Enrich Your Future 08: High Economic Growth Doesn’t Always Mean High Stock Market Return

Andrew Stotz 00:00
Bigger. Fellow risk takers this is your worst podcast host Andrew Stotz from a Stotz Academy, continuing my discussion with Larry sweatproof, who for three decades was the head of Research at Buckingham wealth partners. You can learn more about history story on episode 645. Larry's unique because he understands the academic research world as well as the practical world of investing. Today we're going to discuss Chapter Eight from his recent book enrich your future, the keys to successful investing. And that chapter is titled, be careful what you ask for Larry, take it away.

Larry Swedroe 00:34
Yeah, thanks. And good to be back. Andrew in this chapter. Like almost all of the chapters in the book begins with an analogy to help people understand the difficult concept. And everyone I think is pretty much familiar with. Be careful what you wish for in the story of King Midas, who was granted a wish because he was a generous host. And the wish was, he wanted to be the richest man in the world. So he asked for everything he touched with turn to gold. Unfortunately, he wasn't specific, and everything included food, and everything else. And eventually, he was so upset, he went to hug his daughter and consoled himself, and she turned to go. He was so despondent and pleaded with the gods so eventually relented and restored his daughter. Sorry, yeah, the analogy is to be careful what you wish for in investing. Because if the whole premise of active management is the belief that you can forecast what's going to happen better than the market, right. And so a study was done by a fellow named Jim Davis at a dimensional and he looked at the hypothesis of what if I could predict in the emerging markets, which countries would have the fastest growth rate, and then just invest in them. And you could even go short the ones that would go slower. Now, nobody can predict with that kind of accuracy. And yet, the strategy, it turned out that Davis ran the data, and he found that the high growth countries in this period, which was 90 9205, returned 16.4%, and the low growth countries, guess what, return exactly the same 16.4%. So the lesson in that story is really, it doesn't matter if you can even forecast that these are going to be the great country, it's the market also forecast that and in other words, you have to be able to forecast better than the market. So the low growth countries may have turned out to actually do better than expected. And they got the same returns because of that the high growth countries was so higher growth, but maybe not as high as the market expected. And so they ended up with the same returns there. So that's really an important lesson here. It's that we see the same phenomenon. And we've talked about this, when companies report what looked like good earnings, you know, earnings growth, 20%, and the stock drops, 15%. Why? Because the market expected better. And the same time we see earnings down, Tesla just reported, their sales were down, and the stock jumped because they weren't down as much. So again, the key is here, you have to be able to forecast better than the market and already expects, which means you can forecast surprises, which by definition, are unpredictable.

Andrew Stotz 04:00
So there's a few things about this, first of all, the concept of, you know, forecasts in the economy. I mean, it's hard enough to forecast companies in the stock market, but to forecast the economy is if the premises is a tough one, because also there's such a delay in information compared to companies. So that was the first thing I thought of when I was reading what you wrote. The second thing is, you know, one of our best examples of this is China, where the economy grew at a nominal pace of let's say, 15% over the last 25 years. But the stock market has basically returned zero on an average annual basis over that time, having gone up massively and crashed massively up, down, up, down, but now down a lot. So China's a great example how there just really isn't this connection between the economy and the market?

Larry Swedroe 04:54
Well, and the logic is exactly the same logic we talked about between Been thinking about great companies, which are growth companies, which do have higher growth rates of earnings and sales, etc, then value companies which tend to be distressed, but they trade at much lower valuations. And so people think if I can identify the stocks that are not the higher growth rates, I can get higher returns, but exactly the same phenomenon played out and value companies actually have had higher returns in the long term, because the viewed is riskier, the market discounts. And the only way you could really evaluate before is if the market was thinking some growth, stock quality and video would grow earnings 30%, and they ruined 100%. So you have to be able to predict much better than the market, because you now have to impose your costs of gathering that information and trading as well. So that creates another hurdle. You can't just be smarter than the market, you have to be smarter than the market sufficient enough to overcome all of your expenses of gathering the information and your trading costs and implementing it. And then of course, you have to overcome if you're a fund manager, the expenses, you charge your investors. And also,

Andrew Stotz 06:20
you know, a prelude to the next chapter where we're going to talk about the money illusion. I did a just went back and did a calculation for my students in my valuation masterclass and looked at the it was either the US or OECD countries since post World War Two, and the nominal growth rate was about 6%. For economy. What can we use that number four, I mean, if we know on a year to year basis, or on a quarter to quarter basis, that just as there's no benefit of correlating that with the market? Is there anything that we could use that number four? Yeah,

Larry Swedroe 07:01
if Well, first of all, you have to make an assumption here about whether that's predictive of the future which will be dependent upon lots of policies, and geopolitical events and, etc. But what we do know is that over the long term, corporate earnings should grow in line with nominal GNP, if there will be periods when corporate earnings will grow faster. And that's usually in recession coming out of recessions, because workers can command big wages, labor markets are loose, and companies can now start to get productivity increases as volumes go up. And they don't have to raise wages, you get into the latter stages of recovery, like the US is in now, for example, and labor markets are tighter, you now have to pay your way, you know, the workers more, and they tend to have more bargaining power. So what has happened is corporate profits as a percentage G and B over the very long term up until recently, had wandered between about six and 10%. And it would get up to about 10%. And then workers would command, you know, more of the share of the GNP, and it would go down and would cycle. What happened as since the Oh, eight period, is that corporate profits expanded more and workers, and that showed up with workers having less real wages. But, you know, that can't go on forever, right? So I would expect if you think, for example, today, you're going to get 2% inflation and 2% nominal growth, then that's 4% nominal GDP, then you should expect corporate earnings to go up 4%. And you should expect stock return.

