Why Are Investors Still Worried About GDP?
In a recent 2016 investment outlook paper, Joseph Davis, Vanguard’s chief economist, estimated annual global equity growth over the next five to ten years to be in the 5%-8% range, significantly below the 10% average from 1926-2014. He based this expectation to a large extent on lower U.S. and international GDP real growth rates. While the analysis is otherwise reasonably sound, is it appropriate to bring in GDP at all? After all, there are at least two studies that have determined that there is no correlation (actually negative correlation) between GDP growth and stock market returns.
I first wrote about this topic in 2012, citing data reported by Ben Inker at GMO. (See https://www.cognizantwealth.com/2012/08/22/is-gdp-growth-a-good-predictor-of-stock-market-performance/). More recently, Wesley R. Gray at alphaarchitect.com reviewed research by Jay Ritter at the University of Florida that draws a similar conclusion. Gray states it more emphatically than I did: The idea that strong economic growth translates into strong stock returns is a superstition, not backed by evidence.
Why is this? Ritter offers some ideas for the lack of correlation between the two measures. One is the possible tendency of investors to build expectations into prices at the start of the year. Another is the fact that larger companies (both U.S. and foreign) have significant multinational operations. I’ve read that close to 40% of the revenue of S&P 500 companies comes from overseas. Whatever the reason, GDP simply hasn’t been shown to work as a broad predictor of stock market performance.
Ritter believes that stock returns are driven by company-specific performance, not by economy-wide growth. The two primary factors are price (current P/E ratio) and return on invested capital. In other words, the highest returns are earned by investors paying low prices for firms with the ability to invest in projects that return more than their cost of capital. Although that sounds straightforward, trying to identify the former and predict the latter comes pretty close to clairvoyance. From these various studies I would conclude that whatever data you choose to utilize for making your equity investment decisions, GDP is one measure that should be eliminated.