- Canada lost one million jobs in March, 2020.
What did the S&P/TSX Composite Index do on the day
that Statscan released that data?
It closed up 1.73% for the day.
It's easy for investors to see economic news
like unemployment or GDP data
and get worried or excited about the impact
that the data will have on their investments.
But there's something that many investors don't realize.
The stock market is not the economy
and the economy is not the stock market.
The stock market is a forward-looking pricing machine.
It incorporates expectations about the future
into stock prices today.
Economic news on the other hand
is backward looking.
Telling us what has already happened
and often telling us way after it has happened.
I'm Ben Felix Portfolio Manager at PWL Capital.
In this episode of Common Sense Investing
I'm going to tell you why the economy should not inform
your investment decisions.
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There have been plenty of days in recent history
where historically terrible economic data announcements
have been paired with historically
high daily stock market returns.
This is one of the reasons that market timing is hard.
Understanding the relationship between economic data
and stock market returns starts
with the concept of market efficiency.
Stock investors are investing in the right to participate
in a company's future profits.
In an efficient market stock prices contain information
about expected future profits
and the riskiness of those profits.
If anticipated economic news like unemployment numbers
for example, is already incorporated in the market prices,
we would not expect stock markets to change
when that news is released
if it's released as anticipated.
It is only unexpected economic events
which are by their nature unpredictable
that drive big short-term changes in stock prices.
Whether news is good or bad does not matter.
What matters is whether news is better
or worse than expected.
A good case study might be the US stock market
throughout the global financial crisis.
The US stock market started to decline in October 2007
two months before
the US National Bureau of Economic Research
defines the economic recession as having started.
NBER defines the recession as having started
in December 2007 and ended in June 2009.
It's important to note that these dates were not announced
until December 2008 for the start of the recession,
a year after it was determined to have started,
and September 2010 for the end of the recession
more than a year after it was determined to have ended.
The dates are not determined purely quantitatively either.
They're determined by the Business Cycle Dating Committee.
This is a clear example
of the lagging nature of economic data.
Us unemployment had been above 9% since May 2009
and it reached a peak of 10% in October 2009.
Real GDP reached its low point for the recession
in the second quarter of 2009.
Remember, the committee decision declaring
the end of the recession did not come out
until September 2010.
Based on the economic data continuing to look worse
through 2009 it was not obvious
that things were getting better.
With all of that gloomy economic data continuing
to come to light,
it would seem like this was a bad time to own stocks.
Well, it wasn't.
We know now looking back
that the stock market bottomed out in February 2009
and then started on a strong rebound.
Don't forget that for months after
the only-known-in-hindsight stock market bottom,
the economic data were only getting worse.
Despite the deteriorating economic data being released
the US stock market increased 56% from March
through December 2009.
And it continued on a historic run from there.
Why did the stock market start to recover so quickly
and aggressively in the face of dismal economic data?
Very simply, the markets had expected the economic
data to be even worse.
The bad news was better
than what the market had already priced in.
I'll borrow a quote from Warren Buffet here.
"If you knew what was going to happen in the economy,
you still wouldn't necessarily know what was going to happen
in the stock market."
A more academic example comes from the 2018 paper
"Inverted Yield Curves and Expected Stock Returns"
by Eugene Fama and Ken French.
They acknowledged in the paper
that there is strong empirical evidence suggesting
that inverted yield curves tend
to forecast economic activity.
But like Buffett said,
that may not tell us much about what's going to happen
in the stock market.
To test this,
they built an active market timing model
that shifts out of stocks and into treasuries
based on a yield curve inversions.
Based on their analysis Fama and French conclude.
"We find no evidence that yield curve inversions
can help investors avoid poor stock returns."
They go on to explain the simplest interpretation
of the negative active premium we observe
is that yield curves do not forecast the equity premium.
Well, the yield curve may be pretty good
at forecasting economic activity.
The ability to forecast economic activity does not translate
to the ability to make stock market timing decisions.
Short-term it should not be a surprise
when bad economic data are met
with strong positive stock market returns.
I'm not saying that it can't go the other way.
If bad economic news is worse than expected
or good news is not as good as expected,
the market can drop.
But the point is that the relationship
between the stock market and the economy
has little to do with what is happening in the economy
and a lot to do with what is happening
in the economy relative to what was expected
to be happening.
But what about the long-term?
What if we experienced a declining GDP
and a long slow economic recovery.
In normal times,
a rapidly growing economy like China
would be expected to have a higher GDP growth rate
than a developed economy like Canada or the United States.
Big economic events like a countrywide quarantine,
for example, are expected to have
a meaningfully negative impact on GDP.
Intuitively it seems obvious that
a country exhibiting stronger GDP growth
would be well-positioned to deliver higher stock returns,
and lower GDP growth would lead to lower stock returns.
