The connection between the stock market and the economy
Economists define real (inflation adjusted) growth as the sum of capital, labor and productivity growth [Growth = Capital + Labor + Productivity]. Real growth is thus constrained by the supply of labor, technological advancement, and the formation of capital.
Out of these terms, labor is the largest constraint because it takes two decades to create, grow and educate a new worker. The best predictor of real growth is the investment level – which is the formation of capital. The component of real growth that labor and capital growth does not explain is assumed to be productivity gains/losses.
Change in investment has historically explained 76% of quarterly change in real growth (Figure 1). The real question is what drives investment? We turn to financial markets to find the answer. The Equity Risk Premium (ERP), which we estimate as the difference between the Earnings Yield (Earnings per Share / Price) on stocks and the Real 10y yield, has a very strong inverse correlation with the investment level in the economy (Figure 2).
The ERP is a measurement of financial market risk-aversion; the higher ERP is the larger the amount of fear in markets. The Earnings Yield is assumed to be real – that is, the pricing power of stock earnings is expected to keep up with inflation. Consequently, the ideal comparison to the Earnings Yield is the real risk-free yield. The difference between them form a minimum return equity investors demand for the additional risk of holding equities.
Holding a basket of stocks is riskier than government bonds. Turning cash into fixed assets, the act of which we define as investment, is riskier yet: it is less diversified, less liquid, requires a higher minimum investment, and much longer holding periods. For these additional risk factors, investors reasonably demand a higher return for investment in fixed assets versus financial assets(for example liquid securities).
Fixed investment follows the patterns of financial investments, and a high level of fixed investment in the economy is dependent on a low risk premium in financial investments. After all, why would any rational investor build a house to rent when he could buy one with the same cash flow expectations just as cheaply?
The inverse relationship between the Equity Risk Premium and Investment Level is strong, but there are historical divergences. One possible explanation for this is when the depreciation level expected by investors in existing capital diverges from that of newly committed capital. For instance, in the mid 2000s, the investment level became higher than the ERP would have suggested as real estate prices dramatically rose (the inverse of depreciation). This implies that investors during that period expected that depreciation in existing fixed assets would be higher than the on new investments being made at the time.
The Equity Risk Premium can help us explain one further phenomenon in the real economy: the profit level. In order to increase the sample size by several decades to capture a more complete view of the relationship, we substitute expected inflation with realized inflation as the deflator of the Earnings Yield to estimate the Equity Risk Premium (Figure 3 ).
The higher the risk premium, the higher the corporate profit level becomes. In short, the profit level competes for economic share with the investment level. Therefore, the higher the risk premium, the lower the investment, and all other things being equal, the higher the profit level.
It is often said that "the market is not the economy". While this is true, we’ve identified some linkages between the two which further prove the most important rule in finance; investors require a higher rate of return for taking on additional risk.