Sunday, December 30, 2012

Growth of the Economy, Stock Market Returns and Real Risk

Paul Krugman's Dec. 27 NYT piece "Is Growth Over?" reminded me that we also have a rather serious interest in GDP growth, specifically what it means to investment returns.
First up, the Herr Professor Doktor Doktor:
The great bulk of the economic commentary you read in the papers is focused on the short run: the effects of the “fiscal cliff” on U.S. recovery, the stresses on the euro, Japan’s latest attempt to break out of deflation. This focus is understandable, since one global depression can ruin your whole day. But our current travails will eventually end. What do we know about the prospects for long-run prosperity?

The answer is: less than we think. 

The long-term projections produced by official agencies, like the Congressional Budget Office, generally make two big assumptions. One is that economic growth over the next few decades will resemble growth over the past few decades. In particular, productivity — the key driver of growth — is projected to rise at a rate not too different from its average growth since the 1970s. On the other side, however, these projections generally assume that income inequality, which soared over the past three decades, will increase only modestly looking forward. 

It’s not hard to understand why agencies make these assumptions. Given how little we know about long-run growth, simply assuming that the future will resemble the past is a natural guess. On the other hand, if income inequality continues to soar, we’re looking at a dystopian, class-warfare future — not the kind of thing government agencies want to contemplate. 

Yet this conventional wisdom is very likely to be wrong on one or both dimensions.
Recently, Robert Gordon of Northwestern University created a stir by arguing that economic growth is likely to slow sharply — indeed, that the age of growth that began in the 18th century may well be drawing to an end. 
Mr. Gordon points out that long-term economic growth hasn’t been a steady process; it has been driven by several discrete “industrial revolutions,” each based on a particular set of technologies. The first industrial revolution, based largely on the steam engine, drove growth in the late-18th and early-19th centuries. The second, made possible, in large part, by the application of science to technologies such as electrification, internal combustion and chemical engineering, began circa 1870 and drove growth into the 1960s. The third, centered around information technology, defines our current era....MORE
Spoiler Alert!
I'll put the answer up front. Stop here if you want to maintain the frisson of suspense.

From our April 3, 2012 post:
"Correlation Between Stock Returns and GDP"
From History Squared:

The correlation is non existent, except that you would have earned a 21% one-year return if you invested when GDP is less than zero percent....
So there.Or not.
The only reason you'd have made money buying when the economy was contracting is because throughout the history of the U.S. we always resumed our growth. However:
...We only have one sample of U.S. market history, only one time the U.S. rose to economic dominance, only one period of invention like the one described above.

Anyone who uses past performance as anything more than past performance is either a mental defective or a charlatan.
The post continues:
...The best time to invest is when unemployment is peaking and higher than trend.  Study conducted by O’Shaughnessy Asset Management. 

Is it just me or is the sentence ""There appears to be no actionable relationship between economic growth and stock returns" hilarious in its pedantry?

In addition to HistorySquared's comment on the short to medium term you have to consider an economy that is steady-state to infinity.

I mean the authors use the words exactly and correctly in the instant case but in the big picture if there is no economic growth there are no stock returns other than the sine wave of movement caused by mean-reversion of P/E multiples.
Sine-waving for all eternity.

You invest in the stock market?
That sounds risky 
Some recent posts on growth. First, a couple links to the Gordon paper:
A Strong Case That Economic Growth as We Know it Is Over
Is U.S. Economic Growth Over?: A Century of Stagnation

 And more generally:
McKinsey--"Manufacturing the Future: The next Era of Global Growth and Innovation (DDD; SSYS
Jeremy Grantham "On the Road to Zero Growth" as His Co-head of Asset Allocation Does the Full Monty
How Persistant is Economic Growth in Industrial Civilization?
"When the Growth Model Changes, Abandon the Correlations"
YCombinator's Paul Graham on "Startup = Growth"

And a bit older:
Limits to Growth: Is the U.S. Economy Running at Max Growth Rate?
Growth of GDP per Capita vs Stock Prices since 1871