WSJ - Markets

If Economy Grows, Do Stocks Follow?

After years of sluggish growth, the U.S. economy is bouncing back. It grew at an estimated 3.5% annual rate in the third quarter, capping the strongest six-month stretch of growth in more than a decade.

San Francisco also got a little rain last week.

Those two statistics may be equally useful at telling us where the stock market might go over the next year. Both predict, on average, roughly nothing about future market returns.

That is the takeaway of a study by Joe Davis, the chief economist of asset manager Vanguard Group. Mr. Davis and his colleagues looked at market data going back to 1926 and measured how popular economic yardsticks correlated with future returns of the S&P 500 index.

The bottom line: What the economy is doing today tells us very little about what stocks might do tomorrow. In fact, no single metric, even the most intuitive, tells us much about where stocks might go next. Assuming this year’s strong economic numbers bode well for stocks may seem logical, but history just doesn’t back it up.

Mr. Davis examined how well variables we can measure today statistically predict future market returns.

“A lot of variables that investors scrutinize really don’t matter that much,” he said in an interview.

Take gross domestic product, the granddaddy of economic metrics, which measures the size of the total U.S. economy.

Mr. Davis’s research, originally published in 2012 and recently updated through the end of last year, shows that the change in GDP growth rates—a closely watched measure—tells us virtually nothing about what stocks might do next.

Changes in GDP growth rates have a correlation to inflation-adjusted stock returns over the following year of just 0.01, and 0.05 when looking at the next 10 years’ returns, using a scale in which 1 stands for perfect predictability and 0 shows no correlation at all.

Consensus analyst estimates of future GDP growth had almost no correlation to real stock returns over the subsequent 10 years, either. Interest rates on 10-year Treasury notes also don’t tell us much about stocks, with a 0.01 correlation to returns over the following decade. Ditto for current profit margins.

For fun, Mr. Davis also measured the correlation between nationwide rainfall and future stock-market returns. Amazingly, it ranked right down there with GDP growth and earnings estimates at predicting where stocks might go over the next year and 10 years.

“We wanted to really show how weak some of these popular metrics were at signaling market returns,” he says.

Vanguard has a dog in this fight. While it offers investment products that attempt to beat the market, it pioneered the use of passive index funds that take a hands-off approach to investing.

But the research highlights a crucial investing truth: Markets rarely move in intuitive ways, where measuring something logical today tells us what stocks will do tomorrow. They are far messier.

Even if investors could predict what, say, interest rates might do in the future, knowing how markets will react is another story.

Interest rates might jump because inflation is rising, which is generally bad for stocks. Or they could jump because real economic growth is increasing, which markets might like.

Profit margins might fall because material prices are rising, which could be bad for stocks. Or margins might fall because wages are rising, which leads to higher consumer spending, which increases corporate revenue, which could be good for stocks.

Often, the biggest drivers of future stock returns are changes in investor emotions, which are impossible to quantify today.

If I want to know what stocks will do over the next 10 years, I have to know how optimistic or pessimistic investors will be 10 years from now. And there is no way anyone can do that, since emotions often stray from what seems reasonable.

This is why, as a plethora of other studies show, beating the market by timing its ups and down is so difficult. According to investment research firm Morningstar, more than 90% of “tactical-allocation” mutual funds—which attempt to jump in and out of various asset classes at opportune times—underperformed a passive benchmark index over the past decade.

“It’s counterintuitive, but most of the time the stock market and the economy are completely out of sync with one another,” says Ben Carlson, a portfolio manager for the endowment fund at the Van Andel Institute, a medical research institute in Grand Rapids, Mich., which manages $ 1.3 billion.

What matters, he says, isn’t what the economy is doing, but how the economy is doing relative to how investors feel. “It all has to do with human emotions.”

Yet all hope isn’t lost for investors looking to outperform the market.

Valuations—that is, stock prices relative to profits—offer the best bet at measuring something today to predict what stocks might do tomorrow. The higher today’s valuations, the lower future returns are likely to be.

But only to a point. Historically, valuations explain less than half of subsequent market returns over 10-year periods, and virtually nothing over one-year periods, according to Mr. Davis.

Valuations are fairly high today. The S&P 500 traded at 25.7 times its average inflation-adjusted earnings of the previous decade in October, compared with an average of 16.5 times since 1880, according to monthly data from Yale University economist Robert Shiller .

Based on that metric, investors “may want to temper their expectation of future returns,” Mr. Davis says. Still, he adds, “you can envision a whole range of potential outcomes.”

At its core, Vanguard’s research is an argument for diversification and humility.

A fund that invests in an array of asset classes, rather than relying on your prowess to gauge where stocks or bonds might head next, is a humble acknowledgment of how complex markets can be.

It hasn’t been a shabby bet, either. The DFA Global Allocation 60/40 Portfolio , a mutual fund that invests 60% of its assets in a basket of global stocks and 40% in a broad group of global bonds, earned an annualized total return of 6.8% in the decade ended Sept. 30, net of fees. (It charges annual expenses of 0.29%, or $ 29 for every $ 10,000 invested.)

By comparison, the Barclays Hedge Fund Index—a proxy for some of the world’s most opportunistic investors—earned 4.5% annually over the same period, net of fees.

Above all, relying on any single variable to predict future returns is a mistake. Markets are too complex to distill into one clean, predictive metric.

“There is a tendency for the brain to want to go from A to B. But it’s really A to C, and there’s a lot of moving parts between A and C,” Mr. Davis says. “I advocate humility.”

—Morgan Housel is a columnist at the Motley Fool.

WSJ.com: Markets

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