Markets have mind of their own and do not reflect the economy
• Investors should realise that there is no relationship between equity returns and GDP growth
There are three things that investors find hard to believe: stock markets do what they do regardless of what happens to the economy; you simply can’t avoid surprises; and having too little information may be better than having too much.
Stock markets do what they do regardless of what happens to the economy.
Given that the market reflects expected performance, it is easy enough to accept that if you want to predict market behaviour this year or next, the economy is essentially irrelevant as the stock market leads the economy, not the other way around. What is more difficult to accept is that even the long-term performance of the economy has little impact on the market.
As Dimson, Marsh & Staunton confirmed in their analysis of the correlation of GDP to the stock market in 17 countries from 1900-2000, “historically, buying into equity markets with a high GDP growth rate has given a return that is below the return of markets with a low GDP growth rate. There is no apparent relationship between equity returns and GDP growth.”
Jeremy Siegel at the Wharton School of the University of Pennsylvania came to the same conclusion when he compared GDP growth to stock markets from 1970-1997.
“A major error investors make in foreign investing in developed countries as well as emerging markets, is assuming that a country with a growing GDP must have good stock returns,” says Ken Fisher of Fisher Investments.
“By the same logic, a flat or negative GDP is often assumed to lead to poor stock returns. This is easily debunked.”
The reasons slower-growing economies generally accompany higher stock market growth are not fully understood, but it could be because higher economic growth is built into stock market prices ahead of time and is often optimistic.
Investments in countries or sectors that are expected to perform well tend to be over-valued, which means their future returns will likely be lower.
Furthermore, as Siegel suggests, “while economic growth influences aggregate earnings and dividends favourably, economic growth does not necessarily increase the growth of per share earnings, as increased growth requires capital expenditures”.
Companies and the economy are also different. For instance, high unemployment is bad for the economy, but good for companies’ bottom lines. In short, stock markets do what they do — grow significantly long term — regardless of what happens to the economy.
You can’t avoid surprises. There are a lot of surprises waiting for us about which we can do nothing, except watch, wait and maybe learn.
But as Daniel Kahneman, corecipient of the Nobel prize for economics, says: “Whenever we are surprised by something, even if we admit that we made a mistake, we say, ‘Oh I’ll never make that mistake again’.
“Whereas, in fact, what you should learn when you make a mistake because you did not anticipate something is that the world is difficult to anticipate. That’s the correct lesson to learn from surprises, that the world is surprising,” he says.
Here’s the problem: we want to think markets are rational, like a machine. They are easier to stomach if we view them that way. When we think of them as rational, we think they should move in predictable ways. And if we can convince ourselves that they move in predictable ways, we can assume we can get better by avoiding tomorrow what didn’t work yesterday.
But markets aren’t rational. They’re adaptive and emotional. They have moods. Since what hurt us yesterday isn’t likely to be what hurts us tomorrow, you can spend a lifetime learning lessons without those lessons leading to better outcomes.
This doesn’t mean we can’t improve our decision making. The thing to remember, to paraphrase Swedish writer Stieg Larsson, is there are only fantasies in the market, fantasies in which people from one hour to the next decide that this or that firm is worth so many billions.
Too little information is better than too much information.
“Wall Street would have you believe that you need to know everything about everything before you make an investment,” says James Montier at GMO. “But, in fact, to make an investment, what I need to know is relatively limited. There’s a classic belief that it’s necessarily better to have more information. The problem is that this ignores the fact that the human brain is a limited processing device.
“We are not a crazed supercomputer that can handle bytes and bytes of information simultaneously … too much information confuses us.
“So … the more information you give investors, the worse their decisions tend to be.”
Psychologist Paul Andreassen showed this to be true; people who receive frequent news updates on their investments earn lower returns than those who get no news.
He divided students into two groups. Each group selected a portfolio of stocks they knew enough about to come up with what seemed like a fair price for it. Andreassen then allowed one group to see only the changes in the prices of its stocks while the other group saw price changes and was given a constant stream of news that supposedly explained what was happening with each stock. Surprisingly, the less informed group did better than the informed group.
“The reason,” Tim Price later suggested in The Price of Everything, “was that news reports tend to overplay the importance of any particular piece of information. When a stock fell, its fall was typically portrayed as a sign that further trouble lay in wait, while a stock that was on the rise seemed to promise nothing but blue skies ahead.
“As a result, the students who had access to the news overreacted. Because they took each piece of information as meaningful, they bought and sold far more frequently than the people who were just looking at the price.”
“Attention is inherently selective, we can only take in a thin slice,” says cognitive psychologist Daniel Simons.
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