BY KENT KRAMER, CFP®, AIF®, Chief Investment Officer, Foster Group
The Cambridge Dictionary defines counter intuitive as “something that…does not happen in the way you would expect.” We have an intuition about something, an expectation about how something should work, or a view of causality that in real life does not prove to be correct or reliable.
Most of us expect the relationship between a country’s Gross Domestic Product (GDP) and its stock market performance to be highly correlated. When GDP is rising strongly, we expect the stock market to rise strongly; when it’s falling into recession, we expect stock prices to plummet. It turns out GDP growth rates and stock market performance are not highly correlated in the way we would expect.
Joe Davis, Chief Economist for mutual fund giant Vanguard, said this while discussing their 2019 Economic Outlook:
“…over a longer period of time, the correlation between stock returns across countries and economic growth is zero, over a very long period of time.”1
He goes on to say that, while there is some correlation in shorter time periods, correlation is far from perfect and stock market valuations must be considered, as well.
Jeffery Kleintop, Chief Global Investment Strategist for Charles Schwab and Co., echoed Vanguard’s findings in the August 2018 article, “What Does GDP Mean for the Stock Market?”
“Stocks do not closely track economic growth of their home country; comparing GDP growth rates across countries tell us almost nothing about the relative performance of their stock markets.”2
The rest of the article showed that indicators other than GDP were much more closely correlated with stock market returns, depending on which country was being considered. Kleintop used the examples of Japan, Germany, and the US to show that although, “GDP isn’t useless…a rising GDP is typically good while falling is usually bad,” there are other specific measures that more closely track the health and performance of stock markets.
What’s the takeaway for investors here?
As is always the case, investors are looking for that reliable predictor of what the stock market will do next. As investors, we read and listen to news; we draw on past experiences; and we build stories in our minds that may or may not be backed up by sound statistical data. But they “sound right” to us; they resonate with our intuitions. With so much recent attention being given to US and global GDP, it seems like a good idea to test our intuitions regarding its effect on stock markets.
Behavioral economists describe our vulnerability to the “substitution effect”: when we are faced with complex circumstances, e.g. GDP and stock market performance, we will substitute intuition for more rigorous statistical evidence. Nobel Laureate Daniel Kahneman summarizes it this way,
“It is natural for System 1 (our intuitive decision making) to generate overconfident judgements, because confidence, as we have seen, is determined by the coherence of the best story you can tell yourself from the evidence at hand. Be warned: your intuitions will deliver predictions that are too extreme, and you will be inclined to put far too much faith in them.”3
Long-term investors should be very skeptical of fundamentally altering their portfolios in response to anything touted as a “reliable short-term indicator” of stock market direction or relative performance, because there is very little evidence that such indicators exist, no matter how loudly the media and advertisers proclaim them. In the case of GDP, which can be a helpful measure of the growth of an economy, the intuition that local stock markets must always be positively correlated to it does not appear to be supported by the evidence. Kahneman’s warning is that we not put much faith in our seemingly intuitive stock market predictions tied to potentially lower GDP growth. As is often the case, upon closer examination, a counterintuitive interpretation of the facts may be the correct one.
1. “2019 economic and market outlook.” https://advisors.vanguard.com/iwe/pdf/FA956404.pdf?cbdForceDomain=true
2. “What Does GDP Mean For The Stock Market?” https://www.schwab.com/resource-center/insights/content/what-does-gdp-mean-stock-market
3. Daniel Kahneman, Thinking Fast and Slow, pg. 194
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| Kent Kramer