During my regular intake of business and finance news stories, I have recently come across many pieces that talk about the increased likelihood of a double-dip recession (which may well be correct) and thereafter use this evidence as a reason to be bearish on stocks (with which I disagree). Just last week, the editor of MoneyWeek, John Stepek, stated:
if the US does continue this slide towards a double-dip recession, I suspect that will result in quite a nasty sell-off in the stock market.
It is easy to see why this fallacy is so commonly repeated. In the most basic sense, Economists measure GDP, or the size of the economy, as C+I+G+X-M (Consumption + Investment + Government Expenditure + Exports – Imports), so weakening consumption, investment, government spending or net exports are all likely to impact upon company revenues and profits. However, it does not follow that this will also lead to poor stock market performance. Firstly, short-term equity market returns are largely determined by changes in valuations (in turn mainly driven by technical factors and investors’ “animal spirits”), not by changes in company profitability. This research from James Montier at GMO shows that changes in equity valuations contribute nearly 80% of total S&P 500 returns on a one-year time horizon (see chart, right). Secondly, even if you remain of the view that changes in short-run economic growth impact equity returns then it is worth remembering that 47% of S&P 500 earnings are generated abroad and the equivalent metric for the FTSE 100 is approximately 70%. Therefore, with the IMF forecasting global economic growth to be 4.5% in 2010 and 4.25% in 2011, then many firms should see short-term revenue and profit growth continue, despite the uncertain outlook for the US and the UK economies. And thirdly, empirical evidence from recent recessions shows that there is no definitive relationship linking poor equity market performance with recessions (see chart, right),
Even in the long-run, evidence suggests that there is little linkage between economic growth and stock market returns. This makes me concerned about statements such as this:
Emerging-market stocks are trading at the highest valuations relative to advanced-country shares in more than two years as faster economic growth persuades the biggest investors to look past historical sell signals.
This appeared in a recent Bloomberg article with the headline “This Time Seen Different as Emerging Stocks Top World” which is full of quotes from investors citing strong economic growth as their rationale for being overweight emerging markets. It is quite appealing to consider there to be a connection between long-term economic growth and stock market performance; however, empirical evidence exists that this is not the case. In “Economic Growth and Equity Returns” Jay Ritter of the University of Florida finds that “the cross-country correlation of real stock returns and per capita GDP growth over 1900-2002 is negative”. He notes that when “increases in capital and labour inputs go into new corporations, these do not boost the present value of dividends on existing corporations” and that “technological change does not increase profits unless firms have lasting monopolies, a condition that rarely occurs”. He also provides empirical evidence to support this thesis, which is presented in the chart below.
In summary, because economic growth leads to the creation of new private corporations which are then sold to public investors via the IPO process, the wealth generated through additional technological progress and capital formation accrues to the entrepreneurs that create these new companies and to the employees of all the companies in an economy who benefit from a higher standard of living, not to the stockholders of existing corporations. Ritter argues that only three factors impact the level of future equity returns:
The first is the current P/E ratio, although earnings must be smoothed to adjust for business cycle fluctuations. The second is the fraction of corporate profits that will be paid out to shareholders via share repurchases and dividends, rather than accruing to managers or blockholders when corporate governance problems exist. The third is the probability of catastrophic loss, i.e., the chance that “normal” profits are a biased measure of expected profits because of “default” due to hyperinflation, revolution, nuclear war, etc.
The recent expansion in the IPO pipeline in emerging market countries can therefore be seen as evidence that the supply of companies is: (a) being created by increasing technological change and entrepreneurship; (b) being floated on regional stock markets; and (c) diluting returns to existing stockholders in the markets in question. To understand the impact of dilution from IPOs, think from the perspective of holding an index fund ETF in an emerging market economy. A large IPO takes place which is immediately added to the index (think Agricultural Bank of China). This ETF (and all other index funds in the market) will need to partially sell-down positions in all its existing investments in order to finance the purchase of the new IPO, thereby depressing stock prices of existing shares on the market. When this effect is scaled-up to reflect the scale and length of the emerging market IPO pipeline, the potential for this process to negatively impact returns to existing stockholders is clear. William J. Bernstein and Robert D. Arnott writing in the Financial Analysts Journal showed how this dilution from new equity issuance subtracted 2%pa from equity returns in developed countries during the 20th century. I would expect this figure to be just as high – if not higher – in emerging markets over the next fifty years.
I think the conclusions that can be drawn from this are clear: firstly, don’t focus upon trying to forecast changes in economic growth to inform your investment decisions as the evidence suggests that valuation changes (not profit changes) are the most significant factors in determining short-run equity returns; secondly, don’t let forecasts long-term economic growth forecasts distort your asset allocation descisions, as the research suggests that economic growth has little correlation with equity returns; and thirdly, concentrate on finding companies (and markets) trading at cheap valuations with the potential for dividend growth, as these are the factors that best explain long-run returns.