introduction
Tune in to Bloomberg TV or CNBC any time of day and there is a great probability the host will probably be explaining the day by day ups and downs of the stock market depending on the most recent economic news. Unemployment is down, stocks are up. Inflation rises, stocks fall. And so forth. The underlying assumption is that the stock market represents the economy. Still, most economic data is released quarterly, and on many days there isn’t a major news. Why are stocks traded on nowadays?
And what if the stock market gets carried away? Ultimately, an excessive amount of enthusiasm from investors led to this Technology bubbles in 2000 and 2021 for instance. While economic growth was strong on the time, on reflection it hardly justified such high returns and valuations. So how essential is the economy to the stock market? It could also be that sometimes it is extremely essential and sometimes it is way less so. Let’s explore.
US GDP growth in comparison with stock market returns
The U.S. economy is driven primarily by consumers, whose spending accounts for 70% of GDP. The remaining 30% is split almost equally between private investments and government spending. Net exports are near zero; The United States imports barely more goods and services than it exports.
This composition is hardly comparable to the US stock market, where technology, healthcare and financials are among the many three most vital industrial sectors. Of course, many corporations sell on to consumers, but increasingly are specializing in corporate and international markets. Apple, for instance, the listed company with the most important market capitalization, generates almost 70% of its sales abroad. So does the US stock market really represent the larger economy?
Well, the annual change in real US GDP and the S&P 500 show broadly the identical trends over the past 20 years. When the economy collapsed in 2008, the stock market also crashed. As the economy recovered from the worldwide pandemic in 2021, the S&P 500 also recovered.
Real US GDP growth in comparison with US stock market returns since 2002
But if we expand the view to available quarterly real US GDP data, the connection between US GDP and the S&P 500 becomes less clear. They followed one another closely between 1948 and 1962, but not a lot afterward: the U.S. economy grew rapidly despite several stock market crashes until the oil crisis in 1970. However, in later periods, each GDP growth increased and S&P 500 returned in sync again.
Real US GDP growth in comparison with US stock market returns since 1948
Correlation between US economy and US stock market
To quantify the connection between the U.S. economy and the stock market, we calculated 10-year rolling correlations. Between 1958 and 1993 the correlation fell from 0.7 to zero. It then rose to 0.8. During the COVID-19 crisis in 2020, because the economy plunged, the correlation decoupled again, however the S&P 500 ended the yr on an upward note due to massive fiscal and monetary stimulus.
U.S. Real GDP Growth Compared to U.S. Stock Market Returns: Rolling 10-year correlations, since 1958
We prolonged our evaluation back to 1900 using annual data from the MacroHistory Lab. Since the stock market is forward-looking and tends to anticipate economic news, we’ve introduced a one-year lag. So for 2000, we compared that yr’s GDP numbers to the S&P 500’s performance in 1999.
Again, the U.S. economy and the stock market demonstrated high correlation throughout most of this era. Correlations only fell significantly 4 times: through the Great Depression, World War II, the Nineties and the worldwide pandemic. All of this implies that the S&P 500 has been a great indicator of the US economy for much of the last 120 years.
U.S. Real GDP Growth Compared to U.S. Stock Market Returns: Rolling 10-year correlations, since 1900
International evidence
However, up to now our evaluation is proscribed to the United States. Do GDP growth and stock market performance show similar correlations in other parts of the world?
The evidence from the Asia-Pacific region tells a unique story. China’s economy grew quite usually and impressively from 1991 to 2019. However, the performance of the Shanghai Composite Index was far less consistent. There have been some exceptional years with gains of over 100%, but additionally some dismal years with declines of greater than 50%.
What explains this divergence? Perhaps the Shanghai Composite, which was only introduced in 1991, has not yet reached the purpose where it reflects China’s modern and dynamic market economy. For example, historically, the Shanghai Composite has listed many state-owned enterprises (SOEs) which have different governance structures. China’s retail investment market has also been liable to bubbles, so Chinese regulators have imposed a ten% day by day limit on share price movements.
China’s GDP growth in comparison with the Shanghai Composite Index
Other industrialized markets exhibit different contexts depending on the country and the time-frame analyzed. After calculating rolling 10-year correlations for 14 developed markets from 1900 to 1959, 1960 to 1999, and 2000 to 2020, we found that the mean correlations between real GDP growth and stock market returns increased from 0.2 to 0.6 are. We attribute this to this Decades of relative peace coupled with a trend towards more capitalist economies with larger and more diversified stock markets.
However, not all countries experienced the identical trajectory: the correlation between Belgian GDP growth and stock market returns modified little over the periods 1960–1999 and 2000–2020, and in Australia the correlation has grow to be negative over the past 20 years, coupled with regular GDP growth with ups and downs on the stock market.
Real GDP growth vs. stock market returns: 10-year rolling correlations
More thoughts
Due to the shortage of long-term data, our evaluation is proscribed to developed markets. However, we expect that correlations would likely be lower in emerging markets, as their equity markets are likely to be more decoupled from their economies and are sometimes dominated by retail investors.
But even when economies and stock markets are highly correlated, this doesn’t necessarily mean that high-growth countries make good investments. The low volatility factor shows that low-risk stocks outperform and generate excess returns from their high-risk counterparts, not less than on a risk-adjusted basis Growth stocks are essentially zero. The same probably applies to each country.
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Photo credit: ©Getty Images / DusanBartolovic
