Relationship between Long-run Rate of Stock Market Appreciation and Sustainable Growth Rate

Potential economic growth is vital to investors. Potential GDP is used to measure the productive capacity of an economy. Investors are always curious to know if earnings growth is attributable to the GDP growth rate. Equally, they are keen on determining if the GDP growth rate limits earnings growth.

The growth earnings exceed the GDP growth only if the ratio of corporate earnings to GDP rises over time. However, in the long run, the long-run earnings growth cannot exceed the GDP growth since the portion of the profits of the GDP cannot increase forever.

Relationship between Stock Prices and Economic Growth

The relationship between return on equities and economic growth is not straightforward. Therefore, we use Grinold-Kroner’s (2002) decomposition of the return to equity to capture the relationship.

$$ \begin{align*} {E(R_e)} &=\text{Dividend Yield}+\text{Expected Capital Gain} \\ {E(R_e)} & =\text{Dividend Yield}+\text{Expected Repricing}\\ &+\text{Earnings Growth per Share} \\ {E(R_e)} & =\text{Dividend Yield}+\text{Expected Repricing} \\ & +\text{Inflation rate} +\text{real Economic Growth} \\ & +\text{Changes in Shares Outstanding} \end{align*} $$

$$ {E(R}_e)=dy+ \Delta \left(\frac{P}{E} \right)+i+g+ \Delta S $$

The dividend yield is fairly stable and a key contributor to equity market returns. The expected return relates to P/E ratio changes in the market. Evidence suggests that increased GDP growth rates have been linked to higher P/E ratios because investors assume the country is low risk and is willing to pay higher for earnings. Earnings growth per share is the primary way economic growth can impact equity returns. The earnings growth per share can be expressed as a function of change in the number of shares traded in the market, inflation rate, and real economic growth.

Real economic growth will translate into higher expected equity returns when the number of outstanding shares remains constant. The dilution effect, \(\Delta S\), plays a crucial role in determining expected equity returns. It varies from country to country for many reasons, such as the complexity of financial markets and the development level of the economy.

The wedge between equity returns and economic growth is attributed to the following two reasons.

1. Publicly traded companies either issue new shares and dilute existing shareholders’ returns or buy back their shares and decrease the share outstanding, thus increasing the equity return. The net result of new issues and buybacks on a national level is measured by the Net buybacks (NBB).
2. The economic growth of private small and medium-sized companies is termed relative dynamism (rd). The greater this effect, the greater the divergence between equity returns and economic growth.

Thus \(\Delta S=nbb+rd \)

Question

Which of the following factors would most likely cause the wedge between equity returns and economic growth to increase?

1. Increase in relative dynamism.
2. Decrease in net buybacks.
3. Existence of free trade.

Solution

The correct answer is A.

The greater the relative dynamism, the greater the divergence between equity returns and economic growth.

B is incorrect. This will cause less divergence between economic growth and equity returns.

C is incorrect. Most developed countries have substantially low trade barriers. Thus free trade will not have an incremental impact on the per capita GDP.

Reading 9: Economic Growth

LOS 9 (b) Describe the relationship between the long-run rate of stock market appreciation and the sustainable growth rate of the economy.