The Stock Market vs. the Economy
In Part 1 of this discussion, we explained why we think investors should exercise caution when making portfolio decisions based on macroeconomic forecasts, which may or may not prove accurate. For example, some people look at a region’s economic conditions as an indicator of future market performance. In the case of emerging markets, one might have thought that given their exposure and leverage to economic growth, a passive index would grow at rates well above economic growth. However, as seen below, the MSCI Emerging Markets Index has failed to keep pace with emerging markets nominal gross domestic product (GDP) over the past 20 years.
MSCI EM vs. EM GDP (Rebased to 100)
Source: Bloomberg, Polen Capital (as of 5/2/2022)
In an article published by the CFA Institute Journal Review, researchers analyzing the correlation of equity market returns with economic growth for small, medium-sized, and large corporations across developed and emerging nations arrived at a similar conclusion. The study found no significant evidence of a positive correlation between stock market returns and GDP.1 Therefore, we would caution against using the market as a proxy for the economy—and vice versa.
In our view, one explanation for the bifurcation between the economy and the market is that the market is forward-looking, reflecting investors’ expectations about the future value of publicly traded companies. In contrast, economic data is backward-looking, reporting what happened during the previous month, quarter, or year. Hence, markets have the ability to look past economic turmoil if future expectations paint a brighter outlook. For example, despite the heavy toll on the U.S. economy during the early stages of the pandemic, domestic equities rallied following the initial market selloff in March 2020 amid ample fiscal stimulus, unprecedented monetary policy support, and signs of progress toward an effective COVID-19 vaccine.
A Virtually New World
Differences in the composition of the market versus the economy also help explain why they may not always move in tandem. Decades ago, the parallels between the health of the largest U.S. companies with the broader economy were significantly stronger, as many of these companies played a vital role in the labor market, generating millions of jobs. According to a Brookings Institution report, the two largest companies by market capitalization in the U.S. in 1962—AT&T and General Motors—employed nearly 1.2 million people combined. Last year, the largest two companies—Apple and Microsoft—played a much smaller role, employing just about 260 thousand people.2
Today, most equity indices are skewed toward high-growth sectors—such as technology and communication services—which have become more prominent with the rise of the digital economy. According to Bloomberg, just six tech stocks make up 25% of the S&P 500’s market cap.3 As a result, the S&P 500 has much less exposure to interest-rate-sensitive or inflationary sectors like financials, industrials, and energy, which dominated the rankings decades ago.
Constructing Resilient Portfolios
Amid higher inflation and the likelihood of additional interest rate hikes down the road, we believe that long-term earnings growth—and not macroeconomic forces—will determine market returns and, ultimately, the success or failure of a company. Therefore, while economic data helps us understand the world around us, we believe market participants should exercise caution when drawing inferences or making investment decisions solely based on backward-looking economic metrics.
At Polen Capital, our equity team believes that the best way to preserve and grow client assets is by investing in competitively-advantaged companies that have the potential to contribute continuous and robust earnings growth to our portfolio of companies under any economic environment. In the case of high-quality and innovative businesses, our research indicates that developing disruptive technologies and opening new markets are some examples of factors that are more critical in determining the future long-term success of a business. This is why we prefer aligning our clients with companies that we feel have favorable long-term earnings power rather than attempting to predict the timing of macroeconomic shifts.
1 Kent, J. (2015). “What’s Growth Got to Do with It? Equity Returns and Economic Growth.” Journal of Investing. Vol. 24, No. 2, (01 Jun Summer). 4. https://www.cfainstitute.org/en/research/cfa-digest/2015/10/whats-growth-got-to-do-with-it-equity-returns-and-economic-growth-digest-summary
2 Davis, J. (2016). Capital Markets and Job Creation in the 21st Century – Brookings. Retrieved May 5, 2022, from https://www.brookings.edu/wp-content/uploads/2016/07/capital_markets.pdf
3 Facebook, Amazon, Apple, Netflix, Google, and Microsoft. As of December 31, 2021
Figure Methodology: Generated by taking the MSCI Emerging Markets Index from Bloomberg and indexing it to the end of 1999 and taking the International Monetary Fund (“IMF”) figures for emerging and developing markets nominal GDP and similarly indexing it to the same date.
The MSCI Emerging Markets Index is a market capitalization weighted equity index that measures the performance of the large and mid-cap segments across emerging market countries. The index is maintained by Morgan Stanley Capital International. It is impossible to invest directly in an index. The performance of an index does not reflect any transaction costs, management fees, or taxes. The S&P 500® Index is a market capitalization weighted index that measures 500 common equities that are generally representative of the U.S. stock market. The index is maintained by S&P Dow Jones Indices. It is impossible to invest directly in an index. The performance of an index does not reflect any transaction costs, management fees, or taxes.
The volatility and other material characteristics of the indices referenced may be materially different from the performance achieved. In addition, the portfolio’s holdings may be materially different from those within the index. Indices are unmanaged.
This information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of May 2022 may involve a number of assumptions and estimates which are not guaranteed, and are subject to change without notice or update. Although the information and any opinions or views given have been obtained from or based on sources believed to be reliable, no warranty or representation is made as to their correctness, completeness or accuracy. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice, including any forward-looking estimates or statements which are based on certain expectations and assumptions. The views and strategies described may not be suitable for all clients. This document does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction.
This information should not be construed as a recommendation to purchase, hold or sell any particular security. Holdings are subject to change. There is no assurance that any securities discussed herein will be in the portfolio at the time you review this post or that any securities sold have not been repurchased. The securities discussed do not necessarily represent the entire portfolio. It should not be assumed that any of the securities, transactions or holdings discussed were or will prove to be profitable or that any investment recommendations we make in the future will equal the investment performance of the securities discussed herein. For a complete list of Polen’s past specific recommendations and current holdings as of the current quarter end, please contact [email protected]. Past performance does not guarantee future results and profitable results cannot be guaranteed.