It is widely assumed that there is a strong link between economic growth and stockmarket returns. Financial news channels seem to spend at least a third of their airtime dwelling on this widely-assumed link with various experts agonising about how dramatically the Indian economy might slow down and how viciously that might hurt stockmarket returns. Indeed, even professional investors across the world seem to assume that there is such a link; no less a legend than Bill Gross recently pontificated that there is something wrong with the US stockmarket because over the last 100 years, the US stockmarket has grown much faster than the US economy.
In reality, correlation and regression analysis shows that there is no link at all between economic growth and stock market returns either in India or anywhere else in the world. In fact, not only is such a link absent today, time series analysis suggests that there never was any link between stock market returns and economic growth (neither in India, nor anywhere else).
Now, many of you will instinctively feel that this does not sound right. So, why isn’t there a link between the size of the economy and size of the stock market?
Economists calculate a country’s GDP by attributing all the income in that country to either land (including natural resources and real estate), labour and capital. The returns to capital are, in effect, the returns that stock market investors reap. Therefore, it is entirely feasible to have a fast growing economy where the returns accrue disproportionately to the owners of land and labour (because there is a scarcity of these resources) rather than the owners of capital (which might be in abundance because, say, foreign investors have poured into that country). In fact, this broadly explains what happened in India in FY11 and FY12 – the price of land rose and the skilled and semi-skilled labour class benefited from higher wages whilst shareholders’ returns languished.
Conversely, you can also have a relatively slow growing economy where the returns to land and labour are squeezed by promoters thereby allowing capital to reap high returns. This was India’s plight for long periods as a British colony and this was China’s plight until two years ago (when the Communist Party realised it had to boost consumption by giving labour a fairer deal).
Even more interestingly, even if the share of capital in an economy stays constant, stock market returns will differ from the level of economic growth in that country. That’s because of a number of reasons such as the entry of new companies into the stock market, mergers and acquisitions between listed and unlisted firms and the entry of foreign firms into a country (which will contribute to economic growth but not stock market returns unless the foreign firms list on the local market).
Now, what implications does this have for investment strategy? The simplest implication is that since the rate of growth of an economy has very little to do with the investment returns you might get from that economy, the strategy of investing, for example, in the BRIC economies (or whatever other set of economies are currently deemed to "high growth") is profoundly flawed. In fact, you can extend this analogy to the sector level as well – the rate of growth of specific sectors (as measured by revenue growth) has very little to do with investment returns from these sectors.
Even more interestingly, investors can seek to profit from this misperception, that is, as many investors run away from a country because they feel its economic growth prospects are weakening, opportunities open up for the discerning investors who realise that even in the midst of a slower growth economy, there are plenty of attractive stocks which have been beaten down by "herd instinct". That, in a nutshell, is the opportunity available to the thinking investor in India today. It is a pity that at present most of these thinking investors are FIIs pouring billions of dollars into the country whilst local investors chase gold and real estate as if there is a scarcity of these commodities.