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 (NYSE: 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  (NYSE: 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 (Nasdaq: MSFT  ) trades at 10.5 times earnings; General Electric (NYSE: GE  ) at 11 times earnings; Dow Chemical (NYSE: 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.

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.


Read/Post Comments (22) | Recommend This Article (82)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On March 23, 2012, at 5:32 PM, jdwelch62 wrote:

    Nice article. Thanks!... :-)

  • Report this Comment On March 23, 2012, at 10:26 PM, whereaminow wrote:

    But there's a great correlation between money supply growth and stock market growth.

    See Frank Shostak's work. Here is in August of last year pointing out we're in for a stock surge if the correlation holds

    http://mises.org/daily/5544

    Kind of blows that whole "you guys are just doomsayers" theory right out the window, doesn't it?

    The growth isn't sustainable, since it's fueled on cheap credit. But the stock market is booming right now.

    See my blog in October on why I'm the biggest Bull on CAPS.

    David in Liberty

  • Report this Comment On March 24, 2012, at 12:03 PM, daveandrae wrote:

    Amen.

    The dominant, determinant, of real world, real life, total investment return is driven by Investor behavior. "investment performance", which most people put their overwhelming amount of energy into, accounts for less than 10%, tops.

    Meaning, at the end of your investment career, your simple continued decision to HOLD equities through all the vicissitudes of a gyrating market, over all other asset classes, will have accounted for a whopping 90% of your total return.

    90%!!!

    Thus, at the end of the day, its not about what the "economy" , or the "market" is doing. Successful investing is far, far, more about what YOU choose to do. Or more importantly, continually choose not to do.

  • Report this Comment On March 24, 2012, at 1:31 PM, snickerdoodle9 wrote:

    I am in agreement with the heading of this article . Despite the issues with the economy in Europe , ( Greece , Spain , Italy , China , etc. ) and yes ; even here in the USA the way that I have my portfolio invested ( high yield divvies that reinvest themselves quarterly and monthly and blue chip/corporate bonds that pay out divvies every 6 months ) I continue to make money in the market . Whether the market rallies or tanks I make money . I will even use market dips to pick up some bargains . I watch and listen to the talking heads on CNBC , CNN , MSNBC . I never act upon stock recommendations from the experts , analysts , etc. without doing the research for myself . I recall reading an article about an investor who bought 3 shares of Abbott Laboratories ( ABT ) at $60 each . She never sold the stock . Over 7 decades ( which probably had faced some economic issues periodically ) the stock had split several times . Because of the stock splits , at the time of her death she was a millionaire 7 times over . If you invest wisely ( not gamble ) for the long term , the title of this article can definitely hold true .

  • Report this Comment On March 25, 2012, at 11:59 AM, wrenchbender57 wrote:

    @snickerdoodle9: Her 3 shares that originally cost $180 turned into 7 million? That sounds like stretching the truth quite a bit. Can you show the details of how this actually happened? I don't doubt that this lady, whoever she was, could have died a millionaire. But I doubt that it was all because of these three shares. Which is what you implied.

  • Report this Comment On March 25, 2012, at 12:31 PM, exileonmainst wrote:

    Looking for corelations between various economic indicators is like reading tea leaves, going to a fortune teller or hiring an investment banker, adviser or broker: a complete waste of time and money. Unless, of course, you're looking for tenure, a new basis for a scam or financial sweeze or a Nobel Prize in the dark science, Stick with the Foolish way: do your homework, buy well run companies with transparent accounts and be prudent with your money. Ignore all politicians, academics and other blow holes on TV, print and the internet (including "social media"). Be your own person. Nobody but your Mom has your best interest in mind.

  • Report this Comment On March 25, 2012, at 4:10 PM, snickerdoodle9 wrote:

    @wrenchbender:A woman turned an investment of 180$ *3 shares in $ABT in 1935 into 7$ million .. REINVEST THOSE DIVVYS BOYS!

    Above is the answer to your doubt that this lady was a millionaire . Do you know how to use a search engine ??? If you do you could have very well looked up this information yourself , This is confirmation that I am not stretching the truth . If you need further information about the above findings , try using your local library .

  • Report this Comment On March 25, 2012, at 4:30 PM, ETFsRule wrote:

    I believe it. $180 -> $1 million would take a 12% total return, compounded annually for 77 years. That doesn't seem unreasonable for a good company like ABT.

  • Report this Comment On March 25, 2012, at 4:33 PM, ETFsRule wrote:

    I forgot it was $7 million, not $1 million. That would take a 15% annual return.

  • Report this Comment On March 25, 2012, at 4:48 PM, portefeuille wrote:
  • Report this Comment On March 25, 2012, at 4:49 PM, portefeuille wrote:
  • Report this Comment On March 25, 2012, at 5:59 PM, dsciola wrote:

    Enlightening article, though I have to wonder if as the old addage goes 'this time its different.' Granted, this saying isn't always true.

    Back then, information was not readily available. There was no internet that could update literally everyone on economic growth, GDP, etc. right away. There was no decimalization and high frequency trading, case in point with the recent BATS fiasco. Also, the world economy wasn't nearly as connected and globalization was not a catch-phrase. A lot of current fear, whether justified or not, is that slow growth in China and Europe may bring a market correction here.

