https://site.warrington.ufl.edu/ritter/files/2015/04/Economic-growth-and-equity-returns-2005.pdf
There has been a lot of work done in this arena, and I think the results would surprise most people. Since 1900, there is actually a negative correlation between per capita, real GDP growth and equity returns.
There has been a lot of work done in this arena, and I think the results would surprise most people. Since 1900, there is actually a negative correlation between per capita, real GDP growth and equity returns.
quote:Here is the conclusion for those that want to cut to the chase;
It is widely believed that economic growth is good for stock returns, and economic growth forecasts are a staple of international asset allocation decisions. Investing in emerging markets with good long-term growth prospects, such as China, is widely viewed as more attractive than investing in countries such as Argentina or the Philippines with prolonged periods of low growth that are expected to persist. But does economic growth benefit stockholders? This article argues on both theoretical and empirical grounds that the answer is no. Empirically, there is a cross-sectional correlation of 0.37 for the compounded real return on equities and the compounded growth rate of real per capita GDP for 16 countries over the 19002002 period.
quote:
8. Conclusion
Over the 19002002 period, for sixteen countries representing perhaps 90% of world market capitalization in 1900, there is a negative correlation between per capita income growth and real equity returns. Most people would think that this correlation should be positive. This article argues that there is at best only weak theoretical support for expecting a positive correlation. Economic growth can occur for two broad reasonsproductivity growth or increased inputs. Krugman (1994) and Young (1995) have argued that the high growth in East Asia that has occurred in the last 50 years has been due largely to increased factor inputsa high personal savings rate and increased labor force participation, combined with rapid improvements in health and educational attainment. Neither of these necessarily benefit the owners of capital. As Warren Buffet (1999) and Jeremy Siegel (1999, 2000) have pointed out, in a competitive economy technological change largely benefits consumers through a higher standard of living, rather than benefiting the owners of capital. And if individuals save more and invest their savings, the increased amount of capital per worker will result in higher real wage rates, which is of no benefit to the owners of shares in existing corporations.
The point is that economic growth does result in a higher standard of living for consumers, but it does not necessarily translate into a higher present value of dividends per share for the owners of the existing capital stock. Thus, whether future economic growth is high or low in a given country has little to do with future equity returns in that country. This article also argues that past equity returns are irrelevant for predicting future equity returns, a point that is far from new, even if it has still not sunk in on most finance professors (see Welch, 2000). If the past is irrelevant, then whether survivorship bias has had a quantitatively large or small impact on measured historical returns is unimportant.
More innovatively, this article argues that future economic growth is largely irrelevant for predicting future equity returns. This is because long-run equity returns depend on dividend yields and the growth of per share dividends. Others have made this argument in the context of U.S. equity markets, but, perhaps reflecting my ignorance, I have not seen this argument made with respect to emerging markets. Economic growth can come from technological change and from either reinvesting earnings into existing firms, or the infusion of cash into new firms. Historically, much of economic growth has come from the infusion of capital into new firms, which does not result in a higher growth rate of dividends per share for existing firms. Technological change has tended to benefit consumers and labor, not the owners of capital.
What, then, does predict future equity returns? The answer is simple: the current earnings yield. The major adjustment that needs to be made is to smooth earnings for the effects of business cycles. Economic growth does not matter. As a first approximation, the return on existing shares will equal the earnings yield on these shares, subject to the caveats that expropriation by insiders or catastrophic market meltdowns will prevent minority shareholders from receiving future earnings. These earnings can be either paid out or reinvested, boosting future payouts. If the earnings are paid out in the form of share repurchases rather than dividends, this will boost the growth rate of dividends per share, but the real return will still just be the earnings yield. If the earnings yield is the real cost of equity capital, does this mean that the textbooks are wrong to say that the E /P ratio of a company is not its cost of equity capital? The answer is yes and no. A company can rationally be expected to earn above- or below normal ROE for a period of time (economic profits), so in general it is incorrect to state that a firm's cost of equity capital is its earnings yield. But for the market as a whole, above- and below-normal rates of profit growth largely cancel out, so in fact the market's smoothed earnings yield is the expected real return on the market.