“If one could divine the nature of the economic forces of the world, one could foretell the future” (Robert Heilbroner)
In theory, it seems logical to think that the performance of a country’s stock market is linked to the state of its economy. After all, strong GDP growth should lift company profits, and that should help share prices.
Yet several studies have shown that this link is actually quite weak. A comprehensive analysis of 21 countries over more than 100 years by the authors of the book Triumph of the Optimists found mixed results between GDP growth and stock market performance. It wasn’t clear that there was a direct connection.
In 2010 MSCI did a study that produced similar results. Most notably, it found that for the 60 years between 1958 and 2008, Spain and Belgium enjoyed real growth in their economies of between 3% and 4% per year, yet the real returns from their stock markets over this same time were negative.
Another example is Japan. Since 1989 it has grown its economy at over 1.5% per year, but the Nikkei 225 Index is still well below the peak it reached in December 1989. That means that for more than 30 years Japan’s GDP growth has not been reflected in broad market returns.
A closer look
This doesn’t only occur over the long term either. It can also play out from year to year.
The tables below cover the last 90 years of GDP growth in the US. On the left are the 15 calendar years in this period when US growth was weakest. On the right are the 15 years in which it was strongest.
Correlation US GDP Growth and Stock Market
[Source: Pension Partners LLC via PSG]
What stands out is that in more than half of the worst years, returns from the stock market were still positive. In six of them, the S&P 500 was up more than 20%, even though GDP growth was zero, or negative.
Not quite as striking, but nevertheless noteworthy, is that even in some of the best years for the US economy, the stock market fell. Incredibly, in 1941, when GDP growth was 17.7%, the S&P 500 declined 12.8%.
Understanding the gap
What this clearly shows is that the state of a country’s economy should not be seen as the only guide for how its stock market is likely to perform. As MSCI notes, there are three main reasons for this.
“First, in today’s integrated world we need to look at global rather than local markets. Second, a significant part of economic growth comes from new enterprises and not the high growth of existing ones; this leads to a dilution of GDP growth before it reaches shareholders. Lastly, expected economic growth may be built into the prices and thus reduce future realised returns.”
This holds true for the JSE, just as it does anywhere else. More than 70% of the profits of the Top 40 companies on the local stock exchange are now generated outside of South Africa. These stocks are therefore not reliant on the local economy.
Importantly, everybody is also well aware of how weak the South African economy has been. That means that this has already been taken into account, and share prices now reflect it. These companies are, however still making profits and paying dividends. That means that there is potential for their share prices to recover from here.
It is not easy being an investor when all the news seems negative. However, what the authors of Triumph of the Optimists also found was that, over time, stock markets deliver the best inflation-beating returns.
That has always been the case. And there is little reason to believe that the last five years on the JSE will override more than 100 years of history.
To discuss the best long-term allocation for your investments, speak to your financial adviser.