    Just my thoughts, agree with previous comments too that stomaching these fears / fluctuations can lead to abnormal returns as well.

    Dom

  • Report this Comment On March 25, 2012, at 9:14 PM, EddieFrecker wrote:

    Sounds like the lady didn't get to use her $7Mil.

  • Report this Comment On March 25, 2012, at 10:27 PM, snickerdoodle9 wrote:

    @EddieFrecker: If I recall I believe that she requested that the money be donated to charity .

  • Report this Comment On March 27, 2012, at 5:33 PM, TMFMorgan wrote:

    <<Because of the stock splits , at the time of her death she was a millionaire 7 times over >>

    Just wanted to point out: The splits had nothing to do with it. Splits do not impact returns at all. It's like trading in a dollar bill for four quarters.

  • Report this Comment On March 28, 2012, at 2:29 PM, kyleleeh wrote:

    I read about that lady too...it was automatic dividend reinvestment that resulted in her accumuating such a huge pile Abbott stock.

  • Report this Comment On April 02, 2012, at 5:33 PM, xLife wrote:

    There may be no correlation between current GDP and five-year forward stock returns, but there is a correlation between the ratio of corporate profits to GDP and future returns. And right now, the ratio is 70% above normal.

    In other words, although weak GDP numbers aren't a predictor, in and of themselves. Weak GDP growth coupled with current high profits is. This is somewhat intuitive, abnormally high profits being unsustainable without growth.

  • Report this Comment On April 02, 2012, at 5:39 PM, TMFMorgan wrote:

    <<but there is a correlation between the ratio of corporate profits to GDP and future returns.>>

    Disagree:

    http://www.fool.com/investing/general/2012/02/10/an-overblow...

    Further, any profit/GDP figure is incomplete unless it accounts for the rising percentage of sales now derived overseas.

  • Report this Comment On April 04, 2012, at 12:19 PM, snickerdoodle9 wrote:

    I posted to this blog over a week ago in regard to the lady who became a millionaire over 7 decades after her purchase of 3 shares of Abbott Laboratories ( ABT ) . I sand corrected that because of the reinvestment of the divvies over that window of time is the contributing factor to her millionaire status . My bad on that one ;-) ! As a dividend re-investor my I failed to recognize the error .Because of a brief pullback in the stock yesterday I did snag 100 shares yesterday in time for the dividend payout for 5/15/2012 . Also ABT is said to be seeing another split before this years end . ABT is and always will be keeper in my portfolio !

  • Report this Comment On April 04, 2012, at 12:25 PM, snickerdoodle9 wrote:

    corrected post :

    I posted to this blog over a week ago in regard to the lady who became a millionaire over 7 decades after her purchase of 3 shares of Abbott Laboratories ( ABT ) . I sand corrected that because of the reinvestment of the divvies over that window of time is the contributing factor to her millionaire status . My bad on that one ;-) ! As a dividend re-investor myself I failed to recognize the error .Because of a brief pullback in the stock yesterday I did snag 100 shares yesterday in time for the dividend payout for 5/15/2012 . Also ABT is said to be seeing another split before this years end . ABT is and always will be keeper in my portfolio !

  • Report this Comment On August 31, 2013, at 8:43 PM, TMFJCar wrote:

    Good ar

  • Report this Comment On August 31, 2013, at 8:46 PM, TMFJCar wrote:

    Good article Morgan!

    CNBC appears to be more concerned with shaping political opinions than actually helping viewers make wise investing decisions.

Add your comment.

Sponsored Links

Leaked: Apple's Next Smart Device
(Warning, it may shock you)
The secret is out... experts are predicting 458 million of these types of devices will be sold per year. 1 hyper-growth company stands to rake in maximum profit - and it's NOT Apple. Show me Apple's new smart gizmo!

DocumentId: 1838774, ~/Articles/ArticleHandler.aspx, 9/15/2014 11:13:54 PM

Report This Comment

Use this area to report a comment that you believe is in violation of the community guidelines. Our team will review the entry and take any appropriate action.

Sending report...

Today's Market

updated 1 hour ago Sponsored by:
DOW 17,031.14 43.63 0.26%
S&P 500 1,984.13 -1.41 -0.07%
NASD 4,518.90 -48.70 -1.07%

Create My Watchlist

Go to My Watchlist

You don't seem to be following any stocks yet!

Better investing starts with a watchlist. Now you can create a personalized watchlist and get immediate access to the personalized information you need to make successful investing decisions.

Data delayed up to 5 minutes

Related Tickers

9/15/2014 4:00 PM
DOW $53.04 Up +0.37 +0.70%
The Dow Chemical C… CAPS Rating: ****
GE $25.92 Up +0.05 +0.19%
General Electric C… CAPS Rating: ****
JNJ $104.72 Up +0.14 +0.13%
Johnson & Johnson CAPS Rating: ****
MSFT $46.24 Down -0.46 -0.97%
Microsoft CAPS Rating: ***
WMT $75.81 Up +0.04 +0.05%
Wal-Mart Stores CAPS Rating: ***

Advertisement