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A n economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today. – Laurence J. Peter Our last article explained why the economy is not relevant to investing – short term. If you want to forecast the stock market this year or next year, the economy is essentially irrelevant – because the stock market forecasts the economy, not the other way around. More surprising for investors, however, is that even the long term growth of the economy is not relevant to investing! Most investors mistakenly believe that, over the long run, stock prices rise because of growth in profits brought on by the economy. Specifically, the belief is that the long run stock market growth = economic growth + change in multiple (normally expressed as P/E, or Price/Earnings multiple). This is widely believed, even though it is obviously false when you look at the numbers! The actual stock market growth in most countries is many times the economic growth long term (see chart below). A related “conventional wisdom” is that countries that have a strong economy will have a strong stock market. This sounds perfectly logical – it’s just not true. In fact, the opposite may be true! For example, many news stories gloat about the high growth of the economy of China at about 10%/year. This is used to claim that investing in China will be a good investment. Recently, other news stories speculate that the US and Canada may have slower growth for a few years, and this is used to suggest that the stock market returns may also be lower. However, in-depth studies comparing countries with high growth economies show this does NOT translate to higher stock market growth. In fact, if anything the opposite is true! The most in-depth study we have seen is in the classic investment book on global stock markets “Triumph of the Optimists”, Dimson, Marsh & Staunton. They analyzed the correlation of GDP growth to the stock market in 17 major countries from 1900-2000 and found: Correlation of GDP Growth to Stock Market Time Period Correlation What it Means 1900-2000 -.27 Negative correlation 1950-2000 -.03 No correlation Note that “negative correlation” means that they tend to move in opposite directions – higher GDP growth generally resulted in lower stock market growth, and vice versa. Higher GDP does NOT mean it is a better place to invest. Their conclusion: “Since 1900, low-growth economies have superior stock market performance. Historically, buying into equity markets with a high GDP growth rate has given a return that is below the return of markets with a low GDP growth rate. There is no apparent relationship between equity returns and GDP growth.” – Global Investment Returns Yearbook 2005, Dimson, Marsh and Staunton. Figure: Higher stock markets generally were in countries with lower GDP growth in their economy. Source: “Triumph of the Optimists”, Dimson, Marsh & Staunton. In another study, Jeremy Siegel compared GDP growth to stock markets from 1970-97 and came to the same conclusion: Correlation of GDP Growth to Stock Market Type of Country Correlation What it Means 17 developed countries -.32 Negative correlation 18 emerging markets -.03 No correlation Jeremy Siegel also did a 107-year study from 1900-2006 with the same conclusion: “The results are striking. Real GDP growth is negatively correlated with stock market returns. That is, higher economic growth in individual countries is associated with lower returns to equity investors.” – Jeremy Siegel, Stocks for the Long Run. Ken Fisher (star fund manager and columnist for Forbes) in his myth-busting book, “The Only Three Questions You Need to Ask” explains: “A major error investors make in foreign investing – developed countries as well as emerging markets – is assuming a country with a growing GDP must have good stock returns. By the same logic, a flat or negative GDP is often assumed to lead to poor stock returns. This easily debunked Question One myth has been a major cause for investor interest in China over the past few years.” This myth is popular because people like to have very simple methods of understanding what is going on and because human beings are wired to see correlations whether or not they exist. Economic data is widely covered in the news with many news stories trying to relate it to the stock market. For investors that do not have an in-depth knowledge of stock markets and market history, the economy provides a simple way to talk about the market in broad generalities. Bottom line: Countries with lower GDP growth generally have better stock markets. The economy and the stock market are different like “chalk and cheese”. The reasons that slower growing economies generally have higher stock market growth are not fully understood, but here are the most likely reasons: 1. Expectations of the economy are built into prices of stocks: Jeremy Siegel believes it is because the higher economic growth is built into stock market prices ahead of time and that it is often overly-optimistic. The price investors are willing to pay for a stock or mutual fund includes their expectations for how good an investment it will be. Therefore, investments in countries or sectors that are expected to perform well will tend to be at over-valued – which means their future returns will likely be lower. 