- Canada lost one million jobs in March, 2020. What did the S&P/TSX Composite Index do on the day that Statscan released that data? It closed up 1.
73% for the day. It's easy for investors to see economic news like unemployment or GDP data and get worried or excited about the impact that the data will have on their investments. But there's something that many investors don't realize.
The stock market is not the economy and the economy is not the stock market. The stock market is a forward-looking pricing machine. It incorporates expectations about the future into stock prices today.
Economic news on the other hand is backward looking. Telling us what has already happened and often telling us way after it has happened. I'm Ben Felix Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing I'm going to tell you why the economy should not inform your investment decisions. (upbeat music) There have been plenty of days in recent history where historically terrible economic data announcements have been paired with historically high daily stock market returns. This is one of the reasons that market timing is hard.
Understanding the relationship between economic data and stock market returns starts with the concept of market efficiency. Stock investors are investing in the right to participate in a company's future profits. In an efficient market stock prices contain information about expected future profits and the riskiness of those profits.
If anticipated economic news like unemployment numbers for example, is already incorporated in the market prices, we would not expect stock markets to change when that news is released if it's released as anticipated. It is only unexpected economic events which are by their nature unpredictable that drive big short-term changes in stock prices. Whether news is good or bad does not matter.
What matters is whether news is better or worse than expected. A good case study might be the US stock market throughout the global financial crisis. The US stock market started to decline in October 2007 two months before the US National Bureau of Economic Research defines the economic recession as having started.
NBER defines the recession as having started in December 2007 and ended in June 2009. It's important to note that these dates were not announced until December 2008 for the start of the recession, a year after it was determined to have started, and September 2010 for the end of the recession more than a year after it was determined to have ended. The dates are not determined purely quantitatively either.
They're determined by the Business Cycle Dating Committee. This is a clear example of the lagging nature of economic data. Us unemployment had been above 9% since May 2009 and it reached a peak of 10% in October 2009.
Real GDP reached its low point for the recession in the second quarter of 2009. Remember, the committee decision declaring the end of the recession did not come out until September 2010. Based on the economic data continuing to look worse through 2009 it was not obvious that things were getting better.
With all of that gloomy economic data continuing to come to light, it would seem like this was a bad time to own stocks. Well, it wasn't. We know now looking back that the stock market bottomed out in February 2009 and then started on a strong rebound.
Don't forget that for months after the only-known-in-hindsight stock market bottom, the economic data were only getting worse. Despite the deteriorating economic data being released the US stock market increased 56% from March through December 2009. And it continued on a historic run from there.
Why did the stock market start to recover so quickly and aggressively in the face of dismal economic data? Very simply, the markets had expected the economic data to be even worse. The bad news was better than what the market had already priced in.
I'll borrow a quote from Warren Buffet here. "If you knew what was going to happen in the economy, you still wouldn't necessarily know what was going to happen in the stock market. " A more academic example comes from the 2018 paper "Inverted Yield Curves and Expected Stock Returns" by Eugene Fama and Ken French.
They acknowledged in the paper that there is strong empirical evidence suggesting that inverted yield curves tend to forecast economic activity. But like Buffett said, that may not tell us much about what's going to happen in the stock market. To test this, they built an active market timing model that shifts out of stocks and into treasuries based on a yield curve inversions.
Based on their analysis Fama and French conclude. "We find no evidence that yield curve inversions can help investors avoid poor stock returns. " They go on to explain the simplest interpretation of the negative active premium we observe is that yield curves do not forecast the equity premium.
Well, the yield curve may be pretty good at forecasting economic activity. The ability to forecast economic activity does not translate to the ability to make stock market timing decisions. Short-term it should not be a surprise when bad economic data are met with strong positive stock market returns.
I'm not saying that it can't go the other way. If bad economic news is worse than expected or good news is not as good as expected, the market can drop. But the point is that the relationship between the stock market and the economy has little to do with what is happening in the economy and a lot to do with what is happening in the economy relative to what was expected to be happening.
But what about the long-term? What if we experienced a declining GDP and a long slow economic recovery. In normal times, a rapidly growing economy like China would be expected to have a higher GDP growth rate than a developed economy like Canada or the United States.
Big economic events like a countrywide quarantine, for example, are expected to have a meaningfully negative impact on GDP. Intuitively it seems obvious that a country exhibiting stronger GDP growth would be well-positioned to deliver higher stock returns, and lower GDP growth would lead to lower stock returns. Intuition does not mix well with investing.
