Stock Market Returns & GDP Growth
In my last article, I summarized the most recent World Economic Outlook from the IMF. In that report, IMF economists stated:
The global recovery is expected to strengthen, led by advanced economies. Growth in emerging market and developing economies is expected to pick up only modestly.
The gap between developed and emerging growth is expected to narrow, but for the most part, emerging economies are expected to have higher growth rates in the future. Some investors may infer that higher economic growth should translate to better equity market performance. There have been a number of studies on the correlation between GDP growth and stock market returns and the majority of the research shows that there is no relationship between GDP growth and stock market returns. Ben Inker of GMO published an article in 2012 where he concluded:
Stock market returns do not require a particular level of GDP growth, nor does a particular level of GDP growth imply anything about stock market returns.
Inker includes the chart below in figure 1 showing the confidence level is only 13% on a scale of 0 to 100 with 100 being the most confident predictor of correlation between stock returns and GDP growth.
Figure 1: Stock Market Returns and GDP Growth, 1900-2000
Source: GMO, Dimson, Marsh, and Staunton, Triumph of the Optimists
In his report, Inker points out that higher GDP growth seems to be associated with lower stock market returns. The article goes on to say that stock market returns in the United States have historically been driven by dividends and real earnings per share growth. As seen in figure 2, the gap between the 1.7% real earnings growth and 5.9% real return on the S&P 500 from 1929 - 2011 is made up by dividends and a small valuation shift.
Figure 2: S&P Total Return and EPS vs. GDP
Source: GMO, BEA, Robert Shiller As of 12/31/11
As many investors have experienced, equity market performance is very unpredictable and volatile. The average return for the S&P 500 from 1900 through 2009 has been 6.6% real (after inflation). However, the ride along the way has been bumpy for equity investors. Figure 3 below shows rolling 3-year real return to the S&P 500, with shaded areas denoting large losses or “bad events” from the Great Depression in 1929 to the Global Financial Crisis in 2008.
Figure 3: S&P 500 Returns and “Bad Events”
Source: GMO, Robert Shiller
GDP growth for developed economies over the past five years has been abysmal, while equity markets have surged further proving the lack of correlation between GDP growth and stock market returns. Bill Witherell of Cumberland Advisors has written that equity market performance has more to do with corporate earnings and earnings expectations than economic growth. He reported earlier this year that consensus earnings per share growth estimates for the MSCI World Index are 8% for 2014 and 11.3% for 2015. Forecasting equity returns is beyond the scope of this article, but the numbers from Witherell suggest a continued moderate increase in global equity markets.
As long-term equity investors, it’s clear that being patient during the good and bad times is important. Both the IMF and Witherell point to potential risks on the horizon including the crisis in Ukraine, concerns regarding the relationship between China and Japan, low inflation, and the removal of central bank stimulus.
GDP: Gross Domestic Product which is defined as the market value of all officially recognized final goods and services within a country in a given year.
Correlation: the extent to which the values of different types of investments move in tandem with one another in response to changing economic and market conditions.
Real Return: The return of a specified index after the effects of inflation. The return before inflation is typically called “nominal return.”
S&P 500 Index: a representative sample of 500 leading companies in leading industries of the U.S. economy; considered a large-cap index.
MSCI World Index: a representative sample of approximately 14,000 securities and includes large, mid, small and micro cap size segments for all Developed Markets countries in the index together with large, mid and small cap size segments for the Emerging Markets countries.
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