Successful Nations Invest Heavily and Wisely

The most basic formula in economics

GDP is the sum of spending by consumers and government plus investment and net exports.

GDP = (C+G) + (I+X)

Investment (I) reveals the most about where the economy is heading.  Without investment, there would be no money for government and consumers to spend.  Investment includes total investment by both the government and private business.    Investment helps create the new businesses and jobs that put money in consumers' pockets.

Consumption is typically by far the largest share of the spending in the economy - more than half.  Investment is usually much smaller, around 20% of GDP in developed economies and 25% in developing economies, give or take.

Investment is the most important indicator of change

Investment is by far the most important indicator of change, because booms or busts in investment typically drive recessions and recoveries.  In the U.S., investment is 6 times more volatile than consumption, and during a typical recession it contracts by more than 10%, while growth in consumer spending merely slows down.

Successful nations versus those facing weak prospects

In successful nations, investment is generally rising as a share of the economy.  When investment is rising , economic growth is much more likely to accelerate.

Any emerging country is generally in a strong position to grow rapidly when investment is high - roughly between 25% and 35% of GDP - and rising.

On the other hand, economies face weak prospects when investment is low, roughly 20% of GDP or less - and falling.   

Much of what makes the emerging world feel chaotic reflects a shortage of investment in the basics.  

In developed economies, investment spending tends to be lower because basic infrastructure is already built.  So pay less attention to the level of spending as a share of GDP and more to whether is is rising or falling.   

Strong growth in investment is almost always a good sign, but the stronger it gets, the more important it is to track where the spending is going.  

Good and bad investment binges.

The best binges unfold when companies funnel money into projects that fuel growth in the future:  new technology, new roads and ports, or especially, new factories.  

Of the 3 main economic sectors - agriculture, services and manufacturing - manufacturing has been the ticket out of poverty for many countries.    

No other sector has the proven ability to play the booster role of job creation and economic growth that manufacturing has in the past.

As a nation develops, investment and manufacturing both account for a shrinking share of the economy, but they continue to play an outsize role in driving growth. 

An investment binge can be judged by what it leaves behind.  

Following a good binge on manufacturing, technology, or infrastructure, the country finds itself with new cement factories, fiber-optic cables, or rail lines, which will help the economy grow as it recovers.  

Bad binges - in commodities or real estate - often leave behind trouble.

• Investment does little to raise productivity when it goes into real estate, which has other risks as well:  it is often financed by heavy debts that can drag down the economy.   
• When money flows into commodities like oil, it tends to chase rising prices and evaporate without a trace as prices collapse.  

So, while investment booms are often a good sign, it matters a great deal where the money is going.

 

Measuring and Monitoring Overheating economy and Slowing economy

Interest rates and Money supply

Interest rates and money supply are the major tools the Fed and other central banks have traditionally used to control economic growth; the key is in how the tools are applied.

A country's economy is regulated by its money supply, which determines interest rates.  And each country's money supply is controlled by its central bank.  These quasi-public institutions are set up by governments but are then given the independence to keep an economy under control without undue interference from dabbling politicians.

How to measure and monitor growth and inflation in an economy?

Despite the tendency of the media to concentrate on the latest major economic statistic, such as GDP growth or unemployment, there is no one single indicator that tells us 

• how fast an economy is growing or 
• if that growth will lead to inflation down the road.

In addition, there is no way to know how quickly an economy will respond to changes in monetary policy.  

• If a country's central bank allows the economy to expand too rapidly - by keeping too much money in circulation, for example - it may cause bubbles and rampant inflation.  
• But if it slows down the economy too much, an economic recession can result, bringing financial turmoil and severe unemployment.  
• When economic stagnation coincides with high inflation, sometimes referred to as stagflation, a worst-case scenario is created.

Central bankers, therefore, need to be prescient and extremely careful - keeping 

• one eye on inflation, which is usually a product of an overheating economy, and 
• one eye on unemployment, which is almost always the product of a slowing economy.

In the twenty first century, with the amount of capital flowing around the world dwarfing many countries' money supplies, it is almost impossible to know with certainty what the effect of any one monetary decision will have on a local economy, let alone on the world.

Fiscal policy or Massive deficit spending

Given the extremely low inflation rates in the 2010s, some have called for alternative methods for controlling economic growth.  Instead of using the central banks' authority to raise tor lower interest rates, referred to as "monetary policy," another solution would be to use "fiscal policy" to alter the money supply - essentially allowing governments to circumvent central banks by printing massive amounts of money to increase the money supply, for example.  

