Turn Off Your Chief Economist: GDP Growth Doesn’t Predict Stock Returns
In a sustained effort to try too hard, investors are constantly analyzing and assessing the growth rates of various markets around the world. The key assumption behind this analysis is that knowledge of these growth rates enhances their ability to predict the future and expected returns. This assumption is empirically invalid. Unfortunately, a big trick in investing, and life in general, is separating the signal from the noise.
A recent article by Baijnath Ramraika highlights what the author calls “The GDP Growth Rate Myth.”
Baijnath references an interesting piece by Vanguard, which stated:
In a 2010 research paper, we cautioned equity investors that these markets should not be expected to outperform their developed counterparts solely on the basis of higher anticipated economic growth.
All great stuff, but why is Vanguard basing a research piece on a subject that has already been explored extensively by academics. This is old news. In an older post we highlight the work of the great academic finance researcher Jay Ritter. Jay has a paper called, “Is Economic Growth Good for Investors.”
Here’s Jay’s punchline:
When measured over long periods of time, the correlation of countries’ inflation‐adjusted per capita GDP growth and stock returns is negative.
And here is the chart from Jay’s paper:
On our piece on behavioral finance, we highlight that Warren Buffet reminds investors why they shouldn’t cling to macroeconomic growth stories. So, if not on growth, in which area should investors focus? As Ritter says quite succinctly: “current earnings yields.” Translated for non-finance geeks, this simply means price. And as any intelligent investor will tell you, the price you pay has everything to do with the returns you will receive. If an investor pays a high price for a given asset, they can expect low returns; if the same investor pays a low price for a given asset, they can expect high returns. The real story here is that high equity returns are earned by investors who focus on paying low prices for firms with strong abilities to invest in positive net present value projects. It may be that the best prices can be had in times of low economic growth when prices are depressed, whereas we tend to overpay in a growing economy. The idea that strong economic growth translates into strong stock returns is a superstition, not backed by evidence.***
Join thousands of other readers and subscribe to our blog.***
Please remember that past performance is not an indicator of future results. Please read our full disclaimer. The views and opinions expressed herein are those of the author and do not necessarily reflect the views of Alpha Architect, its affiliates or its employees. This material has been provided to you solely for information and educational purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such. The factual information set forth herein has been obtained or derived from sources believed by the author and Alpha Architect to be reliable but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission from Alpha Architect.