Why Strong Economic Growth Hardly Equals Outsized Equity Returns

Bulls have been sold to the idea that economic growth equals hefty stock market returns.

A recent report from Credit Suisse argues against such popular thinking for three reasons[1]. 

First because everybody already knows and has priced in growth, “To use public information to try to predict the market is to bet against the consensus view set by a multitude of other smart and informed global investors.”

Second, in the context of risk reward tradeoff, lesser risks means lower returns, “the strategy of buying companies that are on average becoming less risky, and hence offer a lower expected return. It is more risky to invest in companies in distressed economies”

Lastly popular issues and markets deliver lower returns not only because of risk reward balance but because growth assets have been overvalued relative to undervalued distressed assets. “There is extensive evidence that investors bid up the prices of growth assets, to the point that their long-run return is below the performance of distressed assets (sometimes referred to as ‘value’ investments).

What do they recommend as a strategy? BUY DISTRESS-SELL GROWTH; “The strategy would be to buy equities in distressed markets and to short-sell securities in fast-growing markets”

So even in the assumption of the absence of a potential Black Swan, from the conventional perspective, growth assets may not be conducive to deliver ALPHA returns.

I have no idea if the authors or Credit Suisse practice on what they preach, but from their analysis, one would understand why foreign selling on growth markets, e.g. Philippines stocks, has NOT been irrational.

Yet I offer a fourth reason. Strong economic growth may come from credit bubbles and therefore represents artificial statistical growth. Naturally since credit bubbles are not sustainable, when the inflation chicken comes home to roost, “growth” may segue into “recession” and for stocks, “boom” segue into “bust”.

So yes I second the motion: Buy distress (bust/fear) Sell growth (boom/greed).

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[1] Credit Suisse Research Institute Credit Suisse Global Investment Returns Yearbook 2014 February 2014 p.29