It sounds logical enough: Stocks go up when the economy is growing, and they go down when it stumbles. But a number of experts have started questioning this assumption, and they have data to back it up.
Whether they’re right is critical for investors seeking shelter from the limping U.S. economy. Emerging-market economies have grown at almost double the rate of the United States for the past 20 years, so it stands to reason that people who want to chase higher returns should head overseas.
But take a look at China, the modern poster child for blockbuster economic growth. The Chinese economy has grown 8 percent faster than the U.S. economy since 1992. Yet the MSCI China equity market index, a good proxy for the performance of the Chinese stock market, has performed worse than the Standard & Poor’s 500-stock index by roughly 8 percent since 1992, according to a Goldman Sachs report.
How can this be true? If you consider that the stock market is all about expectations, it starts to make more sense.
If investors are excited about a company’s prospects for growth, this enthusiasm is probably already built into its stock price, so its shares can be quite expensive — that is, the ratio of the stock’s price to the company’s earnings is high. In these cases, the upside can be limited for investors. And if the company’s growth winds up being lower than expected, the returns can be very low.
Jay Ritter, a professor of finance at the University of Florida, points out that at the end of 2007, Chinese growth was expected to be high, driving up the price-to-earnings ratios of Chinese stocks. But 2008 turned out to be a terrible year for Chinese stocks, even though the country was still growing rapidly. Expectations were simply too high, and the companies did not meet them.
He noted that stock prices tend to be correlated to surprising changes in the economy, not ones that people are predicting.
“When there’s a pleasant surprise, stock prices will go up. When there’s a negative surprise, stock prices will go down,” Ritter said. “But over the longer term, the relation becomes very weak.”
A recent Goldman Sachs analysis found that since 1991, equity markets in the slowest-growing countries outperformed those in the fastest-growing countries by nearly 5 percent a year.
Another reason for this, Ritter said, is that an economy can grow without corporate earnings growing nearly as much. Some of the growth in a country’s economy could be from smaller companies that are not listed on the stock market. Sometimes massive demographic changes can be a factor, rather than brilliant management at individual companies. As a country such as China industrializes and a huge number of people stop farming and join factories and offices, it follows that China’s economy will boom, too.
The missing correlation between stocks and economic growth also holds true in the United States. For the past six decades, the country’s gross domestic product has grown nearly every year, but in one-third of those years, corporate earnings — a kind of proxy for stock prices — declined.
And the opposite occurs, too, something that became evident in April when the stock market climbed to its highest level in years even though economic growth had slowed and unemployment remained high.
Ed Easterling, founder and president of investment firm Crestmont Holdings in Oregon, said a country’s broader economic cycle is different than the cycle of business profits. And it’s the latter that drives stock market performance.
The business cycle tends to occur over just a few years, whereas the expansion and contraction of the economy tends to happen over decades, Easterling said. As companies make more money, rivals enter the market, creating more competition and lowering profit margins. Profits tend to rise for one to six years in a row before falling for one to three years. According to Easterling, earnings have never risen seven years in a row.
So where are we now in the business cycle?
Companies have been posting impressive profits for a few years, and even though the past few months have been volatile for investors, the S&P 500 has climbed out from the darkest days of early 2009. History suggests, according to Easterling, that companies will not be able to keep up this pace of growth and that stocks are vulnerable right now.
Easterling also pointed out that although most people think the recession caused profit margins at companies to fall, businesses were already posting less impressive results in 2007, before the recession officially started.
“The economy and earnings growth are disconnected,” Easterling said. “They’re so disconnected that a third of the time, even when the economy grows, earnings fall.”
So think about that the next time you hear someone link the stock market’s performance on any given day to an economic figure. In the long run, stocks and the economy are running on two separate tracks.