Download decision drivers: stock prices versus gdp

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MFS
Paper Series
Focus
Month
October2012
2016
®
Author
Robert M. Almeida, Jr.
Institutional Portfolio Manager
DECISION DRIVERS:
STOCK PRICES VERSUS GDP
IN BRIEF
•W
hile many investors believe there is a link between GDP and stock
prices, there is no concrete relationship between the two.
• Company profits carry much more weight in driving stock prices.
• Investors need to consider the data points that drive their decisionmaking to help avoid buying and selling at inopportune times.
Does the prospect of a rapidly growing economy mean that a
country’s equity market will follow a similar upward path? Or
conversely, will a country’s weak economic prospects weigh on its
equity market returns? Not necessarily, though many investors
tend to see gross domestic product (GDP) as an indicator of the
direction of stock prices. It’s a common misperception. But in
reality, there is little correlation between the two. And that’s an
important point, because understanding the true drivers of stock
prices can help investors uncover opportunities, avoid pitfalls and
set more realistic return expectations.
Why the misperception?
In their search for return, particularly as the markets grow more complex,
investors often anchor their analysis to the wrong data point. In this case, they
believe economic activity has some predictive value in forecasting the direction of
stock prices.
GDP is a proxy for population growth/consumer spending
But taking a closer look at the components of GDP tells us more about consumer,
business and government spending and very little about individual company
valuations or the forces behind them.
OCTOBER 2016 / DECISION DRIVERS: STOCK PRICES VERSUS GDP
GDP is essentially made up of 1) total spending by
consumers (C); 2) total investment/spending by businesses
(I); 3) total government spending (G) and 4) net exports (NE)
So, if we expressed GDP as a formula, it would be:
GDP = C + I + G + NE
The stock market is a discounting mechanism of a
company’s value
What’s important to recognize is that two-thirds of GDP is
based on consumer spending. Since that’s generally true of
most economies, GDP is essentially just a proxy for
population growth and consumer spending. Equity prices,
on the other hand, are a discounting mechanism of a
company’s value, which is its steady state value (the value of
the enterprise) plus its future cash flows. Historically, we’ve
seen very little correlation between the two, as we see in the
chart below.
Exhibit 1: What drives stock prices?
Market performance (Calendar years)
100%
-100%
5%
10%
High P/E generally means investors expect higher
earnings growth in the future
15%
200%
0%
0%
So if GDP doesn’t shed much light on stock prices, where
should investors look for signals? In a word, profits (or
earnings). If you think about the simplest formula for equity
valuation, it’s price/earnings. Investors utilize trailing P/E
Over time, the equity-market multiple has been roughly 15
times earnings. Outside extreme valuation periods, or
bubbles, such as in the late 1990s, when the S&P 500 Index
multiple reached an all-time high of approximately 26 times
earnings, what matters most among the components of
stock prices is their profits.
300%
-5%
What drives stock prices?
y = 0.2305x + 0.1231
R^2 = 0.0004
500%
-10%
What does that mean in terms of setting expectations for
equity returns? First, GDP doesn’t have to be growing at
what most would consider a normal rate in order for
investors to find adequate returns in the stock market, nor
does a booming economy translate into higher stock returns.
ratios, which reflect historical earnings versus today’s stock
price, or forecasted P/Es, which compare 12-month
consensus earnings expectations to today’s price. Either way,
most importantly, earnings, or profits, typically carry a lot of
weight in driving stock prices.
Not the economy…
400%
Certainly with respect to the equity market, we recognize
that there are some sectors or industries in which the end
markets or customers are more sensitive to GDP. But
generally speaking, there is no concrete relationship between
GDP and stock market returns.
20%
25%
30%
GDP growth (%)
Low P/E might signal that a company is undervalued
or doing extremely well relative to its past
Regression of GDP and equity returns of 37 countries (1995-2015)
Source: Bloomberg and Bernstein analysis as of 31 December 2015. Analysis
covers 37 countries to gain a large enough sample (Argentina, Australia,
Austria, Belgium, Brazil, Canada, China, Egypt, France, Germany, Hong Kong,
India, Indonesia, Italy, Japan, Malaysia, Mexico, Netherlands, Nigeria, Norway,
Philippines, Poland, Russia, S. Korea, Saudi Arabia, Singapore, South Africa,
Spain, Sweden, Switzerland, Taiwan, Thailand, Turkey, UAE, UK, USA and
Vietnam.
Considering profits and prices
Looking at recent history, consider that over the past 12
months the US economic growth rate has decelerated to an
average rate of 1.3% compared with 2.3% during the prior
12 months. During the same time period, the S&P 500 Index
rose just under 4% on a total return basis, including
reinvested dividends.
Here is some historical evidence. When we look back at
companies that have made money (red line in the chart)
versus those that haven’t (yellow line in the chart), we see
those with profits outperforming those that lose money,
which isn’t surprising. But the magnitude of outperformance
is significant. Over the past 20 years companies that were
profitable were up more than 650% (cumulative), while
unprofitable ones were down 23%.
—2—
OCTOBER 2016 / DECISION DRIVERS: STOCK PRICES VERSUS GDP
Focus on fundamentals, stay disciplined
Exhibit 2: What drives stock prices?
The point is that investors need to think carefully about the
data points they use to make decisions. The importance of
differentiating between what is noise and what are
meaningful fundamental signals has probably never been
greater. That’s a challenge for many, because while
technology has made information readily accessible, it also
tempts investors to act on false triggers. Today’s world of
instant information gives investors the opportunity to
exercise an age old behavioral bias: buying at maximum
enthusiasm and selling at maximum pain, which often leads
to punitive outcomes. Understanding the value of individual
companies over the long term isn’t about the current level
of federal funds, the growth rate of the economy or the
upcoming US presidential election. Rather, fundamentals
drive cash flow, cash flow drives profits, and profits drive
stock prices.
Profits
Cumulative return
700%
600%
Positive earnings
Negative earnings
651%
Cumulative return %
500%
400%
300%
200%
100%
0%
-23%
-100%
-200%
1994
1997
2000
2003
2006
2009
2012
2015
Source: Compustat earnings per share (EPS) data, as of 12/31/15. Each portfolio
of positive and negative earnings companies is rebalanced monthly and market
cap weighted.
The ability to see the potential for future profitability (or lack
thereof) ahead of what the market has discounted is an
active manager’s most critical skill. An important part of that
is to understand where a company’s product or service is in
its life cycle (see Exhibit 3 below), as this can help estimate
future cash flows. Will a company be a price taker, because
there is little competition and high demand, or a price giver,
because its value proposition is no longer unique?
Exhibit 3: Internet and mobile penetration
“S Curve”
Internalization
Institutionalization
% User Adoption
Adoption
Trial Use
Understanding
Awareness
Contact
Time
—3—
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