Is there a Correlation between GDP Growth and Stock Market Returns?
In a theoretical environment stock price increases should exactly match real GDP growth. Why is this often not the case?
Feb 29, 2016
The correlation between economic growth and stock market returns is a recurring question amongst analysts and investors alike. While many claim that 'theoretically' both figures should be the same, others believe that there is no correlation at all. In this research piece we will address some of the most common assumptions and observations. However, please note that the complexity of this issue is high and this simplified approach may not entirely provide an adequate comparison of these two variables.
GDP Growth = Stock Market Returns?
In a theoretical environment stock price increases should exactly match real GDP growth. The underlying economy of a country translates into a company’s profits, thus into Earnings per Share (EPS), which eventually determines the price of a company’s stock. However, this only works if a country’s economy is closed, valuations remain constant and if only domestic companies are listed on a country’s stock market. As we know the world economy isn’t ‘theoretical’, hence this example may not be an appropriate comparison, however understanding the basic principles of stock market returns is crucial for this experiment.
Theoretical versus Real Economy
Studies have shown that in many countries there is somewhat of a correlation between GDP growth and stock market returns. In theory, and over the long-term, aggregate corporate earnings rise when the economy grows or vice versa.
However, there are plenty of examples where the stock market was clearly disconnected from the real economy. Looking at shorter timeframes, we note dramatic variations of the two key variables, especially in times of significant volatility. During the 2008 Financial Crisis (‘GFC’), stock markets around the world plummeted approximately 40-60%, but of course, the real economy did not shrink ~50% within a few months. The following bull market saw the S&P 500 nearly triple in just 6 years, which is also not reflective of real GDP growth.
However if we are looking at a longer timeframe we note a more ‘moderate correlation’, albeit still not perfect. Over the past 50 years the US economy expanded at an average compound rate of between 3%-3.5%, however the past 10 years have been significantly slower with average GDP growth less than 1.5% according to data provided by the World Bank. Between December 2006 and December 2014, the US benchmark index S&P 500 gained 45%, an average simple growth rate of 5.6%, four times higher than the average growth rate of ~1.5%. So why are there still such discrepancies between the two key variables GDP growth and stock market returns?
Reasons for Disproportionate Returns
Both sets of data have expanded over the long-term indicating that GDP growth can generally be considered to be a driver for the US stock market. However as noted above, the US stock market has outperformed GDP growth in the past 10 years. In the real economy there are several factors that cause disproportionate returns, which is why GDP growth and stock market returns are not an ‘exact match’.
Several factors that cause these discrepancies include but are not limited to:
Valuations are Volatile: The market determines the value of a company and various components may influence these valuations, e.g. sentiment, confidence, emotions
Expectations: Expected economic growth may already be built into the prices and thus reduces future realised returns
Dilution: New share issuances dilute return on equity for existing investors, therefore capital growth may be lower than growth in corporate earnings
Dividends: Stock market valuations may be impacted by a company’s willingness to pay dividends. Not paying a dividend could result in a stock to trade at a discount to its ‘net value’ and vice versa
Globalisation: In today’s day and age it makes more sense to look at global, rather than local markets. A company may produce parts of it business outside of the country it is listed and parts of its profit could be earned outside via overseas sales. Parts of the production process for a multinational firm are not reflected in the country’s GDP.
Impact of Central Banks Policies: In recent times the role of central banks and their monetary policies have significantly impacted stock market returns. The most recent example was the ‘quantitative easing’ policy of the Federal Reserve Bank (FED).
Exclusion of Private Sector: Stock markets only track performance of listed companies. While these companies are typically the largest companies of a country and have the strongest weighting on the economy, private companies or sectors which contribute to a country’s GDP are excluded from these returns.
M&A Activity: Mergers and acquisitions often result in significant returns for shareholders, while the impact on the real economy is often less significant.
Influence of Politics and Media: Both politics and media may have a significant impact on stock market valuations and market sentiment. Especially in countries where the media is state-owned and news may not be ‘factually correct’, we usually tend to see greater discrepancies than in markets with less government impact.
Do you know any other factors that cause real GDP growth to differ from stock market returns? Please leave a comment for our investment community.