Turn on any financial, news, or political program in America, and inevitably hosts and guests will spend a good portion of the time discussing economic growth and its relationship to market performance. Of course, all of us got an extra helping of this type of analysis while the budget shutdown was in force, with the general theme being that governmental infighting will hold back the economy, and in turn, the ability of the S&P 500 to reach new highs this year.
In practice, a historical statistical relationship between market performance and GDP growth is non-existent in many cases. Comparing annual S&P 500 returns with annual US nominal and real GDP figures from 1950 through 2012 produces some interesting results using simple regression analysis. Here’s a quick summary of the results:
- From 1950 to 2012 using annual data, there is basically no statistical relationship between yearly real and/or nominal GDP and S&P 500 performance (correlation coefficients of -0.05 and 0.11, real and nominal)
- Likewise, there is very little if any statistical relationship between trailing 10-year compounded GDP (nominal or real) growth and 10-year trailing S&P 500 returns (correlation coefficients of 0.21 and -0.23, real and nominal).
- There isn’t a statistical relationship between GDP in a given year and S&P performance in the following year, nominal or real.
- There is, however, a decent statistical relationship between S&P 500 performance in a given year and real GDP growth in the subsequent year. This relationship did not hold up when running the analysis with nominal GDP numbers (correlation coefficient of 0.63 using real GDP, but only 0.19 using nominal).
Here are the basic numbers:
What are some of our quick takeaways from this simple statistical run?
- Making investment decisions based upon current or prior economic data is probably a waste of time (and opportunity). Certainly many prior studies have demonstrated this, but it never hurts to repeat.
- Equity markets seem to be a decent discounting engine when it comes to future economic growth. Markets seem to get ahead of the data on economic growth. This brings us back to point one. Bottom line: if you’re waiting to see the whites of the economic data’s eyes before making a decision, you’re probably going to be late to the party.
- With an R-squared value of 0.395 (which basically says that S&P 500 performance “explains” approximately 40% of next year’s GDP), that leaves a lot of room for other variables like valuation or interest rates. Our gut feeling here is that even if one has particularly accurate predictive capacity on GDP growth in future years, the investor with that information could still end up with a poor investing outcome, all things being equal. Short-term market decision-making based upon predicted future economic outcomes alone is probably a losing proposition for most investors.
- We do know that statistically, 10-year CAPE P/E values have a decent statistical relationship to 10-year future annualized market returns. Soaking it all in, an investor is much better off paying attention to general valuation levels and their potential impact on future returns than wringing hands over economic data releases, especially when valuations reach extreme levels (perhaps greater than 25x on the overvaluation side or less than 10x or 12x for undervaluation). Of course, the longer term view and patience is essential when it comes to using valuation. Overall, enjoy your days and don’t let the latest BLS release on employment or the latest government GDP release ruin your day or month. It does make for good water-cooler talk and keeps the TV talking heads in business, though.
- If the market is a decent discounting mechanism and moves ahead of the data, not with it, and one is concerned about managing downside risks, it might behoove those interested in risk management techniques to explore employing simple longer-term technical trading rules, such as simple moving average triggers. As discussed in the past, some intermediate to longer-term moving average rules have produced solid historical outcomes from a risk-adjusted return basis. The market as a whole knows more than we do individually. If markets are showing signs of breaking down, it’s often not wise to fight the tape. The same can be said for rising markets, as demonstrated in recent months and years.
- Ultimately, the market doesn’t care about our theses based on current or backward looking information and makes mince meat out of those stuck in the analytical gobbledygook. Many investors were blindsided in ’08 looking backward and accepting the “all is well” economic news at the time. Likewise, many investors have missed the current rally hung up on economic and political news flow. Odds are the next market calamity, like the prior ones, will only become truly apparent in hindsight. And, like the past, most investors will end up selling at precisely the wrong moment by using real-time economic data (and by paying attention to the talking heads in real time).
