Reading the Australian Financial Review on an interstate flight yesterday, I accepted the assertion that the slowing of economic growth in China was a large contributor to the recent volatility to global share markets. This week in Australia at least, we had a drop in the market of 4.1 per cent Monday and a rise of 2.7 per cent on Tuesday!
The Australian (pay-walled link) also reported on Australian Treasurer Joe Hockey advising the PM that the local Australian and the US economy are fundamentally sound, the argument being that the “economic fundamentals” of “Australian, Chinese and global economy are still strong” and that calm was needed by investors.
The suggestion here seems to be that national and/or global economic growth drives equity returns.
Reading an older post on Cautious Bull this week I came across a paper by Jay Ritter titled “Economic growth and equity returns” and had printed it out for more in-flight reading on the way to Melbourne. The paper is well worth a read and tests out the argument that equity returns are driven by economic growth.
A quick primer on correlations if the values seem unfamiliar: correlation values are a measure of a relationship between two variables and range from -1 to 1. The “0” value implies no relationship (i.e. the two variables don’t seem to vary together in any obvious way) whilst -1 and 1 represent a perfect negative relationship (one variable increases, the other decreases and vice versa) or perfect positive relationship (both increase/decrease together) respectively. An example of a positive correlation is fuel consumption for an airplane and miles flown (the more miles flown, the more fuel consumed) and an example of a negative correlation would be the comfort of passengers on a flight and the number of upset babies on board (the more upset babies, the less comfortable the flight!).
Ritter (2004) cites data on 19 countries over 33 years (1970-2002) with the correlation between the geometric real return of equity markets and the mean growth rate of real per capita GDP being -0.08. Looking at a longer period between 1900 and 2002 there is actually a small negative correlation of -0.37 for the compounded real return on equities and compound growth rate of real per capita GDP of 16 countries around the globe for which data was available. These figures imply that contrary to popular opinion, over the long term (three decades), there is no meaningful relationship between growth rate of per capita GDP and equity returns and indeed over the very long run, higher per capita economic growth may contribute to lower global equity returns. Ritter asserts that stock returns are driven by increased earnings and dividend yields.
The relationship above may therefore be because when economic growth is expected to be high, investors tend to assign higher P/E and price to dividend multiples to stocks which lowers released returns because more capital must be committed to receive the same dividend in $ value compared to a lower dividend multiple. Investors optimistic about economic growth may also bid up stock prices, further lowering dividend yields. Ritter also states that when economic growth is driven by fresh capital and labor inputs, if these go to new corporations, there is no benefit to profits of existing corporations (indeed, one might expect the opposite, due to competition and a smaller share of revenue to existing cope rations).
Whatever the reason, it seems that in the short run, positive correlations between economic growth and equity returns may be the result of business cycles, but in the long run don’t seem to matter nearly as much as is purported and perhaps don’t matter at all. For value investors buying over long time horizons, this is very useful to understand (if accurate) as it limits the amount of data the investor needs to examine and digest.
I’m by no means an expert but Ritters analysis is food for thought nonetheless.