Economic Growth and Stock Returns

Welcome to "The Informed Investor." Today's topic is economic growth and GDP. I'm Mark Gochnour. I'll be joined today by Wes Crill and Jake DeKinder. And today's topic, economic growth. It's certainly impacted by what's going on in the news, mostly around tariffs. So let me read a couple headlines, then we'll dive into it and get your thoughts here. The first one, which has more of a negative tone to it, "Stock Market's post-GDP Whiplash Shows It's 'Foolish' "to Expect Anything But Volatility." And one more of a little bit positive tone, "Market Expert Predicts an Acceleration "in GDP Growth This Year." And as we talk about GDP growth, man, it is in the headlines with tariffs and who knows really day to day what's exactly happening with tariffs, but it does have an impact on economic growth. And how do we think about some of this as we think about our investment portfolio? This is the number one question I get asked, especially by people who are not as, you know, deep in the weeds as it pertains to financial markets. Half the time, I just pretend like I'm not an economist whatsoever, and try and move on in the conversation. But definitely a popular topic. Yeah, it definitely is. I mean, it's come up maybe more recently because we are having the tariff discussion. So maybe people are trying to relate what's that gonna mean for economic growth and then what's that gonna mean for my investments? But this idea of looking at GDP as some type of variable or some type of signal that has predictive power for stock market returns has probably been there for quite a long time. You know, as we think about the impact of tariffs, two specific impact of tariffs, the Yale Budget Lab does a really nice job of trying to update expectations based on, I'll call it almost the day-to-day changes depending on the country and things like that. So I just, you know, reference people to the Yale Budget Lab to see what that might look like. Today's conversation will be a little more broad. And just thinking about economic growth on our investment portfolio. And Wes, you've done quite a bit of work around that. Walk us through some of the things you've worked on there. Yeah, I mean I think this is a good example of how markets are forward looking. And many of these economic indicators are, by definition, gonna be backward looking. So what we tend to see in markets is that prices react before an economic slowdown actually occurs. Sometimes I like to describe this as markets don't react to circumstances, they react to changes in circumstances or changes in the expectation for those outcomes. So one way you can very clearly demonstrate this is if you were to just plot out the annual returns for the US stock market and plot 'em against the contemporaneous GDP changes, so whether the GDP contracted or expanded in a given year and look at the return for that particular year, you really don't see much of a correlation between the two. In fact, this scatter plot tends to look like a big old mess. But where you do see, and I think this gets back to the concept of markets being forward looking, is when you'd, rather than using contemporaneous relations, use the lagged market return and then plot that against next year's change in GDP. And there you see a very strong linear relation between the two. What that suggests is that years where we have an expansion in the economy tend to be preceded by positive market returns. I think that's consistent with okay, the market thinks there's gonna be good news for the economy, they're willing to raise the price that they're willing to pay for stocks. And then the reverse will be true if they have a pessimistic view of the economy. Now, my favorite part about that type of analysis, and this is something I always delve into, the broad relations are fun. It's really the anecdotal examples, the outliers that run counter to my assumption that are my favorite. A couple notable examples here. One was the stock market's return in 1945 was strongly positive despite the fact we had a contraction in the economy the following year. If you think about what happened in those years, well, 1945 is when World War II comes to an end. And so yes, you were gonna have a contraction in the economy as most US suppliers switched from wartime efforts to peacetime efforts. But the good news was the overriding idea that the war was ending. And so I think that's a good example of the predictive nature markets, but also how more than one thing is gonna drive your portfolio's return. Well, those are some really good examples here in the US but you did quite a bit of work looking at countries outside the US, and you did find that relationship where there's no real clear evidence of better returns, whether it's a high growth economy or a low growth economy for those respective countries. And Jake, that just seems so counterintuitive to I think a lot of investors out there. I think the natural inclination is, "Hey, these high growth economies are humming and that generates better returns to the market." I mean, love the study that you guys have done 'cause if you look at 'em as a group and you say, "Hey, let's group high GDP growth countries in one bucket and low GDP growth countries in another bucket, and just looking at above and below the median, and then rebalance it each year, what you find is actually the low GDP growth countries actually perform a little bit better than the high GDP growth countries, which to your point is kind of counterintuitive. Now, there's even higher level point, which is if you look at the average returns of both groups over time, both groups have really good returns. So it's not like you would say, "I wanna kick one group out and leave one group in," they're all pretty solid returns over the long term that you may wanna have in your portfolio. It doesn't mean that all countries are up all the time either. No. There's dispersion in returns. Yeah, that's the same thing if you try to get into identifying individual stocks, right? Try to identify individual stocks, individual sectors, individual countries, look at some variable. I mean, this is sort of the classic stock-picking argument, market timing argument. It's really tough to do. We'll go back to the idea that that information is in the price. You think about some of these economies, maybe they're struggling, they have low expectations, but the prices are still set to have a positive return into the future, right? 