The use of a government's ability to issue new currency to influence economic growth, commonly referred to as Modern Monetary Theory (MMT), is not unproblematic in that inflation can come roaring back at a moment's notice.  

Many governments may misuse the power of MMT to pay for massive deficit spending in ways that lack the prudent guidance provided by the world's central banks.

Unforeseen and unpredictable events

Sometimes financial crises are caused by - and sometimes solved by forces -  entirely unconnected to the original problem.  

Most of the recent financial meltdowns, 

• from the stock market crash of 1987, 
• to the bursting of the dot-com bubble in 2000, 
• to the market collapse following the terrorist attacks of September 11, 2001, 

were exacerbated by economic and sociopolitical forces well outside the control of any one country and greatly affected markets around the world.

Market value, business value, Short-term & Long-term Market Returns and the effects of GDP Growth

Long-term stock market growth (by most measures of return, 10-11% annually) can be explained by adding together the following:

• GDP growth of 3 to 5%
• Productivity growth of 1 to 2%
• Long-term inflation in the 3 to 6% range

In the short-term, depending on the value of alternative investments, such as bonds, real estate, and so on, market value may actually rise faster or slower than business value. And inflation also tampers with market valuations.

So can markets grow at 20% per year? 

Not for long. It isn't impossible for the markets to rise 20% in a given year or two, but such growth year after year is hard to fathom if the economy at large is growing at only 3 to 5% annually. 

But for a particular stock? 

Sure, it's possible. If the company is building a new busines or is taking market share from existing businesses, 20% growth can be quite realistic.

But forever? 

Doubtful. Some call this "reversion to the mean" - sooner or later, gravitational forces will take hold and a company will cease to grow at above-average rates. As an investor, you must realistically appraise when this will happen. 


GDP

You can and should expect, in aggregate, that the total value of all businesses would rise roughly in line with the increase in the size of the economy, as represented by gross domestic product (GDP). This is true.

Business value grows further through increases in productivity.

The value of market traded businesses could rise still more if the businesses grew their share of the total economy - as Borders Group and Barnes and Noble have grown their share of the total book selling business in the previous decade.



Main point:  
Business value and market value of a company grow further through increases in productivity (better profit margins) and through growing its market share (higher revenues).

GDP Growth and Market Return

Economic Growth: Great for Everyone but Investors?

While it may be intuitive to presume strong economic growth translates into strong stock market performance, the evidence suggests otherwise.

By Alex Bryan | 12-19-12

By 2050 the world's population is projected to reach 9 billion, up from 7 billion today. Nearly all of that growth will come from emerging markets, where living standards are rapidly improving. Although these markets have experienced large capital inflows, they still have a long way to go to match developed countries' levels of capital and wages. Consequently, emerging markets will likely continue to grow faster than developed markets for the foreseeable future. While this growth may lift hundreds of millions out of poverty and spur investment and innovation, evidence suggests investors may be left behind.

About the Author

Alex Bryan is a fund analyst with Morningstar.

Contact Author | Meet other investing specialists

Jay Ritter, a professor at the University of Florida, documented a negative relationship between economic growth and stock market returns in his seminal research paper, "Economic Growth and Equity Returns," published in 2005. Ritter's findings are no fluke. Using real gross domestic product data from the Penn World Tables and stock market returns, as proxied by the total return version of each market's MSCI country index, I found a weak negative correlation between GDP growth and stock market returns for 41 countries from 1988 to 2010. This relationship is plotted in the chart below. However, excluding China (the outlier at the bottom right of the chart) brings the correlation close to zero.

While the strength of these relationships is sensitive to the start and end dates of the sample period, the general findings are fairly robust over long time horizons. It's clear that higher economic growth does not necessarily translate into superior stock market returns over the long run.

Reasonable Assumptions?

This result should not be surprising given the strong assumptions that would be required to make the jump from GDP growth to stock market returns. In order for this relationship to hold, corporate profits as a share of GDP and valuation ratios would need to remain stable over time. Second, current shareholders' ownership stake of total corporate profits would also need to remain constant. In other words, there should be no dilution from new share issuance, private and public companies would need to grow at the same rate, and there could be no new enterprises or initial public offerings. All existing publicly listed companies would also need to generate substantially all of their revenue and profits from the domestic economy.