2. Companies have many ways to grow profits: Our opinion is that companies are able to adjust their operations to continue to grow their profits, whether or not the economy is growing strongly. Management is focused on annual targets to grow their profits and can do this in many ways – cost cutting, more efficient systems, new products, new technology, selling unprofitable divisions, buying competitors, gaining customers from competitors, new marketing/advertising programs – or replacing the management. Management is expected to grow profits regardless of the economy. 3.The economy is based on gross and the stock market is 15 times net: As an accountant and a finance guy, it is easier to see why they are not a proper comparison. The economy is related to the “total output” of the country, which includes the sales or income of companies (and governments, etc.), while the stock market is normally based on a multiple of the profits or bottom line of companies (typically 15 times). A comparison to your personal budget could be that the economy is like your salary (your gross), while the stock market is like 15 times the money you have saved/invested or have left over at the end of the month (your net). When you think of them this way, you can see why they may grow completely differently for many reasons. For example, if you get a 10% raise, does that mean you will have 10% more money left over at the end of the month? Maybe/maybe not. If you reduce an expense (pay off a loan or buy a cheaper car), your bottom line soars (especially when you multiply it by 15), even though your salary/income did not change. This is why the formula is false: stock market growth (15 times net) = economic growth (1 times gross) +/- change in multiple. You can’t compare 1 times gross to 15 times net! 4.The stock market is linked to the total of all shares, not to the average price per share. Jeremy Siegel also believes that “economic growth influences aggregate earnings and dividends favourably, economic growth does not necessarily increase the growth of per share earnings or dividends . This is because increased growth requires capital expenditures…” (Stocks for the Long Run). He believes that it costs money to support higher growth. This is either borrowed, which lowers profits, or financed by issuing new shares, which lowers the profit per share. 5.The economy and the stock market are like “chalk and cheese”. Companies and the economy are just different. For example: Ken Fisher, “The Only Three Questions You Need to Ask” explains : “Prices are determined by shifts in supply and demand, which may or may not parallel whether GDP growth is strong, weak, or nonexistent.” Some factors affect them differently . For example, high unemployment is clearly bad for the economy, but is arguably good for companies in the stock market. It means that some consumers are less likely to spend money, but on the upside, it also means that there is an available workforce, less pressure to increase wages, and that they are more likely to keep their best employees. The stock market is not the same companies over time . Obsolete or unprofitable companies are replaced by more profitable, innovative companies, especially in a slower economy. Conclusion The economy is not really relevant to stock market investing – short term or long term. I realize this belief is very ingrained in the thinking of many investors, who may find it difficult to understand the stock market without thinking of the economy. However, a growing body of evidence continually confirms that economic growth is not necessary for good stock market returns – and in fact lower economic growth may promote good stock market returns. The stock market does what it does – grows significantly long term with 1 or 2 bear markets per decade – generally regardless of what happens in the economy. If you are an investor, your limited time is best spent on things that are definitely relevant, such as understanding stock market history and researching the quality of your investments. Forecasts and conjecture about the short or long term economic outlook or growth rates for the economy, sector or country may amount to just “market noise” or distraction to be avoided in your investment decisions. Reader Poll Since the reasons that slower growing economies tend to have faster growing stock markets is not fully understood, which of the 5 explanations do you believe is correct (or do you still believe that growth of the economy is necessary for the stock market to grow)? About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching. If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com . You can read his other articles here . Popular Posts: The Smith Manoeuvre – A Wealth Strategy – I The Smith Manoeuvre – A Wealth Strategy – II Canadian Discount Brokerage Comparison Top Cash Back Credit Cards in Canada Child Care Tax Credits Questrade Review Are Hybrid Vehicles Worth it? Tax Free Savings Account (TFSA) Copyright 2010 MillionDollarJourney – All Rights Reserved
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Why the Long Term Growth of the Economy is Not Relevant to Investing
