We all know, that the real economy and the stock market are tightly connected. When the economy shrinks, the companies revenues are going down, same as their share price. On the other hand, the good conditions enable business to thrive, investors are more confident and see a lot of opportunities to put their money up. Their buying shares and the stock market is going up. It works the other way around too. The growing stock market boosts the GDP growth. However, in real world with all countries and markets connected with each other, it is a little more complicated. Both the stock market and the economy has got own cycles and they don’t always coincide with each other. There is a lot of experiments, which try to prove, that the growth of GDP has nothing in common with equity returns (an exemplary research).
We will step aside from this discussion and focus solely on the stock market and the GDP growth in UK. We are going to check, if there is any chance, that this indicator can give us some useful information about the future behavior of our equity investments.
On the chart below, we have FTSE 250 and one year change of a GDP annual growth rate. We have used the preliminary estimate, which are usually released one month after the analyzed quarter. Let’s take a look on this chart:
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We can notice, that our indicator generates a lot of peaks and bottoms. The frequency is very high. We have reached a conclusion, that the peaks look like a good sync point for the market slumps. Let’s mark them on the chart and check, if our theory is correct.
We have 9 syn point and the average interval between them is around 30 months during the last 15 years. During the test, we were afraid that, even the 1 month delay of GDP data release, can turn the entire strategy into something completely useless. A 3 months time after the real, final data are released has been deadly for it. Let’s check the path chart and judge the results:
Our sync points have created:
- 3 negative paths (33%)
- 3 positive paths (33%)
- 2 extremely negative paths (22%)
- 1 extremely positive path (11%)
2 years after the sync point, we have 5 negative outcomes and 4 positive, which gives us 55% chance, that we will lose during this period. The median return is -1%, when the FTSE 250 has generated +19%. It indicates, that our strategy is correct and can signalize the market downfalls and periods with a very low growth. What’s more, all of the positive paths has got rather horizontal, than growing shape. The slumps are deep and clearly visible, the gains are not. Let’s take a look on the median path:
As we can see, the path’s shape is correct and tells us, that the market wasn’t generating a high returns for most of a time. We have a very delicate, maximal growth (+8%), which started one month after the sync points and has last for two. It is a very short period and due to this, the correct moment to invest is hard to catch. For the rest of a time, the shape is horizontal with an -7% slump in the end. The conclusion is that, the median path proves a high probability of the low returns and deep slumps. The downfall can appear around 3 months after the sync point.
We have proved, that the annual GDP growth rate can be used in effective market analysis. This tool is not ideal and points the bear market correctly in only 50% cases, but what’s important it has indicated all the major slumps. The positive returns after the sync points have been 10 pp. lower in the comparison to FTSE 250 median. It means, that even if the recession will not appear, we cannot count on the big profits during the two years after the peak of this indicator.