Kevin O’Leary, host of the television show Dragon’s Den and Shark Tank, is a screaming head who never a person he couldn’t talk over. Having said that, he should be admired as a canny entrepreneur and for understanding and exploiting the modern media game well- scream first, scream loud and scream last; it will get you on television. O’Leary is not a screaming head because he gives good advice, he’s a screaming head because, well, he screams (…and before you think television executives know better than you or I, think Jay Leno and NBC…)
Apropos to this approach of being loud and opinionated, if not necessarily right, Canadian Capitalist recently took O’Leary to task for confusing gross domestic product (GDP) growth with stock market growth. The concept makes for a great sound-bite. For an average investor, equating the two is analytically easy but most average investors also buy high and sell low.
Is there a link between GDP growth and stock market growth? A rising tide raises all boats but one does not necessarily equal the other. Why?
GDP is the market value of all goods and products produced by a country in any given period of time. To state this another way, GDP is a measurement of all public and private sector production. It does not measure profitability. Thus, a country with a large public sector or who controls a lot of the means of production, so much so that the western concepts of private property do not apply (read China), can experience rapid GDP growth without showing any profitability.
A share price is an expectation of future profit. If a publicly traded company is doing well presently, its share price tends to go up since the market has expectations it will continue to do well, if not better, through the reinvestment of profits to build the business. In other words, share price is a function of profitability and not necessarily production.
Thus, it is possible for GDP to grow while stock prices decline. The growth could be all in the public sector, at the expense of the private sector (think Venezuela seizing private property) which sends a chill throughout the entire market or simply inefficient growth making it harder for private enterprise to succeed (if you study modern Chinese history, most would be hard pressed to argue that GDP growth during the Great Leap Forward was efficient or effective).
In fact, corporate profits, the pillar of how share are priced, play a very small role in total GDP production. Charles Ellis, author of Winning the Loser’s Game, wrote that corporate profits consists only 4-6% of total GDP growth historically. Since corporate profits represent such a narrow slice of total GDP, it is analytically lazy to think GDP growth = stock market growth automatically. In fact, at such a small percentage, it is possible for corporate profits to flat-line and not effect GDP growth significantly. Certainly, there is a connection between the two but its strength tends to be overstated.
As a final note, it is important not to be seduced by GDP growth when investing in emerging markets. Many emerging markets are growing through centrally planned economies (China), with heavy government involvement and ownership (Brazil) or regulated by an expansive and byzantine bureaucracy (India). The more practical issue is that with wealth not as evenly distributed in emerging markets as mature economies, it may be more advantageous for a few to horde the profits privately than the many publicly (Russia). Thus, there must be special attention paid not to confuse GDP growth with stock market growth in this context.
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