Systematic Relative Strength

The Economist has a brief article on the debt loads of the G20 developed nations versus the emerging market countries. Because the developed countries are very dependent on their financial services sectors for economic growth, they have seen tax revenues plummet (just as the master of disaster, Harvard professor and former IMF chief economist Kenneth Rogoff, indicated had happened in all of the previous crises). At the same time, developed countries tend to have much more extensive social welfare safety nets—an expense that accelerates as the economy gets worse. The net result is that debt as a percentage of GDP has exploded as The Economist’s graphic below indicates.

The political implications of the developed world being dependent on the emerging market countries to finance them will be interesting to see unfold. The G20 nations are going to have much less leverage in global negotiations. Gone is the ability to boss everyone else around—we need their money as much as they need our expertise and technical assistance. Multi-lateralism has arrived whether we like it or not.

Economists still have a battle raging between the slow growth and fast growth groups. The slow growth economists are basing their belief on current indications of trouble in commercial real estate, housing, and banking that will take some time to resolve. The fast growth economists are basing their argument on market-generated expectations like the steep yield curve (mentioned again today in another article in the Wall Street Journal).

Yet another market-generated indication comes from the markets for Treasury Inflation-Protected Securities (TIPS). According to an analyst quoted in this Bloomberg article:

The gap between yields on Treasuries and so-called TIPS due in 10 years, a measure of the outlook for consumer prices, closed above 2.25 percentage points four days last week, the longest stretch since August 2008. That’s the low end of the range in the five years before Lehman Brothers Holdings Inc. collapsed, and shows traders expect inflation, not deflation in coming months, said Jay Moskowitz, head of TIPS trading at CRT Capital Group LLC in Stamford, Connecticut.

The market, pretty clearly, is expecting faster growth accompanied by some inflation. Of course, market expectations are not always correct—and you can expect some turbulence in the market if expectations are thwarted and have to be readjusted. Maybe in a year or so we will know the answer, but it’s worth noting that the data generated by the market has been correct more often than the economic talking heads.

How should today’s news, that the nation’s gross domestic product rose at a lower annual rate in the third quarter than previously estimated, factor into your investment decisions? Bad news for stocks?

Recently, Brandes issued a report, Gross Domestic Product: A Poor Predictor of Stock Market Returns, that points out that stock market performance has not been correlated with GDP performance. Note this research covers an 80 year period of time.

Exhibit 1 shows the predictive power of changes in GDP (in explaining concurrent equity returns) was not statistically significant. The coefficient of determination, or the portion of the stock market performance, explained by GDP changes, is only 0.1619, and the regression line is a poor fit.

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In addition, Exhibit 2 reveals that predictive power for changes in GDP in explaining subsequent equity returns is not statistically significant. The coefficient of determination for this relationship is 0.0225, and again, the fit of the regression line is poor.

(Click to Enlarge)

It may seem logical to you to try to link GDP growth with stock market performance, but the results just don’t back that thesis up. I believe that these results confirm that investors are best served by focusing on the price movement of a security/market itself when evaluating the merits of an investment.