The Link Between Economic Growth and Profitability

In a closed economy, it would be reasonable to expect that total corporate profits would grow at a similar rate as the economy in the long run. Although the share of corporate profits relative to GDP fluctuates over time, it tends to revert to the mean. Profits cannot persistently grow faster than the economy because they would crowd out all other economic activity and attract new competitors. Similarly, total corporate profits should not grow slower than the economy in the long run, as firms exit unprofitable businesses, allowing those remaining to preserve margins. Of course, it is inappropriate to assume that any country United States investors have access to is closed. The largest companies listed in most countries tend to be multinational firms that generate a large portion of revenue and income outside their host country. For instance, the constituents of the S&P 500 generate close to 40% of their profits outside the U.S. This international exposure means that profits can grow at a different rate than the domestic economy, even in the long run.

Even if aggregate corporate profits grow in sync with GDP, dilution can prevent shareholders from enjoying the benefits of growth. Creative destruction is essential to economic growth. In aggregate all companies that are publicly listed today will grow slower than the economy because new entrants drive much of that growth. Between the time these new companies are launched and publicly listed, their growth dilutes most investors' ownership interest in the economy. Flagrant dilution of corporate earnings through employee stock grants and seasoned offerings is also a very real risk, particularly in developing countries with a tradition of poor corporate governance. Additionally, earnings growth can only create value if it allows firms to generate returns that exceed their cost of capital. High reinvestment rates may enhance both corporate and domestic economic growth but destroy shareholders' wealth through inefficient capital allocation.

Is Growth Already Priced In?

Growth expectations influence stock market valuations. Valuations are rich when investors expect strong growth. However, as developing economies mature, their growth rates slow and valuations tend to decline. Consequently, even when countries realize their expected growth rates, their stock markets may not keep pace.

The impact of lofty growth expectations on valuations can create a treadmill effect, whereby fast-growing economies must realize high growth in order to generate a competitive rate of return. For example, in the mid-1980s the so-called Asian tigers had experienced two decades of rapid growth and investors had high expectations for future growth. In contrast, several countries in Latin America were facing severe inflation, a debt crisis, and low expectations for future growth. As a result, according to research published by Peter Blair Henry and Prakash Kannan in "Growth and Returns in Emerging Markets," in 1986 Latin American stock markets were trading at 3.5 times earnings, while the Asian markets were trading at 18.3 times earnings. Over the next two decades, Latin American stock markets posted more than twice the annualized returns as the Asian markets, despite experiencing lower GDP growth over that horizon. This was because Latin American countries implemented economic reforms that allowed them to exceed investors' low expectations. Conversely, the Asian markets performed in line with investors' high expectations, which were already priced in.

What's an Investor to Do?

In order to benefit from economic growth, investors must identify markets that have the potential to exceed expectations. Russia may fit the bill. The Russian equity market, as proxied by  Market Vectors Russia ETF (RSX), is trading at a paltry 5.6 times forward earnings, making it the cheapest of any major emerging market. Corruption and a taxing regulatory environment have stunted the country's growth and depressed valuations. However, if (and this is a big if) Russia adopts structural reforms similar to those undertaken in Latin America over the past two decades, it could offer investors rich rewards--albeit with high risk.

Even if fast-growing emerging markets do not offer superior risk-adjusted stock market returns, they can provide significant diversification benefits. Over the past 20 years, the MSCI Emerging Markets Index and S&P 500 were only 0.73 correlated. Emerging-markets equities may also offer a long-term hedge against a weakening U.S. dollar.

http://news.morningstar.com/articlenet/article.aspx?id=578607

Country P/E Ratios and GDP Growth

Jun. 23, 2010



If you take stock markets' price to earnings ratio and divide it by their expected growth, then interestingly China and Russia, two of the BRICs turn up as the cheapest stock markets based on this PEG (PE/Growth) method. Obviously growth estimates can be wrong, but this at least opens up the debate:

Bespoke:
Above are the PEG ratios for 22 countries around the world. For each country, we use the trailing 12-month P/E ratio for the index shown as well as estimated 2010 GDP growth. As shown, Russia and China have the lowest country PEG ratios at 1.86 and 1.90, respectively. Russia has a very low P/E at 8 and decent estimated GDP growth at 4.3%. China, on the other hand, has a rather high P/E ratio at 19.24, but its GDP growth is also very high at 10.10%. The US is right in the middle of the pack with a PEG of 5.07. Our neighbors to the south rank just above the US with a PEG of 3.85, while our neighbors to the north rank just below the US at 5.67.

http://www.businessinsider.com/russia-is-the-cheapest-market-based-on-growth-2010-6#ixzz0w02Qccax


----

January 28, 2010




Many investors use the PEG Ratio as a valuation tool these days because it puts a company's growth prospects into perspective along with the widely followed price to earnings ratio. The PEG ratio is the P/E Ratio over the Growth Rate, and a PEG of less than one is generally considered good.