Andrew Stotz 09:07
Just to correct what you said. You said, If you expect inflation of 2%. And I think you meant to say real

Larry Swedroe 09:12
growth and real growth of 2% nonprofit that we get to 4% GNP growth, and

Andrew Stotz 09:19
you use GNP, some people use GDP, is there any particular reason why you're using

Larry Swedroe 09:25
it? St. Yeah, because the numbers look at GDP. And

Andrew Stotz 09:29
so let's now summarize this for just a second. The growth in the economy, let's say has averaged 6% In the past, and corporate

Larry Swedroe 09:38
growth for the US and 3% inflation. Yep.

Andrew Stotz 09:42
And we know that corporate earnings are much more volatile, sometimes coming in below that sometimes coming in above that. But if we calculate the cumulative average growth rate and compare the two, they're pretty close. And I haven't done that yet, but that's something that we could do, but I know from my own experience that they're pretty, pretty close.

Larry Swedroe 10:04
Yeah, exactly.

Andrew Stotz 10:05
So then the next question is, when we think about the market, and forecasting market, here's where it gets difficult. I think John Bogle was probably a great on it, explaining that when he made his chart where he showed the the factors that are driving the market related to the change in earnings, the dividend payout and the P E factor that would sometimes go super high. And sometimes it goes super low. And I guess that if we could say over the long term, there's a correlation between there's corporate earnings and GDP are moving in the same way, then it really is the price factor that just gets so wacky that cause and nuts they unpredictable,

Larry Swedroe 10:44
you know, because we don't know what the risk premium is going to be. Sometimes people perceive things to be less risky. And sometimes they underestimate risk, and you get bubbles of investors become over enthusiastic. And sometimes you get lots of risk showing up and people get overly pessimistic, they fail to understand that governments will enact policies to hopefully turn things are out in the US, that's always happen. So if you bought in the bottom or even during any recession, you know, you got that's when you got the best returns. But by the way, that volatility in corporate earnings, which is much more volatile than the GNP is exactly why there's a big equity risk premium. And why stocks have returned more than the 6% nominal growth in the GDP. It felt corporate stock, our earnings were as stable as the GDP stock prices would be much higher, because equities wouldn't be so risky, right? I mean, the GDP, even in the Great Depression didn't fall 50%. But we've had stocks fall a lot more, right. So that if you had less volatility in corporate earnings, people would use stocks as safer, pay higher multiples, and then the return to stocks, of course would then be

Andrew Stotz 12:15
lower. So one last part that I want to highlight by the way, that's a good that's

Larry Swedroe 12:19
another good one of be careful what you wish for. I wish corporate earnings were much more stable stocks would be less risky. Be careful, you might not like that, because you won't get a big equity risk premium. Yeah,

Andrew Stotz 12:32
that's a great point. And the last part on this, I was thinking about Jeremy Siegel's book stocks for the long run, which I found useful when I was a young analyst because I didn't really have a lot of that kind of data here in Thailand. And but what I was kind of surprised about was that actually emerging markets earnings performance and stock performance, actually would underperform because of dilution and corporate governance and things like that. So even though you may map that's a US earnings growth, corporate earnings growth, when you look at the corporate earnings growth of emerging markets, you may find that dilution prevents that earnings growth from keeping up with the final cumulative growth rate of the economy. It could.

Larry Swedroe 13:15
It's absolutely true. That's one of the big reasons China has underperformed massive issuance of new stock, right. But what could also be the case is the emerging market investors got told these stories by people like Bert maphill, I have the highest respect for says you got to invest in these high growth countries. Well, that's like saying you got to invest in high growth companies. But it's the value companies in the value countries that tend to provide over the long term higher returns because they're riskier. So people got over enthusiastic, beat up Chinese stock prices, other emerging markets, often you had bubbles, and they eventually burst. The price you pay matters. It's not just economic growth. Yeah,

Andrew Stotz 14:08
that's a great discussion. And that helps set the stage for the next chapter. We're going to cover in the next section, which is the Fed model and the money, illusion. Larry, I want to thank you again for another great discussion. And I'm looking forward to that next chapter. And for listeners out there who want to keep up with all that Larry's doing, follow him on Twitter at Larry swedroe. And also of course on LinkedIn. This is your words podcast host Andrew Stotz saying, I'll see you on the upside.