GDP and equities: don't be fooled
Gerard Jackson
Is there any statistical relationship between equities and GDP? In other words, can stock analysts use GDP to predict the movement in equities? To try and throw some light on this question, let us assume that a progressive economy, one that is expanding, is in equilibrium. This means that every sector is expanding at the same rate. It also assumes no technological change. Furthermore, let us assume an interest rate of 5 per cent.
In this situation there are neither profits nor losses. Anyone with any basic understanding of economics will immediately see that the rate of return throughout the economy will be 5 per cent .
Should the social rate of time preference fall to a level that reduces the rate of interest to 3 per cent, capital accumulation — meaning economic growth — will accelerate. However, the rate of return will now be 3 per cent even though GDP will have risen.
This simple illustration demonstrates that the rate of return in equilibrium is not a mere reflection of the rate of interest but is the rate of interest. Anything in excess of this rate, excluding the risk element, is therefore profit.
In genuinely growing economies aggregate profits exceed losses. Hence, on the basis of this analysis, we would expect the return on equities to exceed the return on bonds. And this is precisely what we do find. (Unfortunately, many economists have taken this situation as a case of market failure that requires government attention).
It should be clear that GDP will not act as a guide to returns on equities. Warren Buffett and Jeremy Siegel have been credited with pointing out that economic "growth that comes from technological change largely benefits consumers rather than the owners of capital".
Economic growth comes from capital accumulation, not technological change. A country can accumulate a huge amount of sophisticated technical knowledge and still have very little growth. It is necessary to understand that growth embodies technical change and it is through savings that this feat is accomplished. No savings, no growth.
It was well known, especially by the Austrian school of economics, long before Warren Buffet was born, that consumers are always the beneficiaries of economic growth. However, owners of capital always benefit even when profits are competed away.
It seems to be forgotten that at the end of the day the firm's total value will have increased even though profits have been eliminated by market processes. Of course, no firm is guaranteed a permanent existence or rate of return.
We must conclude that financial advisers who base investment decisions according to changes in GDP are making a grave error of judgment.
Gerard Jackson is Brookes' economics editor
BrookesNews.Com
Monday 19 July 2004