Does the prospect of a rapidly growing economy mean that a country’s equity market will follow a similar upward path? Or conversely, will a country’s weak economic prospects weigh on its equity market returns? Not necessarily, though many investors tend to see gross domestic product (GDP) as an indicator of the direction of stock prices. It’s a common misperception. But in reality, there is little correlation between the two. And that’s an important point, because understanding the true drivers of stock prices can help investors uncover opportunities, avoid pitfalls and set more realistic return expectations.
Why the misperception?
In their search for return, particularly as the markets grow more complex, investors often anchor their analysis to the wrong data point. In this case, they believe economic activity has some predictive value in forecasting the direction of stock prices.
But taking a closer look at the components of GDP tells us more about consumer, business and government spending and very little about individual company valuations or the forces behind them.
What’s important to recognize is that two-thirds of GDP is based on consumer spending. Since that’s generally true of most economies, GDP is essentially just a proxy for population growth and consumer spending. Equity prices, on the other hand, are a discounting mechanism of a company’s value, which is its steady state value (the value of the enterprise) plus its future cash flows. Historically, we’ve seen very little correlation between the two, as we see in the chart below.
What does that mean in terms of setting expectations for equity returns? First, GDP doesn’t have to be growing at what most would consider a normal rate in order for investors to find adequate returns in the stock market, nor does a booming economy translate into higher stock returns.
What drives stock prices?
So if GDP doesn’t shed much light on stock prices, where should investors look for signals? In a word, profits (or earnings). If you think about the simplest formula for equity valuation, it’s price/earnings. Investors utilize trailing P/E ratios, which reflect historical earnings versus today’s stock price, or forecasted P/Es, which compare 12-month consensus earnings expectations to today’s price. Either way, most importantly, earnings, or profits, typically carry a lot of weight in driving stock prices.
Over time, the equity-market multiple has been roughly 15 times earnings. Outside extreme valuation periods, or bubbles, such as in the late 1990s, when the S&P 500 Index multiple reached an all-time high of approximately 26 times earnings, what matters most among the components of stock prices is their profits.
Considering profits and prices
Here is some historical evidence. When we look back at companies that have made money (red line in the chart) versus those that haven’t (yellow line in the chart), we see those with profits outperforming those that lose money, which isn’t surprising. But the magnitude of outperformance is significant. Over the past 20 years companies that were profitable were up more than 650% (cumulative), while unprofitable ones were down 23%.
The ability to see the potential for future profitability (or lack thereof) ahead of what the market has discounted is an active manager’s most critical skill. An important part of that is to understand where a company’s product or service is in its life cycle (see Exhibit 3 below), as this can help estimate future cash flows. Will a company be a price taker, because there is little competition and high demand, or a price giver, because its value proposition is no longer unique?
Focus on fundamentals, stay disciplined
The point is that investors need to think carefully about the data points they use to make decisions. The importance of differentiating between what is noise and what are meaningful fundamental signals has probably never been greater. That’s a challenge for many, because while technology has made information readily accessible, it also tempts investors to act on false triggers. Today’s world of instant information gives investors the opportunity to exercise an age old behavioral bias: buying at maximum enthusiasm and selling at maximum pain, which often leads to punitive outcomes. Understanding the value of individual companies over the long term isn’t about the current level of federal funds, the growth rate of the economy or the upcoming US presidential election. Rather, fundamentals drive cash flow, cash flow drives profits, and profits drive stock prices.
Robert M. Almeida is Investment Officer at MFS.
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