Money flow drives markets

There isn’t much that can be said with absolute certainty about stockmarkets. But one thing history makes very clear is that there is no positive correlation between the performance of the stockmarket of a country and its GDP growth.

Instead, the statistics go so far as to suggest that there might be a negative correlation: markets do better in slower growing economies than in faster growing economies.

Examples of this aren’t hard to find. Look at Japan up until the 1970s. It was growing at a good 10% a year. But its stockmarket – aside of a few ups and downs – did very little.

The real market boom (and then bubble) in Japan came later – when growth slowed to more like 5%. Why? The market was cheap.

But at the same time, with breakneck growth over, attention turned more to wages, to consumption and to profit generation, while lower investment by companies meant hopes of slightly higher dividends.

You can argue (quite rightly) that all these things need a tad more attention now, but markets turn more on change – which drives money flows – than they do on actual success.

This brings me to China, the other classic example of the irrelevance of economic growth to stockmarkets: over the last 30-odd years of super-fast growth, a conventional portfolio of Chinese stocks would have returned you very little.

But here’s the interesting thing. That’s changed. Everyone agrees that Chinese economic growth has slowed to at least 7% (and probably 5%), but the stockmarket is up not far off 20% this year.

You can read Hugh Hendry’s views on this in our interview with him, but the argument is much as it was in Japan all those years ago: stocks are reasonably cheap, and focus is shifting from fast growth to the kind of growth that drives stockmarket returns.

The other thing to bear in mind is that over and above everything else, it is money flow that drives markets. That’s another reason to think about China: this week, restrictions on how foreigners can invest in the domestic stockmarket were partially lifted. The result? Over $2bn poured in.

Today, the negative correlation between the performance of economies and the performance of stockmarkets is massively exaggerated by quantitative easing (QE): the worse an economy does, the more we get and the more stocks rise. That could mean even more of a boost for China at some point.

It also brings us back to Japan – a country that today is home to both the slowest GDP growth and the greatest stockmarket experiment in the developed world.

Finally, for more on how markets can easily become disconnected from fundamentals, do read our property round table. Are we at the beginning of a great cycle of property price rises in the UK, or at the end?