The growth delusion

01 October, 2012

It is widely assumed that there is a strong link between economic growth and stock market returns. Financial news channels seem to spend at least a third of their airtime dwelling on this widely assumed link with various experts agonising about how dramatically the Indian economy might slow down and how viciously that might hurt stock market returns. Indeed, even professional investors across the world seem to assume that there is such a link; no less a legend than Bill Gross recently pontificated that there is something wrong with the US stock markets because over the last 100 years, the US stock markets have grown much faster than the US economy.

In reality, correlation and regression analysis shows that there is no link at all between economic growth and stock market returns either in India or anywhere else in the world. In fact, not only is such a link absent today, time series analysis suggests that there was never was any link between stock market returns and economic growth (neither in India, nor anywhere else).

Now, many of you will instinctively feel that this does not sound right. So, why isn’t there a link between the size of the economy and size of the stock market?

Economists calculate a country’s GDP by attributing all the income in that country to either land (including natural resources and real estate), labour and capital. The returns to capital are, in effect, the returns that stock market investors reap. Therefore, it is entirely feasible to have a fast growing economy where the returns accrue disproportionately to the owners of land and labour (because there is a scarcity of these resources) rather than the owners of capital (which might be in abundance because, say, foreign investors have poured into that country). In fact, this broadly explains what happened in India in FY11 and FY12 – the price of land rose and the skilled and semi-skilled labour class benefited from higher wages whilst shareholders’ returns languished.

Conversely, you can also have a relatively slow growing economy where the returns to land and labour are squeezed by promoters thereby allowing capital to reap high returns. This was India’s plight for long periods as a British colony and this was China’s plight until two years ago (when the Communist Party realised it had to boost consumption by giving labour a fairer deal).

Even more interestingly, even if the share of capital in an economy stays constant, stock market returns will differ from the level of economic growth in that country. That’s because of a number of reasons such as the entry of new companies into the stock market, mergers & acquisitions between listed and unlisted firms and the entry of foreign firms into a country (which will contribute to economic growth but not stock market returns unless the foreign firms list on the local market).

Now, what implications does this have for investment strategy? The simplest implication is that since the rate of growth of an economy has very little to do with the investment returns you might get from that economy, a strategy of investing, for example, in the BRIC economies (or whatever other set of economies are currently deemed to “high growth”) is profoundly flawed. In fact, you can extend this analogy to the sector level as well – the rate of growth of specific sectors (as measured by revenue growth) has very little to do with investment returns from these sectors.

Even more interestingly, investors can seek to profit from this misperception, as many investors run away from a country because they feel its economic growth prospects are weakening and opportunities opening up for the discerning investors who realize that even in the midst of a slower growth economy, there are plenty of attractive stocks which have been beaten down by “herd distinct”. That, in a nutshell, is the opportunity available to the thinking investor in India today. It is a pity that at present most of these thinking investors are FIIs pouring billions of dollars into the country, whilst local investors chase gold and real estate as if there is a scarcity of these commodities.

(Saurabh Mukherjea is the Head of Equities at Ambit Capital. The views expressed here are his own and not Ambit Capital’s)

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Amit Agrawal . 5 years ago

Well again interesting article Saurabh, but quite bold and aggressive this time.

Well I would grossly disagree this time. Simplistically Equities form very small form part of overall capital market, its dominated by debt (banks, NBFCs). Even within Equity, publicly traded ones are again a fraction only so your theory try to say “investment thesis” based only on publicly traded non-capital stocks which obviously cant represent any economy. Investments are a combination of publicly traded capital stocks (baking stocks, non-banking finance stocks), non-capital stocks( your theory seem to base on), private capital (majority of capital of any economy), debt (sovereign publicly tradeable) debt(private and publicly tradeable) and debt (private). So I guess most parts of the investment capital seem to have been left behind.

arjun a . 5 years ago

off the total capital available in India (or any economy) isn’t larger share debt capital? Interest rates were high in India in FY11 and FY12; In that case, why do you say return on capital suffered?

Amit Agrawal . 5 years ago

Exactly Arjun, Thats the point. I guess Saurabh refers only to listed equities of non-finance companies in higher m-cap range here which perhaps he tracks. This dataset should not be even 1% of the aggregate of investible set, so not representative of the fundamental premise. Otherwise how can and why would markets not reflect the economy and all economists and investors across the globe would work in illusion in tandem. Its little funny.

Ben Foster . 5 years ago

The argument here is that of listed equities share price movement correlation to GDP is missing, so in essence irrespective of how good/bad the domestic economy is doing, stocks will move according to multiple factors. I think SM is just trying to castigate positive-macro-chasing FIIs, for their fickle investing patterns.

Mudit . 5 years ago

Interesting attempt to explain market behaviour from economic first principles vs. attributing it to “perception”.

Would your conclusion imply that in the current scenario of low growth in the Indian economy, land and (esp.) labour will be unfairly squeezed to generate high returns on capital? (a trend which the markets have recently shown in the form of higher profitability and below inflation wage increases – and which Ambit’s market projection seems to imply will only increase)

Or would you think that it has to do with India remaining a capital-scarce economy where bulk of the capital is of the “hot” variety (rather than directly going into productive assets), and therefore this somewhat artificial scarcity results in higher returns unrelated to underlying GDP growth?

Question is: why is there so much hot and unproductive capital in India – and whether the high returns on such capital the cause of it remaining unproductive, or an effect of productive assets being riskier to protect (the basic reason for most of India’s ills…no rule of law)?

Deepak Jain . 5 years ago


Very bold assertion. Essentially you’re right as the stock market never represents the entire economy.

Wonder if the market tycoons have already announced a booty for you or not…

The growth delusion

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