Higher or lower economic growth doesn’t necessarily translate into higher or lower stock prices. Market commentators have remarked on how year-to-date stock market performance seems at odds with recently published economic data. While a positive correlation may hold (under certain conditions) over the long run, there are a number of reasons why such dislocations should not be read as a sign of the market mispricing risk.
The link between economic growth and the stock market runs like this: changes in stock prices are a function of changes in corporate profits, which in turn are a component of economic growth. If economic growth is showing signs of weakness, the common inference is that constituents such as corporate profit growth are similarly weak, and this should keep stock price movements tethered.
Firstly, there are several reasons why corporate profits don’t have to grow in line with economic growth. For example:
- Corporate profits could be contributing to a greater or lesser extent than other components of GDP
- Companies listed in the domestic market may generate a large (and variable) share of their profits in other countries.
- Unlisted (or smaller) companies may be proportionally more or less profitable than listed (or larger) ones.
Next, the stock market doesn’t have to move in line with corporate profits. Stock prices are concerned with expectations of all future profits, not just the recent past or the coming quarters. Changes towards more favourable expectations could occur at a time of weaker profit growth; it doesn’t mean that the market is ignoring these data, rather it may see these data as short-lived or noisy.
Finally, changes in the cost of equity (COE) impact stock prices; a lower COE translates into higher prices and vice versa. The COE can be thought of as being the sum of a time factor and a risk premium. Central banks have a pretty good ability to anchor the former by adjusting base rates. A credible commitment to a lower base rate could cause an upward adjustment in stock prices, for example. Furthermore, the risk premium can move lower if future profits are expected to be less volatile, regardless of what happens to growth. The Economist’s Philip Coggan argues (here) that higher growth may actually reduce risk premia. But if growth is fueled by higher leverage, the risk to equity could actually go up so higher growth does not necessarily reduce the COE.
Over the long term a relationship between economic growth and stock prices should hold provided that the growth and the interplay with corporate profits are not being perfectly anticipated. But it is plausible that the market might appear “dislocated from fundamentals” for periods of time, without the need to immediately revert to a higher or lower level. A greater appreciation of the links in the chain should facilitate a deeper debate of the issues and provide a more reliable means of identifying times when the market really has mispriced risk.