In this regard, Bespoke created "PEG" ratios for a number of countries using the P/E ratio of each country's main equity market index along with 2010 estimated GDP growth rates. Just as with stocks, the lower the country PEG, the more attractive.

As shown, India has the best PEG out of the countries we analyzed. It has a P/E ratio of 26.19 and estimated 2010 GDP growth of 8%. While its P/E isn't as low as a lot of countries, its growth rate is very high. China ranks 2nd with a PEG of 3.66.

The U.S. ranks in the middle of the pack with a P/E of 24.53 and estimated GDP growth of 2.6%.

At the bottom of the list sits Switzerland, Italy, and the UK, while Australia, Japan, and Spain have negative PEGs due to either a negative P/E Ratio or negative estimated GDP growth.


http://protect-your-assets.blogspot.com/2010/01/country-pe-ratios-and-gdp-growth.html

Bullbear Stock Investing Notes

Economic PEG = (P/E) / (100*GDP growth)

Buffett (1992): Short-term market forecasts are poison and worthless.

Short-term market forecasts are poison and worthless. Over the long-run, share prices have to follow growth in earnings and anything more could result in a sharp correction.




Warren Buffett's 1992 letter to shareholders discussed his thoughts on issuing shares. Let us see what other nuggets he has to offer.

We have for long been a supporter of making long-term forecasts with respect to investing and we are glad that we are in extremely good company. For even the master thinks likewise and this is what he has to say on the issue.

"We've long felt that the only value of stock forecasters is to make fortunetellers look good. Even now, Charlie and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children. However, it is clear that stocks cannot forever overperform their underlying businesses, as they have so dramatically done for some time, and that fact makes us quite confident of our forecast that the rewards from investing in stocks over the next decade will be significantly smaller than they were in the last. "

The above lines were most likely written by the master in the early days of 1993, a year which was bang in the middle of the best ever 17 year period in the US stock market history i.e. the years between 1981 and 1998. However, this period did not coincide with a similar growth in the US economy. Infact, the best ever stretch for the US economy was a 17-year stretch, which started around 17 year before 1981 and ended exactly in 1981. Courtesy this economic buoyancy and the subsequent lowering of interest rates, the corporate profits started looking up and they too enjoyed one of their best runs ever. Thus, a period of buoyant GDP growth was followed by a period of strong corporate profit growth, which in turn led to increase in share prices. However, share prices grew the fastest because they not only had to grow in line with the corporate profits but also had to play catch up to the economic growth that was witnessed between 1964 and 1981.

Another extremely important factor that led to a more than 10 fold jump in index levels in the period under discussion had psychological origins rather than economic. Investors have an uncanny knack of projecting the present scenario far into the future. And it is this very habit that made them believe that stock prices would continue to rise at the same pace. However, nothing could be further from the truth. Over the long-run, share prices have to follow growth in earnings and anything more could result in a sharp correction. Thus, while the share prices can play catch up to economic growth and corporate profits and hence can grow faster than the two for some amount of time, expecting the same to continue forever, could be a recipe for disaster. And even the master concurs.

