EconomicsFinancial Markets

Economic Growth and Stock Market Returns: The Missing Link

By June 30, 2014 No Comments

Many people mistakenly assume that high economic growth leads to high returns on the share market.

In an economy, all else being equal, corporate profits grow with GDP. The GDP growth rate is their natural upper bound – they cannot grow at a greater rate than the economy in the long run.

But what matters most to investors is not earnings growth overall, but rather growth in earnings per share.

Over recent decades the Chinese economy has grown at double-digit rates, but between January 1993 and October 2013 the US dollar total return of the MSCI large+mid-cap index was 0.13% annualised. After inflation, you actually lost 2.24% of your money per year over the period [1].

The difference then, between GDP growth and dividend/earnings growth is caused by the dilution of company stock through the issuance of new shares.

Imagine you are one of four shareholders in a company with only four shares. You each own one share and therefore 25% of the company. If the company issues a new share to a new investor, there are now five shareholders who each own 20% of the company. Each of the original four shareholders have had their share of the company reduced by 20%.

Now imagine that the company earned $4 last year, and each shareholder received $1 in dividends. The new investor’s money has allowed the company to expand and grow its earnings by 10%. Unfortunately for the original shareholders, the earnings per share that they receive from their holdings will have gone backwards, and they will only receive an $0.88 dividend ($4 x 1.1 / 5 = $0.88) this year.

In developed markets,  share dilution is generally observed to run at about 2% per year [1].

By one estimate, China’s equity pool is diluted with new shares to the tune of about 30% per year. Noting that the 50 wealthiest members of the Chinese National People’s Congress have a combined net worth of $95 billion [3], you might have an inkling where a lot  of these new shares are ending up.

So even though the last 20 years have seen spectacular economic growth and increases in corporate profits, the share pool has been growing even faster, so per-share earnings have actually been falling. This goes a long way to explaining the apparent contradiction between China’s spectacular economic growth and its woeful share market performance.



[1] William Bernstein, Rational Expectations (Efficient Frontier Publications, 2014)