Big Questions for Investors
23 Sep 2010 | 3 min
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"With forecasts of subdued economic growth, should I reduce my focus on equities? And should I invest in countries that are experiencing high economic growth?"
These are the big questions for many investors right now. We believe equities still have an important role in your overall asset allocation, and so in this newsletter, we focus on key considerations for equity investors.
Rather than relying on economic forecasts, we use an approach to determine likely market outcomes that considers three key return elements: income, growth in income and the effect of changing valuation ratios. It's an approach that can be used to forecast long-term returns with remarkable accuracy.
Is economic growth a reliable indicator of investment returns?
Surprising new research from the London Business School
Is it logical to invest in high growth economies? Should you buy equities in countries that, prior to your purchase date, have experienced economic growth - on the assumption that a record of high growth indicates that stock returns will subsequently be high? Or by following such a strategy do you end up overpaying for growth?
The conventional view is that over the long run corporate earnings will constitute a roughly constant share of national income and so dividends ought to grow at a similar rate to the overall economy. This then suggests that fast-growing economies will experience higher growth in real dividends and hence higher stock returns.
Which all seems very logical, doesn't it?
However, when academics from the London Business School analysed more than 100 years of data (from 1900-2009), they found that over the long run there is no clear relationship between changes in real GDP per capita and stock market performance. In fact, the correlation is negative (-0.23).
Why high growth economies don't always mean high stock returns. There are many possible explanations for these findings. Here are just four:
- The growth of listed companies contributes only a part of a nation's increase in GDP. Rob Arnott and William Bernstein have pointed out that in entrepreneurial countries, new private enterprises contribute to GDP growth but not to the dividends of public companies. There is thus a gap between long-term economic growth and dividend and earnings growth.
- The largest firms quoted on most national markets are multinationals whose profits depend on worldwide, rather than domestic, economic growth.
- Increases in market capitalisation are not the same thing as portfolio appreciation. Market capitalisation can grow through privatisation, demutualisation, deleveraging, acquisition, initial public offerings, equity issues by companies, and listings by countries that may be traded elsewhere. None of these factors is necessarily a source of added value for holders of listed shares.
- Equity markets anticipate economic growth. For example, the strong current and projected economic growth of emerging markets has been common knowledge for many years. It seems inconceivable that investors are not aware of this expectation or that the implications of this projected growth are not already fully impounded in emerging market stock prices.
Implications for investors
Whatever the explanation, the absence of a clear-cut relationship between economic growth and stock returns should give investors pause for thought.
It doesn't mean that economic growth is irrelevant. Rather it means that investors need to consider a more complex set of factors than simply projected GDP growth when assessing where and how to invest to achieve their desired investment returns.
We recommend focusing on the appropriate asset allocation for your personal strategic outcomes, and constructing a portfolio using likely asset class returns over the long-term to enhance your investment returns.
Information in this article was sourced from the Credit Suisse Global Investment Returns Yearbook 2010
For top quality financial advice contact Multiforte today on 02 8209 1607.
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