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W ith the talks of the Canada Pension Plan Investment Board (CPPIB) bidding on the company Intoll for $3.2 billion, it got me curious to do more research on the deal. InToll owns 30% of the Toronto toll highway 407 and 25% of a toll highway Westlink M7 in Sydney Australia. The CPPIB interest in the company was based on their share of the ownership of the 407. As I have family in Toronto, I tend to visit often and have traveled along the 407 quite a number of times, especially to and from Pearson Airport. The 407 is a unique toll highway in that it’s 100% automated by electronic sensors/transponders and video cameras. In other words, there’s no stopping required to pay for access like traditional toll highways. They electronically track your travel at the access/exit points, and send you a bill at the end of the month. While driving on the 407, often times I think about the amount of revenue the toll highway must generate if they are charging by the kilometer. What are these charges? They charge per kilometer, a monthly transponder fee, and a video fee if the transponder isnt’ detected or not used. These fees can also vary depending on the vehicle class. For light vehicles, peak time travel varies between $0.201 and $0.2135 per km, add on a transponder fee of $2.50 per month, and a toll charge of $0.40 per trip. Doesn’t sound like a lot, but to put it in perspective, over 170,000,000 KM’s were travelled in 2009, with over 900,000 transponders in circulation. All of that with 2010 growing at an even greater pace. Out of curiosity, I did some searching for revenue numbers and found that they had some presentations on their website. In 2009, they had a little over $500,000,000 in revenues. Sounds impressive, but it surely must be expensive running and maintaining a highway. I mean, they have to pay for salaries, highway maintenance, a portion of police coverage, snow clearing and unreadable vehicles, let alone capital costs. From the presentation, their earnings after expenses, but before interest, taxes and deprecation/amortization (EBITDA) in 2009 was around $400,000,000 (not counting capital costs). Which makes their annual operating expenses around the $100,000,000 mark. Knowing the earnings, lets look into valuation. I’ve read that the $3.2 B bid was based on 80% highway 407 and 20% Westlink M7 highway, which means CPP is willing to pay $2.56B for 30% ownership of the 407. This brings the total valuation of the highway to $8.53B. For this amount, they would be getting an infrastructure asset that returns a EBITDA of $400M which means CPP is paying approximately 21 times EBITDA (Price/EBITDA). With expansion and capital projects ongoing, investing in the 407 may be a growth investment that cash flows well, but at 21 times earnings, it is quite the premium. However, there are high valued assets at play here, which means highway 407 most likely comes with a high book value. What do you think? Do you think CPPIB is paying too much for the highway? Popular Posts: How capital Gains Tax Works How Dividend and Interest Income Tax Works Registered Education Savings Plan (RESP) Top Cash Back Credit Cards in Canada Questrade Review Are Hybrid Vehicles Worth it? Tax Free Savings Account (TFSA) Copyright 2010 MillionDollarJourney – All Rights Reserved Share on Facebook
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“ I’ve always said if you spend 13 minutes a year on economics, you’ve wasted 10 minutes. ” – Peter Lynch M any investors believe there is some sort of cause-and-effect between the stock market and the economy. They think that if they can predict the general direction of the economy, it will help them predict the direction of the stock market and therefore their investments. However, the general direction of the economy is almost useless in predicting the stock market. Studies (e.g. Dalbar study) consistently show that most investors buy and sell investments at the wrong times. One of the main reasons for this is because they base their decision on a mainly irrelevant factor – their outlook for the economy. The media and professional investors very often make this same mistake. Articles about the stock market and presentations by investment companies and fund managers often include their outlook on the economy as a key part of their investment recommendations. For example, recent articles claim now is a good time to invest because the economy is recovering from the recession, or that investors should be cautious now because of the risk of a “double dip recession”. Which one of these will happen and should this affect our investment decisions? The usefulness of information about the economy for investing is vastly overrated. This is what we call “conventional wisdom” – something most people believe and that seems to make sense – but is false. There are 2 main reasons why the economy is not really relevant to investing: The stock market forecasts the economy, not the other way around. The stock market is the head & the economy is the tail. Expectations of how the economy will perform are already built into the prices of stocks. (We will discuss this in the next article.) The stock market is the head & the economy is the tail. Let’s look at the facts. The best indicator of the economy is probably GDP (Gross Domestic