The recovery from the Great Recession of 2007/08 has been unusually weak from almost every measure, GDP growth, employment, capital expenditures, capacity utilization, etc. Most macroeconomic forecasters expect the current slow-growth to continue for the next decade as a result of federal and state budgetary deficits, exploding entitlement programs, and a history-making monetary expansion that must eventually be reversed. But does this mean or then imply that the returns to domestic equities will then be lower than normal? Let’s examine the facts.
I. PROBLEMS WITH FORECASTING STOCK MARKET RETURNS
I spent a portion of my career at the CFA Institute. In my role as Director – Education Department, I helped specify the content of the educational materials that future CFA candidates were expected to master before they could be awarded their CFA designations. One critical component of the required curriculum discussed and explored how stock prices were a direct function of corporate earnings which in turn were a direct function of the condition of the overall economy. These two relationships have become the all too common and overly simplified conventional wisdom.
Today, the vast majority of individual investors and professional economic strategists begin their efforts utilizing the approach identified above – i.e., by estimating what the economy will do and how it will perform over the next several years (perhaps, 1-4 years into the future). They then base their asset allocations and investment strategies on their economic outlooks. Unfortunately, this approach has little hope of succeeding since the relationship between economic prosperity and equity returns is not all that far from zero.
As Ned Davis observed “. . . the stock market usually leads the economy. So why, I wondered, would most people spend so much of their time trying to figure out the economy to be able to call the stock market?”  Unfortunately, it is even worse than Ned identifies in this quote. Over the 52 years ending 12/31/2012, the stock market actually does far worse when the economy is strongest and performs best when the economy is weakest. According to Ned Davis Research, the S&P 500 returned -4.6% annualized on average during the 10% of the time (during these 52 years) when the economy was strongest. Similarly, the market returned +10.5% annualized during the 13% of the time when it was the weakest (growing most slowly) . Even worse, if one extends the analysis back to 1948 (65 years in total), then the S&P 500 retuned 18% annualized whenever the economy was growing at less than +0.5% per annum (this includes periods when the economy was contracting).
II. RELATIONSHIP BETWEEN ECONOMIC GROWTH AND STOCKMARKET RETURNS
To explore the relationship between economic growth and stock market returns, I selected annual inflation-adjusted GDP growth and real S&P 500 returns for the 137 years ending 12/31/2012. I compared the growth rate of our economy with the returns to stocks over identical time-windows of varying lengths (ranging from 1-year all the way up to 11-years). It was found that the strongest relationship held for 3-year time windows. In other words, the growth rate of the economy over the next three years had the greatest association or correlation with the stock market’s returns over the same three years. The relationship drawn from these 137 years of economic and capital market history was:
Average annualized 3-year return for the S&P 500 = 3.2% + 97% of the 3-year annualized growth rate in the US economy
In other words, for each additional 1% growth rate in the US economy, the stock market delivered an extra 0.97% return – on average. For example, based on this historical relationship, one might conclude that if the economy is expected to grow at a 3.3% rate each year for the next three years, then the return for the S&P 500 could be expected to be 6.4% per year (over and above inflation). 6.4% = 3.2% + (0.97 x 3.3%).
Unfortunately, the key operative phrase here is “on average.”In this case, these words speak volumes and are the ultimate condemnation. Upon closer examination of the statistical measures, one finds that only 11% of the stock market’s returns are explained by the economy’s growth (utilizing these 3-year time windows). And recall, that this is as good as it gets. If instead, we had used 8-year windows (i.e., the returns to stocks over the next eight years versus the rate of economic growth over the next eight years), then the economy’s performance explained only 2% of the stock market’s returns – In other words, economic growth was absolutely irrelevant to what you earned on your equity investments!
III. HOW STRANGE CAN IT GET
Consider just how counterintuitive the relationship can become between economic prosperity (or decline) and stock market returns:
3 Years Annualized Annualized
Ending GDP Real S&P 500
On Growth Rate Return
12/31/1974 +3.0% -16.1%
12/31/1919 +2.9% -11.4%
12/31/1941 +11.2% -10.8%
12/31/1942 +14.7% -7.3%
12/31/2003 +2.1% -5.9%
12/31/1939 +3.1% -5.1%
12/31/1947 -4.5% +0.1%
12/31/1946 -1.7% +6.7%
12/31/1934 -1.6% +14.0%
12/31/1915 -1.5% +3.9%
12/31/1930 -0.8% +1.6%
12/31/1982 -0.1% +6.2%
These data demonstrate the lack of any meaningful direct association between economic growth and investment returns when considering asset allocation decisions. This is not to say that economic growth is independent of equity returns, instead, only that it is swamped by the other factors and thus becomes absolutely useless as a trading strategy at the asset mix level.
In truth, stock returns are driven primarily by simple supply/demand relationships, or to put it another way, by the nature of crowd psychology. The human mind that directs the market swings between fear and greed. Consider the extremes to which valuations levels can and do go. Back in 1940 the ratio of the value of all stocks (total stock market capitalization) to GDP stood at 19% . This ratio then rose to 79% by 1973. At which point it promptly fell back to 32% by 1982. By 2000, the stock market capitalization-to-GDP ratio stock at a breathtaking 173% and then fell to under 60% by 2009. Far more powerful forces than simple economic growth and prosperity drive stock market returns.
Thus, when asset allocation professionals attempt to set their asset mixes on the basis of their (perhaps quite accurate)forecasts of what the US economy will do over the next several years, they are probably wasting their time and your money.The solution is to either adopt a Buy & Hold strategy (something I am not a great fan of) and thus avoid active asset mix decisions or it is to recognize that market returns will be driven in larger measure by powerful behavioral issues that must be understood before profitable asset allocation decisions can be made.