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.
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