'Cause nobody's gonna buy a stock that has a negative expected return. So it really all points in time there is that positive return there. Yeah, this is a good point about just separating your enthusiasm or lack thereof for the economy from your enthusiasm in investing in stocks. So that, again, like you mentioned, the expectations are gonna be priced in, which means that if the expectation is pessimistic for the future, well if that's part of the market's expectation, then that means you can still have a good rate of return in your portfolio if the future ends up resembling what those expectations were. In fact, if the opposite occurred, if the future ended up being exactly like what the expectations were, there was a bad expectation for the economy, the economy was in line with those expectations, and if you got a zero or negative return, that would by definition mean the market had priced in a negative expected return, which to your point, I just don't think market participants would do in equilibrium. I love this idea of sort of this expectation, what's priced in, and then we get new information. I mean, you brought up tariffs earlier on. I mean, let's go back to April, right? You have some chatter about there's going to be some form of tariffs. I think it was on the Wednesday we actually get what the tariffs are gonna be. The market did not like that by the way. Thursday and Friday looked really bad. You roll to the next week, right? And then we get news midweek around, I think it was on Wednesday, that "Hey, we're gonna have a little bit of pause on that." And what do we see? Markets rally. So the whole time, these expectations are being priced in. And then if you get maybe better news, the market may go up and if you get worse news, the market may go down. But we're not waiting. Markets aren't waiting around for the official data. They're always forming those expectations and then they react once the news comes out. Well, it's also a good sign for the fact that the market was doing its job, right? If you have all those changes in expectations, I know volatility is not comfortable for investors, but if I saw market not moving while there's all these drastic changes in the information set, that would be pretty unnerving. It'd be really weird if that was happening in markets. One of the things that we also hear about in concerning economic times then is the big R word, recessions. You know, and what does that mean for investors? And again, we've done quite a bit of work looking at that to saying, "Hey, over these different time periods where we did have recessions, what did markets look like before and after we were identified we were in a recession?" One of the points you've made, which is a good one, is that usually when the NBER is doing a lot of the work around recessions, that's all data from the past, right? They're not really doing a lot of forward-looking analysis on that. Right, yeah, and the National Bureau of Economic Research, which you mentioned, the NBER, yeah, they're using a bunch of backward-looking metrics to identify when we've had a change in the business cycle when we go into recession again. Because markets are forward looking, by the time they identify that we're in a recession, it's likely the market has already moved on. One of my favorite examples of this is if you go back, and the NBER started formally identifying changes in the business, like we're announcing them in 1979. We've had six recessions since then. And if you look at those recessions, in four out of the six, the market had already bottomed out by the time the announcement was made that we were in a recession. There typically is a market downturn surrounding, or, you know, maybe preceding a recession, but by the time they announced it, and more often than not, the market had already moved on. And so you think about what that implies for your asset allocation decisions. If you were to withdraw from markets when the recession is announced, you might miss a portion of the recovery. The tough part about the recession piece too is you go back and you look at those recessions, and you look at unemployment, and you look at GDP, and you look at inflation, you look at all these variables and there's no really like cookie cutter recession, right? And this, I think is the broader point of why we're talking about these signals is people wanna be able to look at this economic data and then translate it over to here's what's going to happen. And it's just not that simple. There's just so much noise that's out there. Well, it's a good point. Is it different this time? Yeah, it is. It's always different. Each one is different. Yeah. For sure, a lot of different things happening in that point in time in history. But you mentioned some of the work done there. My favorite example is the recession around the financial crisis in sort of that 2008-2009 time period. And I think at that point, the recession officially started in December of 2007. We didn't hear about "We are in a recession" until a year later. The official announcement. December