We believe similar events are playing themselves out in the Indian stock markets with investors expecting every stock to turn out to be a multi bagger in no time. But as discussed above, this could turn out to be a proposition, which is full of risk of a permanent capital loss. Investors could do very well to remember that over the long-term share prices would follow earnings, which in turn would follow the macroeconomic GDP and this could be a very reasonable assumption to make.

http://www.equitymaster.com/detail.asp?date=12/13/2007&story=3

Basic Knowledge for International Investing

Evaluating Country Risk For International Investing
http://myinvestingnotes.blogspot.com/2009/12/evaluating-country-risk-for.html

Malaysia's economy stagnant, needs reform
http://myinvestingnotes.blogspot.com/2009/12/malaysias-economy-stagnant-needs-reform.html


Economics Basics: What Is Economics?
http://myinvestingnotes.blogspot.com/2009/12/economics-basics-what-is-economics.html

What is GDP and why is it so important?
http://myinvestingnotes.blogspot.com/2009/12/what-is-gdp-and-why-is-it-so-important.html

What Is The Balance Of Payments?
http://myinvestingnotes.blogspot.com/2009/12/what-is-balance-of-payments.html

Understanding The Current Account In The Balance Of Payments
http://myinvestingnotes.blogspot.com/2009/12/understanding-current-account-in.html

Current Account Deficits: Government Investment Or Irresponsibility?
http://myinvestingnotes.blogspot.com/2009/12/current-account-deficits-government.html

What is a trade deficit and what effect will it have on the stock market?
http://myinvestingnotes.blogspot.com/2009/12/what-is-trade-deficit-and-what-effect.html


What is RISK? Equity investment is the most risky investment in all the financial markets.
http://myinvestingnotes.blogspot.com/2009/12/what-is-risk-equity-investment-is-most.html

Long-term Stock Market Growth and GDP

A stock market represents the sum total of the public's perception of the business value of the companies trading in that market.

True business value, is the sum total of productive assets and, in particular, what those assets produce in the form of current and future earnings.

As long as companies produce more, it makes sense that their values rise.

And as long as the public perception matches true value, the stock value rises in lockstep.

GDP

You can and should expect, in aggregate, that the total value of all businesses would rise roughly in line with the increase in the size of the economy, as represented by gross domestic product (GDP). This is true.

Business value grows further through increases in productivity.

The value of market traded businesses could rise still more if the businesses grew their share of the total economy - as Borders Group and Barnes and Noble have grown their share of the total bookselling business.

Long-term stock market growth (by most measures of return, 10-11% annually) can be explained by adding together the following:

GDP growth of 3 to 5%
Productivity growth of 1 to 2%
Long-term inflation in the 3 to 6% range

In the short-term, depending on the value of alternative investments, such as bonds, real estate, and so on, market value may actually rise faster or slower than business value. And inflation also tampers with market valuations.

So can markets grow at 20% per year?

Not for long. It isn't impossible for the markets to rise 20% in a given year or two, but such growth year after year is hard to fathom if the economy at large is growing at only 3 to 5% annually.

But for a particular stock?

Sure, it's possible. If the company is building a new busines or is taking market share from existing businesses, 20% growth can be quite realistic.

But forever?

Doubtful. Some call this "reversion to the mean" - sooner or later, gravitational forces will take hold and a company will cease to grow at above-average rates. As an investor, you must realistically appraise when this will happen.

What is GDP and why is it so important?

Investment Question
What is GDP and why is it so important?

The gross domestic product (GDP) is one the primary indicators used to gauge the health of a country's economy.

It represents the total dollar value of all goods and services produced over a specific time period - you can think of it as the size of the economy. Usually, GDP is expressed as a comparison to the previous quarter or year. For example, if the year-to-year GDP is up 3%, this is thought to mean that the economy has grown by 3% over the last year.

Measuring GDP is complicated (which is why we leave it to the economists), but at its most basic, the calculation can be done in one of two ways: either

• by adding up what everyone earned in a year (income approach), or
• by adding up what everyone spent (expenditure method).

Logically, both measures should arrive at roughly the same total.

The income approach, which is sometimes referred to as GDP(I), is calculated by adding up total compensation to employees, gross profits for incorporated and non incorporated firms, and taxes less any subsidies.

The expenditure method is the more common approach and is calculated by adding total consumption, investment, government spending and net exports.

As one can imagine, economic production and growth, what GDP represents, has a large impact on nearly everyone within that economy. For example, when the economy is healthy, you will typically see low unemployment and wage increases as businesses demand labor to meet the growing economy.

A significant change in GDP, whether up or down, usually has a significant effect on the stock market. It's not hard to understand why: a bad economy usually means lower profits for companies, which in turn means lower stock prices. Investors really worry about negative GDP growth, which is one of the factors economists use to determine whether an economy is in a recession.

For more on this topic, see this section of our Economic Indicators tutorial and the article Macroeconomic Analysis.

http://www.investopedia.com/ask/answers/199.asp?ad=feat_fincrisis