimson; Triumph of the Optimists: 101 Years of Global Investment Returns; New Jersey: Princeton University Press 2002
Benjamin Graham; The Intelligent Investor; Harper Business Essentials (2003); (with commentary by Jason Zweig)
Msci Barra;
Is There a Link between GDP Growth and Equity Returns?; MSCI Barra Research Papaer No. 2010-18
Jay R. Ritter; Is Economic Growth Good for Investors?; University of Florida; August 7, 2012
Jeremy J. Siegel; Stocks For The Long Run: The Definitive Guide to Financial Market Returns and Long-Term Investment Strategies; McGraw- Hill (Second Edition); 1998
Keith Wade; Anja May; GDP growth and equity market returns; Schroders 2013
Great write-up. Much appreciate your work.
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