It Makes No Difference What the Economy Does

I don't watch CNBC very often, and when I do, I usually regret it. It's harmful to your investment health. Satirical news site The Onion once joked: "Citing a need to provide quality programming 24 hours a day, CNBC has extended an invitation to anyone who owns a suit to drop by the financial news network and be a guest expert, co-host a show with Larry Kudlow, or do whatever." That about sums it up.

Anyway, while watching during the last few weeks, at least two guests cited sluggish GDP growth as a reason to avoid owning stocks (sorry I didn't get names; I'm quick to change the channel before getting sucked in). Economic growth was just 1.7% last year, and is perhaps 2% this quarter. That's weak. And if the economy's weak, why should stocks keep rallying? Or so the logic goes.

I'll tell you why, or at least why you should stop paying attention to such calls: There is basically no relationship between current GDP growth and future stock returns.


Let's go to data:

Sources: Robert Shiller and the Federal Reserve. S&P returns include dividends.

Do you see the correlation? Can you spot it? Don't squint, you'll hurt your eyes. I'll just let you know: It doesn't exist. For you math nerds, the correlation between current GDP growth and five-year subsequent stock returns is -0.06. About zero, in other words. For three-year forward-looking market returns, the correlation is -0.09 -- still about zero! For one-year returns, it's -0.21 -- still low. To put it another way, what GDP does today has basically no bearing on what stocks will do tomorrow.

How can that be? Economic growth drives profits, and profits drive stocks, after all.

In short, the best predictor of future market returns is not economic growth, interest rates, oil prices, or unemployment. It's valuations.

The economy can do really poorly while stocks produce great returns (and vice versa) if valuations are right. The period from 2000-2005 was a lousy time to invest, even though the economy was, for the most part, fairly strong, and unemployment was fairly low. All of that had to do with stocks being overvalued in 2000. On the other hand, the economy was about as awful as it's ever been in 2009, yet the market surged. That was due to starting valuations about as cheap as we've seen in a generation.

At an investment conference in Vancouver a few summers ago, investor Vitaliy Katsenelson put it another way:

I set out to try and find what causes [market] cycles. In general, we think market cycles are caused by 1) the economy, 2) earnings growth, 3) interest rates, and 4) inflation. Recent history shows this to be the case. If you look back at the last 50 years of market data, there's a tight negative correlation between interest rates and market returns. But if you take the data out over the past 110 years, the correlation breaks down. There's a much more important factor that determines market returns: starting valuations.

He gave two great examples of what this looks like in the real world (this was two years ago; the numbers are slightly different now):

Take Wal-Mart (NYS: WMT)  as an example. In 2000, it earned $1.30 per share. In 2010, it earned $3.60 per share. So it had very solid earnings growth. Interest rates also fell over the last 10 years. But what happened to Wal-Mart's stock? It dropped from $57 to $53. The reason is because its P/E ratio fell from 45 in 2000 to 14 today.

You'll find the same thing for a company like Johnson & Johnson  (NYS: JNJ) : earnings growth of 12%-15% per year, but P/E ratios contracting by the same amount. Investors love to focus on earnings growth. They think that's all that matters. But the most important part is the starting valuation.

This all raises the question of where valuations are today. When looking at a broad index like the S&P 500, the unfortunate (but honest) answer is no one really knows. Using a straight P/E ratio, the market looks a little cheap historically. Using a metric like the cyclically adjusted P/E ratio that averages 10 years' of earnings together, it looks a little pricey. Profit margins are near all-time highs and could contract. But interest rates are low, so stocks look attractive when compared with bonds. Equally smart people disagree on what these all actually mean. That's what makes markets.

One area of the market that to me looks undoubtedly cheap is large-cap international stocks. Microsoft (NAS: MSFT) trades at 10.5 times earnings; General Electric (NYS: GE) at 11 times earnings; Dow Chemical (NYS: DOW) at 10 times earnings. Go down the list of big multinational companies, and valuations still look good. Or at least good enough to lead you to reasonably expect decent future returns -- something GDP growth can't.

At the time this article was published Fool contributor Morgan Housel owns shares of Wal-Mart, Johnson & Johnson, and Microsoft. Follow him on Twitter @TMFHousel. The Motley Fool owns shares of Wal-Mart Stores, Microsoft, and Johnson & Johnson. Motley Fool newsletter services have recommended buying shares of Microsoft, Wal-Mart Stores, and Johnson & Johnson. Motley Fool newsletter services have also recommended creating diagonal call positions in Johnson & Johnson and Wal-Mart, as well as creating a bull call spread position in Microsoft. The Motley Fool has a disclosure policy. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. Try any of our Foolish newsletter services free for 30 days.

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Bill

Thank you for writing this superb article. I don't know if Warren Buffet read it too but if he had, I think he would agree wholeheartedly.

March 24 2012 at 12:31 PM Report abuse rate up rate down Reply