We need to think about the omitted variables bias, because this idea is the key to whether we should expect equities to do well this year.
My chart shows the point. It shows that there is a link between annual returns on the All-Share index and economic growth, as measured by annual changes in industrial production. Big falls in output have been accompanied by big falls in equities, as we saw last year and in 2008-09; smaller falls in output have seen more moderate falls in equities, such as in 2001 or 2012; and rising output has been accompanied by rising share prices, such as in the late 1990s, 2009-10 and in 2016-17. Since 1997, the correlation between annual changes in output and in the All-Share index has been a hefty 0.56.
With economists expecting a strong economic recovery this year – the consensus is for GDP to grow more than 5 per cent, the fastest rate since 1988 – this correlation suggests equities should do well this year.
But, but, but. We all know that correlation is not causality. The fact that output and share prices have risen and fallen together does not mean that rising output causes shares to rise. There are two other explanations for the link.
It could be that the causality runs the other way. In theory, rising share prices could cause stronger economic growth, for example by cutting companies’ cost of capital thereby stimulating investment or by enriching shareholders and so raising consumer spending. We can discount this possibility because these are both weak mechanisms, especially in the short run.
What we cannot discount at all, however, is the possibility that output and equities rise and fall together because both are driven by some other factor – an omitted variable.
In 2008-09, for example, shares fell not because output did but because the banking crisis depressed both. At other times, output and shares have risen and fallen together because animal spirits have waxed and waned: increased confidence causes investors to bid up share prices, consumers to spend more, and companies to expand output, whilst falling confidence has the opposite effects. And last year the pandemic hit both economic activity and shares: shares didn’t fall merely because the market took fright at falling output.
If the co-movement of shares and economic activity is due to both being moved by other factors, it’s not obvious why an economic recovery this year – when it comes – should raise share prices. In fact, common sense suggests it shouldn’t. With the economic upturn so widely expected, it should be already embedded into prices. You don’t need to subscribe fully to the efficient markets hypothesis to believe that some things should be discounted by markets in advance.
One fact bolsters this suspicion. Before the mid-90s, there was no significant correlation between output growth and equity returns – perhaps because the factors which have since caused the two to move together were weaker then.
All this should worry equity investors because if economic recovery won’t raise prices it’s not clear what will. Valuations aren’t great: the dividend yield on the All-Share index (traditionally a great predictor of returns) is only around its long-term average. And some predictors of returns, such as the ratio of the global money stock to share prices, are sending a bearish signal.
We do, however, have one reason for hope. It comes from the market in American houses with swimming pools.
Yes, really. A study of this by Brigham Young University’s Jaren Pope and colleagues has found that houses with pools sell at higher prices in the summer than in the winter. This, they say, is because people fail to appreciate that their tastes will change. In hot months, people like the idea of a swimming pool and fail to anticipate that in the winter it will be just a liability. So they pay too much for houses with pools. Conversely, in winter, people see the liability and fail to anticipate that the pool will be nice in the summer. This is an example of what Harvard University’s Matthew Rabin calls the projection bias: we project our current tastes into the future, and fail to see that they’ll change even if it is obvious that they will.
Why is this a reason for optimism about equities? Simple. It suggests that even though investors are anticipating an economic recovery they might not be anticipating that this recovery will increase their appetite for risk. To the extent that they are not doing so, the fact of the recovery – when it comes – should raise prices.
So yes, we can be optimistic. Sadly, however, this is only the case if investors are systematically irrational.