The economy is not the stock market

Are the economy and the stock market perfectly correlated?

It's one of the most common misconceptions in investing, the assumption that when an economy grows, its stock market must rise in lockstep. The two are certainly connected, but the relationship is far less simple and far less automatic than most people think, and understanding why can save investors from some costly mistakes.

In this video, Peter Westaway, Chief Economist at Vanguard Asset Management, explains the real link between economic growth and stock returns. Surprisingly, the countries with the fastest GDP growth aren't necessarily the ones with the fastest-growing stock markets. That's because existing, expected growth is already reflected in share prices. The fact that one country grows more quickly than another is, in effect, already priced in. Where the genuine connection lies is in unexpected shocks: if a country's GDP suddenly comes out far stronger than anticipated, you'd expect its stock market to surge in response.

You'll learn why this matters so much for investors. Since it's shocks, by their very nature unexpected, that move prices, the only way to profit systematically would be to predict what's going to happen better than everyone else, and position your portfolio ahead of the surge. But consistently out-forecasting the entire market is extraordinarily difficult, which is precisely why so few investors manage it.

The video also explains why high-growth economies often, though not always, do generate higher stock returns. Emerging markets like India can deliver stronger returns, but largely because they're riskier and more volatile. Investors need to be rewarded for that extra uncertainty, a reward that's less necessary in a more stable market like the US. In other words, higher returns in those markets are compensation for higher risk, not a free lunch from fast growth.

The takeaway: how useful is a knowledge of economics for beating the market? Not very. Westaway finds it reassuring for long-term investors to understand the economic backdrop, but using that understanding to second-guess everyone else and squeeze out extra returns is, he says, a fool's errand. Tellingly, he admits that even after spending all his time studying these issues, he wouldn't claim to have a systematic market edge, and if a distinguished economist doesn't, the odds are that you don't either.

Chapters / Key points

• The common myth that the economy and stock market move in lockstep
• Why fast-growing economies don't always have fast-growing markets
• Why expected growth is already reflected in prices
• How unexpected shocks are what really move markets
• Why predicting shocks better than everyone else is so hard
• Why high-growth economies often, but not always, deliver higher returns
• Why emerging market returns are a reward for higher risk
• Why a knowledge of economics doesn't give you a market edge
• Why even a distinguished economist admits he can't beat the market

Transcript

Are the economy and the stock market perfectly correlated?

Robin Powell: One of the most common misconceptions about investing is that the economy and the stock market are perfectly correlated. Yes, they are connected, but it's not that simple. Peter Westaway is Chief Economist at Vanguard Asset Management.

Peter Westaway: Well, there are connections between economic growth and the stock markets, but those connections aren't as obvious and automated as you might necessarily think. For example, if you look at the countries with the fastest GDP growth, they're not necessarily the ones with the fastest stock market growth. Where there is a connection, though, is when you get an unexpected shock to a particular country's GDP. So if, say, UK GDP suddenly comes out more strongly than people were expecting, what you expect to see is a surge in the stock market. In other words, the existing growth is already reflected in the price. So the fact that China grows more quickly than the UK should already be reflected in the stock markets.

Robin Powell: So, it's shocks that cause price movements, and, by their very nature, shocks are unexpected.

Peter Westaway: It's very much about, can you predict what's going to happen, better than everybody else, before it happens. Because if you can predict and position your portfolio accordingly, you will then benefit from the surge in the stock market. But of course, it's really difficult to systematically be better at predicting what's going to happen in the economy than everybody else.

Robin Powell: As Peter explained, it doesn't always follow that high-growth economies generate the highest stock returns. But often they do. Why should that be?

Peter Westaway: It's the case that countries like India, a lot of emerging markets, may tend to generate better stock market returns. But as much as anything, that's because those countries are more risky. So, you will get periods when growth is strong and that will be reflected in strong stock market growth. But often, performance in those economies is very volatile. And so, investors need a reward for that extra degree of uncertainty, that maybe isn't so much the case with a country like the US, for example. That's really where it's going, it's a reward for risk for investing in riskier markets.

Robin Powell: How useful is it, then, for investors to have a knowledge of economics? Actually, not particularly useful at all.

Peter Westaway: For many investors, especially investors who have a long-term horizon, I think it's important and reassuring to understand what the economic backdrop is. But to then use that information to try to second-guess everybody else and to try and eke that extra bit of return out of their portfolios is really a bit of a fool's errand. One of the things that I say a lot to investors is that I spend all of my time looking at these issues, but I wouldn't like to claim that I could systematically beat the market because of my insights.

Robin Powell: So, if even a distinguished economist like Peter Westaway admits he doesn't have a market edge, the chances are that you don't either.