Stock market and gdp correlation

Stock market and gdp correlation

Author: Boris_V On: 25.05.2017

Why is there a correlation between equity returns and aggregate GDP growth but not per capita growth? THE annual report on markets by Elroy Dimson, Paul Marsh and Mike Staunton of the London Business School produced in association with Credit Suisse is always good value and this year's effort is no exception.

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The main theme is related to emerging markets and will be the focus of this week's column. But one oddity emerged in the course of the report that it is quite difficult to explain and is worth exploring in more detail.

An oft-quoted argument for investing in emerging markets is their superior economic growth. But the professors have pointed out in the past that economic growth and equity returns are not correlated at all.

Jay Ritter of the University of Florida has a paper on the same issue. If this lack of relationship seems odd, the professors' argument is more subtle; yes, it would be useful to be aware of future economic growth. But being aware of past economic growth does not help; or rather, it is a a contrary indicator. You would be best placed investing in the slower-growing economies of the past, not in the fastest.

This may well be a value effect; stocks in fast-growing economies get bid up in price price-earnings ratios go up and dividend yields go down while the opposite occurs in the slow growers. A shame this hedge fund didn't spot this simple rule.

Little Relationship Between Stocks, GDP - Business Insider

It would help investors to know which economies will grow fastest in the future but of course investors don't know this; the academics have a wonderful scatter chart showing the lack of correlation between growth rates in one year and the year after next.

But now for the puzzle. Over the long run , there is actually a negative correlation But there is a positive correlation between aggregate real GDP growth and real equity returns 0. Why the big difference? Of course, the gap between aggregate and per capita growth is explained by population movements. South Africa's aggregate GDP has grown faster than Ireland's but more than half of this is accounted for by a bigger population; Ireland's population has risen very slowly thanks to periods of emigration so almost all its economic growth is per capita.

The professors use the analogy of equity issuance; as countries grow their stockmarkets get bigger as more companies float and more shares are issued. In theory, profits might double but if share issuance doubles, investors will be no better off.

But this analogy seems the wrong way round. Correlation is not causation but the statistical relationship shows that investors do better when the population is rising and pushing up GDP than when productivity growth alone is pushing up GDP. If growth is being shared out between more people, why do investors get a bigger chunk?

Is it because a bigger population thanks to immigration or a high birth rate increases the sze of the workforce, drives down real wages, and increases the return to capital? Going forward, we know that population growth will be sluggish in the developed world so aggregate GDP will rise slowly. Will this be bad news for equities? The Japanese have done quite well in terms of GDP per capita in the last 20 years but not so well in aggregate terms.

And their stockmarket is still less than half its peak.

stock market and gdp correlation

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