Jul

24

GDP and SP, from Duncan Coker

July 24, 2012 |

1 Comment so far

1. Andrew McCauley on July 24, 2012 6:45 pm

   Arguably the most cited study on this particular subject is the work of Dimson, Marsh, & Staunton (Triumph of the Optimists, 2002). They observe the contemporaneous relationship between compounded real equity returns & compounded real GDP per capita growth for 16 countries over a 101 year period from 1900 to 2000. They report a negative cross-sectional correlation of -0.27 for the total period & -0.03 for 1951 to 2000. The authors concluded “we find no link between stock market performance & GDP growth.”

   Dimson, Marsh, & Staunton in collaboration with ABN AMRO (Global Investment Returns Yearbook, 2005) extended their previous work using 105 years of history (17 Countries) to test a trading rule. Each year, the authors ranked countries by their GDP growth over the previous 5 years. They found that a strategy of always investing in the bottom quintile of countries with the lowest GDP growth led to higher returns than one of investing in the quintile of highest GDP growth countries. Employing this same strategy on an extended group of 53 countries (smaller sample period than 105 years for most countries) again produced higher returns for lower quintile versus higher quintile investors. The study also suggested that none of the so called “BRIC” developing nations (Brazil, Russia, India & China) were found to exhibit a significant relationship between equity return & economic growth.

   Jeremy Siegel (Stocks for the Long Run, 1998) had similar findings in the period from 1970 to 1997. For 17 developed countries & 18 emerging markets, Siegel, found negative correlations of -0.32 & -0.03 respectively, between stock returns & GDP growth.

   More recently, Jay Ritter (Pacific-Basin Finance Journal 13, 2005, pages 489 – 503) suggested that “Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.” Professor Ritter hypothesises that one reason for the negative correlation between real equity returns & real per capita income growth is “a general tendency for markets to assign higher P/E & P/D multiples when economic growth is expected to be high, which has the effect of lowering realised returns because more capital must be committed by investors to receive the same dividends.”

   There are probably many reasons why the GDP to Stock Market Return relationship is insignificant. Professor Ritter cites a few reasons albeit not exhaustive. GDP is somewhat sales driven while Stocks are corporate profitability driven, poor corporate governance can provide high returns to managers at the expense of minority shareholders, company returns may be earned offshore away from listed domicile, the stock market only represents part of the broader economy, economic growth through increased labor force participation rather than productivity growth, deployment of excess capital into new firms (no benefit to existing firms).

   Interestingly much of the investment community believes that a strong relationship exists between GDP growth & equity market returns. After the Sex Pistols’ last gig in San Francisco (1978), Johnny Rotten famously chided his audience, “Ever get the feeling you’ve been cheated?”