Stock Market Returns – The GDP Growth Rate Myth

April 14, 2015

by Baijnath Ramraika, CFA®

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The idea that nominal equity market returns approximate the country’s GDP growth rate is historically uninformed and intellectually dishonest. If there were any merit to the idea that equity market returns should approximate GDP growth rate, we would see this in a tight relationship between the two variables across countries. But we don’t.

In their research paper, The Outlook for Emerging Market Stocks in a Lower-growth World, Joseph Davis et al.1 compared long-term real equity market returns and real GDP growth rates. Their finding, summarized by the chart below, clearly shows that high GDP growth rates do not result in high equity market returns and vice versa. In fact, the r-squared between the two variables is zero; statistically speaking, there is norelationship between GDP growth rates and equity market returns.

This issue came to light in an article in The Times of India. Prashant Jain, CIO of HDFC Mutual Fund (an Investment Management firm in India), suggested that equity market returns follow nominal GDP growth rates. Here is what he had to say, “The reason for this is simple. Equities over time grow in line with the growth of underlying businesses. As businesses comprise the economy, the nominal growth of the economy (real growth plus inflation) is a good proxy for the average growth in businesses. …. The Indian economy has grown at a remarkably constant nominal growth of 15% p.a. No wonder that the Sensex2 CAGR of 17.1% is close to 15% nominal GDP growth.”

Stock Market Returns GDP Growth Rate

Source: The Outlook for Emerging Market Stocks in a Lower-growth World, Vanguard Research

The spurious nature of the relationship between GDP growth rates and equity market returns observed by Jain is also evident in these data points for the United States. Over the last 130 years, while the nominal GDP of the U.S. grew at 5.6%, the equity markets generated a nominal total return of 8.9%3; significantly outstripping GDP growth rate. If we followed the simple reasoning offered by Jain, equity markets in the U.S. should have returned not much more than 5.6%.

  1. The Outlook for Emerging Market Stocks in a Lower-Growth World, Vanguard Research, Joseph Davis, Roger Aliaga-Diaz, Charles J. Thomas, and Ravi J. Tolani, September 2013.
  2. Sensex refers to the S&P BSE Sensex Index, a market-cap weighted index comprised of thirty stocks.
  3. Long-Term Sources of Investment Returns and a Simple Way to Enhance Equity Returns, Baijnath Ramraika CFA, November 2014.

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