The Market That Cried Wolf: The End Isn’t Near

by Fisher Investments | August 4, 2012 6:00 am

In recent weeks, there’s been an increasing din in media proclaiming stocks are either dead, dying or at least seriously infirm. Most often, the evidence provided that the end is near are comparisons of GDP growth and long-run equity market returns.

The claim: Long-run stock market returns have outpaced GDP for too long — an unsustainable disconnect, creating a situation destined for collapse.

To put it nicely, this rationale is a stretch.

It’s fair to say we doubt the death of equities is coming — much like it didn’t come following the famous 1979 Businessweek cover proclaiming the same, didn’t come following commentary (from much the same sources) in late February 2009 and didn’t come following numerous other media mentions over time. In fact, we expect a robust finish to 2012 for stocks.

All that aside, it’s more the rationale we take issue with — a rationale falsely linking equity returns and GDP.

GDP is a flow of economic activity; a highly imperfect attempt at calculating the total output of a particular country or region in a certain period of time (quarter, year, etc.).The calculation: Consumer Spending + Government Spending + Net Exports + Business Investment.

In this way, the U.S.’s GDP is about $15.6 trillion, which essentially means that this year, about that much economic activity will occur in the U.S. Said differently: If the U.S. economy were to experience no GDP growth over the next four years, our economy would churn out over $62 trillion in cumulative output over the period.

But even with that, GDP isn’t a pure look at economic health, which its creator Simon Kuznets stated while releasing the very first GDP report in 1934.

Now consider what stocks are: A piece of ownership in a business. Said another way, they are a slice of wealth. The difference between economic activity and wealth is huge. It’s not only the calculation flaws in GDP that are a problem, but the fact that the two metrics aren’t even an attempt to measure the same thing.

GDP isn’t helpful in calculating total national wealth, which would be more related to the total value of housing, commercial real estate, government-owned land, cash in bank accounts, bonds owned, stocks owned, jewelry, raw materials, machinery, goods, intellectual property and ever so much more. Therefore, the idea that the return of one should about match the return of the other is rather lacking.

What’s more, there’s no hard and fast correlation between rates of economic growth and stock returns. Emerging markets can and often do have fast growth rates, while stock returns can be wildly variable. In developed nations, stocks can be up huge on middling growth, and in more lackluster years growth is robust.

Through market history, there is a relatively tight relationship over long periods between corporate earnings growth, rather than GDP, and stock returns. That includes earnings growth regardless of whether the source of the earnings is mostly domestic or not.

This should make sense intuitively: When you buy stock, you aren’t buying a slice of future domestic economic activity. No, you’re buying a slice of future earnings. And considering both revenue and earnings growth have exceeded GDP growth in the present cycle to date, it’s just not all that surprising annualized equity returns have too.

Now, this shouldn’t be taken to mean earnings growth is an ironclad, cyclically predictive factor — decelerating or even contracting earnings growth happens quite frequently during a bull market.

Moreover, stocks can, in the short run, move on very irrational, utterly unpredictable forces. But with time, these forces tend to average out and what’s left are stock returns being highly correlated with the profitability and competitiveness of the private sector.

In this competition, some businesses will succeed while others fail — but most often, it is a form of Schumpeter’s creative destruction, a process by which overall societal value is created by a natural process in which successful innovations are rewarded while others are eliminated.

As Fisher Investments’ CEO Ken Fisher has often said, stocks are simply hugely adaptive, as their value is based on creativity, investors’ assessments of future earnings associated with that creativity, innovation and more.

In this regard, the world constantly advances, because one idea that generates a profit can easily be the seed for many, many more ideas.

Equities harness this — in this way, not only are they a piece of national wealth, they’re among the most dynamic pieces of it. Which is why stock returns are better than other similarly liquid asset classes over the long run. And, we might add, that has next to nothing to do with GDP.

— Todd Bliman, Fisher Investments

This article constitutes the views, opinions, analyses and commentary of the author as of August 2012 and should not be regarded as personal investment advice. No assurances are made the author will continue to hold these views, which may change at any time without notice. In addition, no assurances are made regarding the accuracy of any forecast made herein. Past performance is no guarantee of future results. A risk of loss is involved with investments in stock markets.

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