of 2008. The official announcement that recession has started. Yet kinda the point you made earlier, Wes, the market was down about 40% until, you know, from the time where it officially started to where it was announced. So markets just don't sit around and wait for it, in this case, the NBER, to say, "Hey, recession started," then you get this huge drop, right? They're anticipating the impact, some of the information that's coming out there. And then we found out when the recession was over, it was I think about 16 months later than when it officially ended, right? So again, at that point in time, the market rebounded significantly until we found out we're out of the recession. So I think as an investor, you can take a lot of comfort. To your point earlier, the market's working, constantly pricing in new information, whether it's positive or negative, it's in the price. Well, think about what you're kind of putting yourself through as an investor if you take the other side of that argument, which is, "I'm gonna analyze all of this economic data. I'm gonna try to form better expectations than what the market is priced." I mean, think about the stress that you're putting yourself through. It reminds me actually of Weston Wellington, our colleague and he talks about this high handicap versus low handicap strategy, which is, you know, the high handicap strategy is literally you spend your entire day as an investor pouring over data, forming expect, doing everything you possibly can. You got no time for golf, right? The other side of it is is you believe in the markets, you throw the clubs in the trunk and after 30 years, you may have similar, if not better returns 'cause you're not trying to market time based on all of this data. I mean, you know, decent market returns and a low handicap sounds pretty good to me. I don't have time for golf. I also don't have the temperament for golf. But getting back to Mark's earlier point, and you use the anecdote of the Financial Crisis recession, that's not uncommon to see a strong return coming out of it. In fact, if you look at the three-year return starting from the first month of a recession, you know, over the past 12 recessions, the average three-year return coming out of there was very similar to just the unconditional three-year return. They're both over 40% cumulatively over that stretch. And so again, that just suggests there's an opportunity cost if you are to give up because of concerning economic news. Well, Jake, I think one of your examples is around COVID, when it comes to the recession, where it not always follows that exact rule of two negative quarters of GDP, right? It can be, in this case, a month or two around COVID. Well I think if you go back to 2020, I believe the official recession was two months long. And that surprises a lot of people 'cause the conventional definition I think a lot of people subscribe to is exactly what you said, two quarters of negative GDP growth. But your 2020 example in, I'll say spirit, is exactly the same as your '07-'09, which is when you got the official announcement of the recession, the market was already long into the recovery and that was that, "Hey, we have gone into a recession, yet the markets are taking off. We get the official announcement that it comes out of the recession, like literally the following year, right? I mean, it's using current economic data to try to say, "Here's what the market's gonna do." I mean, to Wes's point, a lot of it's delayed when it comes out. Yeah, it's hard to know the real time health of the economy. I would say the best prediction of the future, like we always say, is the market itself, and trying to second guess where the market has set prices historically not been a good bet. Well we have referenced Gerard O'Reilly, our co-CEO and co-CIO. I think he makes a great comment as we're talking about economic variables there, that the market prices pain in immediately in the economy is sort of slow to price that pain in. I think that's exactly what you're just talking about there. As we wrap up the conversation on recessions. I just have a second favorite example I was just thinking about, and it goes back to COVID when you were talking about that. It was in April of 2020 and unemployment hit 14.8%, which is one of the worst years we've had since I think the Great Depression. Yet the market was up almost 13% that month. So again, it's just another example of how the market has a forward-looking nature, anticipating certain results. And it seems, you know, in that case, maybe their pricing is something much worse than what it actually came out to be at only 14.8% at that time. So anything you guys would summarize the conversation today? No, I think this just fits in the bucket of one of the many indicators that are probably not very reliable indicators of where the market is going. That it's best to just take a disciplined approach so you don't miss out on, okay, if there is a downturn associated with a slow down in the economy, you don't miss out on the recovery. All right, well let me highlight one of the papers that Wes was alluding to that you can have access to it. We'll put it in our show notes. It's called "Recession and Markets." And guys, as we keep the theme going here on the economy and is there anything out there that can be a signal or somehow tell us about future returns on our portfolios, the next topic is gonna be what I'll call the big one, the granddaddy, interest rates. So if you wanna make sure you get notified of the next episode when we talk about interest rates, be sure to go into your settings, click that notification, and then you'll find out when the next episode is around interest rates. Thanks for joining us today and have a fantastic rest of the day.