Monday, 14 November 2011 - 20:00

 

Charts

Economic Growth versus Market Returns

A common assumption often made by the layman and sometimes by the professional investor is that good growth, be it in company earnings or in an economy, will be followed by strong returns (from the company or market as a whole, as the case may be). The logic behind this thinking is that good growth should equate to good returns, and poor growth to poor returns. What is often forgotten is that markets are forward looking, and that good growth often gets priced in before it happens.

In order to determine whether good economic growth was generally followed by good market growth I took South Africa’s annual GDP real growth and the ALSI’s annual (calendar year) real return (i.e. both measures stripping out the effects of inflation) from 1969 – 2010, over which time the South African economy has grown at an average of 2.7% per annum. I then split each year’s growth into a bucket: GDP growth of between 1% and 4% was considered to be average (2.7% + or – approximately 1.5%) with any growth in excess of this considered high and any periods below this considered low growth periods.

The chart below shows the GDP growth buckets and the following year’s return from the market. It is interesting to note that periods of low economic growth have typically been followed by strong 12 month periods of market returns and average growth was followed by the worst returns.

In the following chart it is plain to see how uncorrelated these two data sets are, just going to show that good economic growth isn’t always followed by good market growth. Importantly this is just a general observation and there are good economic periods followed by good market growth and vice versa (in 1986 for instance, GDP growth was 0% and in 1987 the market fell by 20%). Investors should therefore be wary of blindly using this type of strategy when investing.

With my interest piqued, I decided to see whether there was any correlation between current market returns and future GDP growth. The logic behind this thinking was that markets should react favourably to future GDP growth.

Using the same data set, but lagging GDP growth rather than market returns, gave the outcome below. Essentially the graph indicates that good market returns are typically followed by strong economic growth, although one can’t assume that good market returns are the cause of good economic growth.

Variations of this research have been done in many countries and economies with similar results. This isn’t a uniquely South African occurrence. Essentially what this research indicates is that investors at all times need to establish what’s in the price of any market (or share for that matter) and determine the difference between a good economy and one that will produce strong market returns, bearing in mind they often aren’t the same.

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Take care,

Mike Browne
info@seedinvestments.co.za
www.seedinvestments.co.za
021 9144 966

Mon, 14 Nov 2011

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