Product), which is the total value of goods and services produced in a country. We calculated the correlation of GDP to the TSX60 from 1987-2010 and it is only 12%. This means that GDP and the stock market only move similarly 12% of the time. Generally, correlations under 20% are considered “no correlation”. (Correlation of 100% means they move the same, -100% is negative correlation which means they move opposite to each other, and 0% means no correlation – that they move opposite as much as they move the same.) For example, in 2008, the economy was fine, but the stock market crashed. In 2009, the economy was in a recession, but the stock market boomed (like it usually does during recessions). Last year, I was asked quite a few times whether now is a good time to invest, given that it looks like it will be a bad year. My response normally was to ask: “Which one do you think will have a bad year – the economy or the stock market?” It is actually very rare for both to have a bad year at the same time. * Data from Bank of Canada & Morningstar There is, however, some correlation if you compare the stock market this year to GDP next year. This correlation is 33%, which is considered “low correlation”. The reason that the stock market somewhat predicts the economy is that the prices of stocks include the future expectations of all investors in those stocks. This is confirmed by the Bank of Canada which uses the stock market as one of the key components of the “leading indicator”. This is a statistic published regularly by the Bank of Canada and used as a forecaster of the economy. When investors buy an investment , the price they are willing to pay takes into account their expectation of how that investment will do. So, if investors are optimistic or pessimistic about the economy for the next year, that might affect the price they are willing to pay for an investment today. That is why the stock market somewhat predicts the economy. A low correlation of 33% makes sense, though. The value of a company that is part of the stock market is normally a multiple of the profit of that company. If you talk to any business owner and ask them what affects the profit of their business, they will quickly rattle off a list of items – competition, taxes, available labour, new products, technology, cost cutting, the economy, etc. The general state of the economy is only one item in a long list of factors affecting profits. In short, if we could accurately predict what the economy will do this year, then we have an indicator (only a 33% indicator) of what the stock market did last year . This is not really useful, since we already know what the stock market did last year! 
If we that want to know what the stock market will do this coming year, we would have to accurately forecast the economy 1.5 to 2 years from now. This is extremely difficult even for top economists to do. So, I can settle the big debate. A “double dip recession” probably will not happen this year. How do I know? Because the stock market went up last year ! If we use the stock market for the last year as a predictor of the economy in the next year, then it looks like the economy is recovering like it always does after a recession, but possibly a bit more slowly. A 33% indicator is not very useful. What good is an indicator that is only right 33% of the time??? You can predict the stock market more accurately by simply always predicting it will go up! In the last 25 years, the Canadian and global stock markets have been up 76% of calendar years and the US market has been up 72% of years. (Morningstar) Conclusion: In short, the reason why the economy is mainly irrelevant is that, even if you could accurately predict the economy 1.5-2 years from now, it would only help you predict the stock market for this coming year 33% of the time. You can predict the stock market far better (75% of the time) just by always predicting it will go up. Our experience from evaluating fund managers , as a broad generality, is that the more a fund manager talks about the economy, the worse investor he is! The next time you read an article about the economy, remember that it tells you virtually nothing about what will happen to your investments. Just repeat to yourself: “The stock market is the head of the dog and the economy is the tail.” You can’t really tell where the head is going by studying the tail. If you are an investor, stop wasting time trying to predict the economy. The economy is not really relevant to stock market investing. It is almost useless for predicting the stock market. About the Author: Ed Rempel is a Certified Financial Planner (CFP) and Certified Management Accountant (CMA) who built his practice by providing his clients solid, comprehensive financial plans and personal coaching. If you would like to contact Ed, you can leave a comment in this post, or visit his website EdRempel.com . You can read his other articles here . Popular Posts: Canadian Discount Brokerage Comparison Top 6 ways to Save on Auto Insurance High Interest Rate Savings Accounts MBNA SPG Credit Card Review Questrade Review Are Hybrid Vehicles Worth it? Tax Free Savings Account (TFSA) Copyright 2010 MillionDollarJourney – All Rights Reserved
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