The Atlantic spots an interesting outlook piece from the Goldman Sachs private wealth group, which argues there is a “negligible, if not zero” chance the US will suffer a Japan-style lost decade (or two).
Phew. But we were most intrigued by the discussion of the relationship between GDP growth and equities.
Or perhaps it’s more accurate to call it a complete lack of a relationship between the two variables.
The Goldman team explore various studies (and conduct some of their own) of what this non-correlation means for investors who are deciding how to allocate their holdings between the developed and emerging worlds — and they find that it is unanticipated changes in growth rates, rather than the rates themselves, that are highly correlated with equities returns.
Long excerpt follows, though we’ve emphasised the important bits — and if you want to dive deeper, read the whole thing in the usual place.
The most extensive authoritative studies we have seen are those of Elroy Dimson, Paul Marsh, and Mike Staunton from the London Business School and of Jay Ritter from the University of Florida. Jay Ritter, in fact, not only provides compelling empirical evidence but also provides rigorous theoretical analysis as to why economic growth does not necessarily benefit stockholders. The studies have examined data across developed and emerging markets since 1900.
Dimson et al have concluded that there is no stable relationship between growth and equity returns, as shown in Exhibit 2. The correlations vacillate between virtually zero and -0.25 for the first 30 years or so and then rise to 0.43 over 42 years only to drop to virtually zero again over 43 years. The point of highlighting such odd years is to demonstrate that within the investment horizon of our clients, the relationship is negative and beyond the investment horizon of our clients – let’s say 40 to 100 years – the relationship is completely unstable.
Similarly, our own analysis within the US has shown no statistical significance in the relationship between equity returns and pace of economic growth. A recent report published by our colleagues in Goldman Sachs Global Economics, Commodities, and Strategy Research also showed that there was no statistically significant relationship between growth conditions, as identified by a country’s growth environment score, and subsequent equity returns (equity valuations, on the other hand, were more significant).
The divergence between equity returns and economic growth is even more stark when we look at actual returns of slower growth versus faster growth countries. Dimson et al have shown that if one invested in the slowest growing quintile of countries during this hundred-year- plus period, the equity returns would have outperformed the fastest growing quintile by 3% a year as shown in Exhibit 3. Our own analysis for emerging market countries since 1991 showed the equity markets of the slowest growing countries within emerging markets outperformed those of the fastest growing countries by nearly 5% a year.
China probably provides one of the best examples of the lack of correlation between strong economic growth and equity returns. As shown in Exhibit 4, China’s economy has outgrown that of the US by about 8% a year since the end of 1992 (the inception date of the MSCI China equity market index). Its equity market, however, has lagged that of the US by about 8% a year. Over the last 15 years, earnings per share growth in China has been negative 0.9% while that of the S&P 500 companies has been 5.4% a year. Most recently, in 2010, China has outgrown the US by an estimated 7% but the MSCI China Index has returned just 4.8% (the local Shanghai Composite Index is actually down 12.8%). On the other hand, US equities have returned 15.1%. Since the peak of US and Chinese equities in October 2007, China has outgrown the US by an estimated 10% a year, but Chinese equities have lagged the US by 2.7% a year.
Whether it is 1 year, 3 years or 18 years, economic growth has not translated into better investment returns in China. That is not to say that Chinese equities have not outperformed US equities significantly over specific periods of time; Chinese equities provided an annualized return of 46.0% a year compared with US returns of 15.0% a year between October 2002 and October 2007, during which China grew at 11.1% a year compared with US growth of 2.6%. In general, however, the timing of entering and exiting a market, as well as its valuations, are much more important than faster economic growth.
The evidence shows that faster economic growth rates do not result in higher equity returns. In fact, if faster growth is priced into the equity markets, the equity markets are most likely going to lag those of slower growth economies. Rather, it is the unexpected changes in economic growth rates (and earnings growth rates) that affect stock prices. As such, we think allocating more assets to the faster growing emerging markets beyond market capitalization levels is not prudent given current market expectations and the higher valuations.
Related link:
Chasing the dragon – FT Alphaville