What you should know about stock returns...

What really drives stock returns?

1) Well first it is not GDP growth. This one may come as a surprise. Many people think GDP growth is key to stock returns but as shown in Chart 1, from Ben Inker of asset manager GMO, there is no discernible relationship between a country’s GDP growth and its stock market returns.

2) What is relevant? Valuation. Chart 2, also from Inker, shows a strategy that works far better than picking GDP winners. It is to pick stock markets that are cheap. The relationship between cheapness and returns is remarkably strong. The cheapest quartile of markets at any point outperform the most expensive significantly over the long term.

3) News doesn’t matter. An awful lot of people spend an awful lot of time trying to out predict others. The problem is predicting the future is hard – no one has done it well. And second, even if you could predict the news, it’s not clear how markets will move as a result.

There is no evidence that economic news has a lasting effect on stock market returns any how.  Ben Inker looked at monthly employment numbers, which are widely believed to move the market. He found that the market did slightly better on days when there was a positive surprise but that slight outperformance disappeared within a month – and eventually reversed!

Did the monthly release of the all important employment numbers affect returns? Not really... valuation still mattered more. When the market was cheap, the three-year return was three times what it was on days when the market was expensive.

4) Valuation matters, but the long-term matters even more.

The important thing to know is that it takes time to reap the rewards of cheapness. 

Charts 3-5 come to us from statistician Nate Silver by way of The Motley Fool and show the relationship between valuation (P/E)  and return over time. In Chart 3, there is no real relationship over one year. But order does start to appear within five years, and clearly so in 10 years. The takeaway is simple: Buy cheap and hold on for the long term.