In a 2012 paper titled "Is Economic Growth Good for Investors? " Jay Ritter examined the relationship between GDP growth and stock returns. He argued on both theoretical and empirical grounds that economic growth does not benefit stockholders.
Ritter showed for 19 mostly developed market countries from 1900 through 2011, that the cross-sectional correlation between the compounded real return on stocks and the compounded real growth rate of per capita GDP was negative 0. 39. Ritter also looked at a sample of 15 emerging market countries for the 14 year period from 1988 through 2011, including Brazil, Russia, India, and China.
And he found a similarly negative correlation of negative 0. 41. This evidence suggests that countries with stronger economic growth have historically had lower stock market returns.
That may be counter-intuitive on the surface but it will quickly make sense once we get into the details. One of the main theoretical explanations for the negative relationship between market returns and economic growth is similar to what we just discussed for short term economic data. In an efficient market, investors tend to build expectations into prices.
Paying a high price for expected growth should only lead to high stock returns if realized growth ends up being higher than expected. If economic growth happens in line with prior expectations, there wouldn't be a boost to stock returns. Based on the data showing a negative correlation between stock returns and economic growth, it could even be argued that investors have historically overpaid for expected growth resulting in disappointing investment returns.
This could be one reason for the low returns on Chinese stocks despite their massive economic growth. Another big reason for the negative relationship between economic growth and stock returns is less theoretical and more structural. It was described as slippage in a 2003 paper by Robert Arnott and William Bernstein titled "Earnings Growth: The Two Percent Dilution.
" They described slippage as the shortfall between economic growth and growth in earnings per share. They showed that GDP and corporate earnings have been directly related going back to 1929 with aggregate corporate earnings making up a constant eight to 10% of GDP. But growth in aggregate corporate earnings does not directly benefit investors.
It is increases in earnings per share that benefits investors. The problem here is that per share earnings growth can only keep up with GDP growth if no new shares are issued. Let me explain.
If you own shares in a company in a rapidly growing economy and a new company listed shares on the stock exchange, you don't benefit from the new companies economic impact. You would need to reallocate some of your capital to the new company to participate in its earnings. But doing so does not increase the value of your portfolio.
The economy is growing but your portfolio has not. Over time the effect of this slippage have been meaningful. China might again be a good example.
Much of the growth in the market value of Chinese equities has come from an increase in the number of listed companies as opposed to price appreciation from existing listed companies. Based on the slippage effect, it is easy to see why Chinese stock returns could be relatively poor despite huge growth in their total market capitalization. We would expect the slippage effect to be more pronounced in a country going through rapid economic development.
Arnott and Bernstein gave the example of war-torn and non war-torn countries from 1900 through 2000. They show that well, war-torn countries had their economies devastated by war within little more than a generation their GDP caught up with and in some cases surpassed the GDP of non war-torn countries. But here's the interesting part.
The war-torn countries stock market growth trailed their economic growth by nearly twice as much as the non war-torn countries. The explanation for higher slippage is that war-torn countries had to go through a high rate of equity recapitalization. New companies needed to form and existing companies needed to raise new capital diluting the benefits of economic growth for existing shareholders.
Higher growth economies will see more companies raising more capital which is great for the economy but doesn't translate directly to returns for existing stock holders. It should be clear at this point that economic outcomes whether in the short-term or the long-term do not translate directly to stock market returns. In the short-term stock price changes are driven by expectations about the future.
In times of volatility those expectations can change quickly based on new information, but it cannot be known ahead of time. How new information will relate to the markets current expectations. Record breaking jobless numbers are bad economic data but they will not drive down stock prices unless the market was expecting better data.
In the long-term, investing in faster growing economies has not proven to be a successful strategy. In fact, historically the opposite has been true. Which is possibly explained by the market pricing in or even overestimating economic growth.
And by slippage from earnings dilution due to new share issuance. Paying attention to economic data might be interesting for some people. And it might even be a little bit useful from the perspective of understanding what's going on in the world.
For investors though, economic data should not play a role in informing investment decisions. If economic data makes it hard to stick with a well thought out long-term investment plan, it might be best to ignore it altogether. Thanks for watching.
My name is Ben Felix of PWL Capital and this is Common Sense Investing. If you enjoyed this video, please share it with someone who you think could benefit from the information. And don't forget if you've run out of Common Sense Investing videos to watch, you can tune in to weekly episodes of the Rational Reminder podcast or wherever you get your podcasts.
