There are some generalisations about investment which are highly influential, intuitively convincing and largely wrong.
As a result most of us waste a lot of time speculating about things which do not really matter, and do not spend enough time analysing things that do. The most obvious example of this collective error, which is also a waste of billions of pounds of clients’ money, is the obsession with macro-economic forecasting, an activity whose real usefulness in helping us to make better investment decisions is, as far as the evidence goes, somewhere between astrology and feng shui.
But surely, you protest, there must be some sort of link between the overall health of an economy and its rate of growth, and the fortunes of the businesses based in it? After all, there is a huge overlap between what companies do (hire staff, make capital investments, buy supplies, sell their goods and services, and pay dividends) and the aggregate measures of national income which GDP statistics record. And if this is true, should it not also be true that the faster a national economy grows, the faster company profits and dividends will grow, and the higher the local stock exchange will rise?
This simple mantra, especially when combined with another widely held belief that the only decision that really matters is asset allocation, has encouraged investors to overweight regions (such as the emerging markets) where the expected long-term rate of growth is high, and to underweight regions (such as Japan and Europe) where growth is expected to be more modest. And below this strategic long-term level, there is a tactical obsession with short-term fluctuations in various sub-indicators. We sit and watch the numbers flashing across our screens and try to work out what they mean: German exports, Chinese inflation, US employment - on and on they come like an ever-rolling stream.
On the basis of the facts, the value of this work is a lot less than its cost. The most comprehensive survey of long-term equity market returns was published 10 years ago by Dimson, Marsh and Staunton. Their work, Triumph of the Optimists: 101 Years of Global Investment Returns, came out with pretty convincing evidence that over the whole of the 20th century there was actually a slight negative correlation between real GDP growth and stock market returns. This startling and counter-intuitive conclusion generated a flurry of interest within the academic community but seems to have been largely ignored by investors.
This lack of interest is surprising and depressing, because the reasons which explain why the negative correlation hypothesis might be true should be of interest to all investors who are genuinely inquisitive about the world they work in.
There are some small countries whose stock exchanges are dominated by a number of global businesses: Sweden and Switzerland are good examples. There is very little correlation between the profits of these multinational giants and the economies of their home countries, because most of their sales and costs are generated internationally.
At a more general level, while GDP measures turnover, the stock market (quite rightly) only really cares about the bottom line – profits and dividends. Variations in tax rates, local costs and management practices can and do make a difference to profitability.
And even if the level of profitability in two countries is identical, investors might apply different valuations to the same pile of money, for reasons that could include varying qualities of corporate governance and the potential for shareholder returns to be eroded by dilutive equity issues. Nor does the stock market reflect the profitability of unquoted businesses (state-owned or privately held), which may differ from that of the quoted sector but which is included in GDP.
Correlation
The most interesting of the attempts to disprove the Dimson/Marsh/Staunton hypothesis did succeed in showing some degree of positive correlation, albeit over a shorter period and with a smaller sample of markets. A good summary of the literature can be found in Gevit Duca’s paper The Relationship Between the Stock Market and the Economy. The fascinating quirk was that what they seemed to show was not that economic growth was a good predictor of share prices, but vice versa: share price movements can be good predictors of growth. In one way this is not surprising, since stock markets are a continuous opinion poll with real money, which reflect rising or falling levels of optimism about the outlook. There is also the “wealth effect” whereby increased dividends and capital gains have a positive impact on spending and consumption.
Unfortunately this is of little practical use: if economic growth is not a leading but at best a lagging indicator of share prices (which is what we are really interested in), then by the time we have formed an accurate view of economic conditions the market will already have moved. The logical implication is that economists ought to pay stock-pickers to forecast short-term market returns, since that would help them make better guesses about medium-term GDP growth. However, bitter experience suggests that whoever takes the lead, it is likely to be a case of the blind leading the blind; equity analysts and economists were, on the whole, equally unable to predict what happened between 2007 and 2009 until the storm was breaking over our heads.
So to summarise, even if economic forecasts were consistently accurate (which they are not) they would not in themselves provide much help in suggesting which investments we should buy or sell. Because of this, two final questions need to be answered. Why do we continue to devote so much time to such an apparently unproductive activity? What could we do differently which might help us to pick better investments?
Such is the force of habit, the invisible but ever present atmospheric pressure of what everyone else is doing, that it takes a conscious and continuing effort to break free. We spend a lot of time looking at the macro background because our competitors do it, because we have always done it, and because it is expected of us. Wherever investors gather to talk among themselves or to talk to clients, this sort of chat is the professional equivalent of stage extras rhubarbing in the background while the real action takes place elsewhere. The mouths open and close and sounds emerge, but nothing much useful is achieved beyond lending a little colour and authenticity to the scene.
Does this mean that we can ignore economic trends completely and concentrate on pure bottom-up stock selection? By no means. Businesses do not exist in a vacuum and nor can our analysis. If we want to make any kind of estimate of how well a particular business is going to perform, we simply cannot avoid taking a view about the conditions it is likely to encounter. I am suggesting three things.
* A different balance between macro and micro inputs.
* Using what the companies themselves tell us about their expectations as a critical macro input.
* Broadening the scope of traditional economic forecasting and analysis in order to give proper weight to global themes such as demographics, technological change and resource scarcity.
Instead of starting with a few arbitrary headline numbers as a basis for asset allocation, and then using stock selection to fill in the details, there should be a continuing dialogue, in which the appetite (or lack of it) of stock pickers for opportunities within their field should be one part of a duet, with the insights of asset allocators providing the other voice. When the two sides come together, the contribution of the stock pickers can be most effective if it goes beyond a simple list of stocks from their universe with recent results, forecasts and valuations, and includes some narrative about what the companies themselves are saying about trading conditions and the outlook. Lastly, we are missing several tricks if in our asset allocation we confine ourselves to conventional short-term silos, ignoring the huge impact of longer-term forces which will play out not over the next few quarters but over decades to come.
This is not a simple method; it will not appeal to those who dislike untidiness, incompleteness and uncertainty. But for the same reasons it is suited to the messy, complicated world in which we live and have to work, and will improve our chances of protecting and increasing the wealth of our clients.
Gareth Howlett is investment management director of Brooks Macdonald Asset Management
