The economy is growing. That’s good for the stock market… right?
One of the most basic assumptions in stock market analysis is the idea that economic growth leads to higher share prices. Wait for the release of any economic growth (GDP) figure, and then listen to TV’s talking heads breathlessly describe what it means for “the market.”
Over the long term, economic growth is important for share prices. Economic growth means more opportunities for companies to make and sell more things and more services. This leads to higher revenues and higher earnings. And when companies earn more, investors are willing to pay more for their shares – and share prices go higher.
But it’s not that straightforward. And the timing has to be right. So to say, “The economy is growing… buy stocks!” is usually just plain wrong.
It turns out that, in general, the best time to buy stocks is when the economy is doing poorly. And the best time to look at other asset classes, or to lighten up on your stock portfolio, is when the economy is doing poorly.
To demonstrate this, Truewealth Publishing looked at stock market performance and GDP growth in Japan since 1994. During that period, the economy grew, on average, by 0.8% per year (Japan is a slow-growth, developed country). Just buying and holding the stock market index from 1994 to the end of 2015 would have earned you a compound annual return of just 0.2%.
However, there were some periods – nine quarters over the entire 21-year period – when Japan’s GDP growth did far better than average, to grow at more than 3%. During 12 different quarters, economic growth was less than negative 1%, so it was underperforming and actually shrinking. We defined these economic growth ranges by looking at the standard deviation (which measures how much a statistic varies) of GDP growth during the period.
But most of the time, Japan’s economic growth was between negative 1% (shrinking), and positive 3% (growing) and, as mentioned, averaged 0.8%.
Then we looked at the performance of the stock market after each of these quarters, and computed the compound annual returns.
The results show that after the quarters in which Japan’s GDP did better than usual, shares fell – by nearly 8% on an annual basis. And in the quarters after Japan’s economy performed worse than usual, share prices rose – by an annualized 3.5%. After periods of “average” performance in the economy, shares rose at an annual rate of 0.7% – just a bit more than if you’d bought and held over the entire period.
Why is this? In general, good economic conditions are “priced in” to the stock market. By the time things are great in the overall economy, stocks have already moved up. Remember, share prices don’t reflect what’s happening right now – they reflect what investors think is going to happen. So it’s possible to make money in stocks during normal times. But the biggest gains come after the economy has been doing poorly.
Different markets, and different economies, behave in different ways. And big, long-term changes in growth rates can change this dynamic. But for Japan, and many other economies, the time to buy shares in the stock market is when growth is weak – not when it’s strong.