Intuition does not mix well with investing.
In a 2012 paper titled
"Is Economic Growth Good for Investors?"
Jay Ritter examined the relationship between GDP growth
and stock returns.
He argued on both theoretical and empirical grounds
that economic growth does not benefit stockholders.
Ritter showed for 19 mostly developed market countries
from 1900 through 2011,
that the cross-sectional correlation
between the compounded real return on stocks
and the compounded real growth rate
of per capita GDP was negative 0.39.
Ritter also looked at a sample
of 15 emerging market countries
for the 14 year period from 1988 through 2011,
including Brazil, Russia, India, and China.
And he found a similarly negative correlation
of negative 0.41.
This evidence suggests that countries
with stronger economic growth have historically
had lower stock market returns.
That may be counter-intuitive on the surface
but it will quickly make sense
once we get into the details.
One of the main theoretical explanations
for the negative relationship between market returns
and economic growth is similar to what we just discussed
for short term economic data.
In an efficient market,
investors tend to build expectations into prices.
Paying a high price for expected growth
should only lead to high stock returns
if realized growth ends up being higher than expected.
If economic growth happens in line with prior expectations,
there wouldn't be a boost to stock returns.
Based on the data showing a negative correlation
between stock returns and economic growth,
it could even be argued
that investors have historically overpaid
for expected growth resulting
in disappointing investment returns.
This could be one reason for the low returns
on Chinese stocks despite their massive economic growth.
Another big reason for the negative relationship
between economic growth and stock returns
is less theoretical and more structural.
It was described as slippage in a 2003 paper
by Robert Arnott and William Bernstein titled
"Earnings Growth: The Two Percent Dilution."
They described slippage as the shortfall
between economic growth and growth in earnings per share.
They showed that GDP and corporate earnings
have been directly related going back to 1929
with aggregate corporate earnings
making up a constant eight to 10% of GDP.
But growth in aggregate corporate earnings
does not directly benefit investors.
It is increases in earnings per share
that benefits investors.
The problem here is that per share earnings growth
can only keep up with GDP growth
if no new shares are issued.
Let me explain.
If you own shares in a company in a rapidly growing economy
and a new company listed shares on the stock exchange,
you don't benefit from the new companies economic impact.
You would need to reallocate some of your capital
to the new company to participate in its earnings.
But doing so does not increase the value of your portfolio.
The economy is growing but your portfolio has not.
Over time the effect of this slippage have been meaningful.
China might again be a good example.
Much of the growth in the market value of Chinese equities
has come from an increase in the number of listed companies
as opposed to price appreciation
from existing listed companies.
Based on the slippage effect,
it is easy to see why Chinese stock returns
could be relatively poor despite huge growth
in their total market capitalization.
We would expect the slippage effect to be more pronounced
in a country going through rapid economic development.
Arnott and Bernstein gave the example of war-torn
and non war-torn countries from 1900 through 2000.
They show that well, war-torn countries
had their economies devastated by war
within little more than a generation
their GDP caught up with and in some cases surpassed
the GDP of non war-torn countries.
But here's the interesting part.
The war-torn countries stock market growth trailed
their economic growth by nearly twice as much
as the non war-torn countries.
The explanation for higher slippage
is that war-torn countries had to go
through a high rate of equity recapitalization.
New companies needed to form
and existing companies needed to raise new capital
diluting the benefits of economic growth
for existing shareholders.
Higher growth economies will see more companies
raising more capital which is great for the economy
but doesn't translate directly
to returns for existing stock holders.
It should be clear at this point that economic outcomes
whether in the short-term or the long-term
do not translate directly to stock market returns.
In the short-term stock price changes
are driven by expectations about the future.
In times of volatility those expectations can change quickly
based on new information,
but it cannot be known ahead of time.
How new information will relate to
the markets current expectations.
Record breaking jobless numbers are bad economic data
but they will not drive down stock prices
unless the market was expecting better data.
In the long-term,
investing in faster growing economies
has not proven to be a successful strategy.
In fact, historically the opposite has been true.
Which is possibly explained by the market pricing in
or even overestimating economic growth.
And by slippage from earnings dilution
due to new share issuance.
Paying attention to economic data might be interesting
for some people.
And it might even be a little bit useful
from the perspective of understanding
what's going on in the world.
For investors though,
economic data should not play a role
in informing investment decisions.
If economic data makes it hard to stick
with a well thought out long-term investment plan,
it might be best to ignore it altogether.
Thanks for watching.
My name is Ben Felix of PWL Capital
and this is Common Sense Investing.
If you enjoyed this video,
please share it with someone who you think could benefit
from the information.
And don't forget if you've run out
of Common Sense Investing videos to watch,
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of the Rational Reminder podcast
or wherever you get your podcasts.
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