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Why Investors Should Stop Looking At the Economy

Here’s a quick question for you: Looking at the economic statistics for two different countries shown below and being forced to make a decision on which country would have better stock market returns over that period, which would you choose?

First, there’s Country A, which according to the World Bank, had grown its annual gross domestic product (GDP) by 7.8% in 2012. Latest readings released a month ago showed that its GDP had also expanded further by 7.7% in 2013.

Next, there’s Country B. Pulling the relevant data from the World Bank showed that the country’s annual GD had shrunk by 6.4% in 2012. The year that just passed, 2013, wasn’t kind to Country B as well as its GDP dropped again by 3.7%.

So, there you have it, the performance of the economies of both Country A and Country B over the past two years. Which would be your pick for the country with the better stock market?

As it turns out, Country A is China, whose Shanghai Stock Exchange Composite Index (or “SHSEC” for short) has fallen by 2.6% so far from 2,169 points at the start of 2012 to 2,114 today. Country B, on the other hand, is Greece. Its stock market, as measured by the Athens Stock Exchange General Index (or “ASE Index” for short), has climbed by some 85% from 674 points to 1,250 in the same period.

So, Country B has had the better stock market by far. Did the answer surprise you? Isn’t economic growth important (after all, it’s what drives corporate profits, which is in turn, what drives stock prices)?

Well, it seems there’s another more important driver of stock market returns – and that’s valuations. The ASE Index in Greece was valued at a cyclically-adjusted price earnings (CAPE) ratio of around 2 back in June 2012 and that abysmally low valuation helped propel the Greek stock market to blockbuster returns when it gained almost 150% by Oct 2013 despite its terrible GDP.

In contrast, the economy can do brilliantly and yet produce horrible stock market returns. This how China’s GDP has grown since 2008:

Year

GDP annual growth rate

2008

9.6%

2009

9.2%

2010

10.4%

2011

9.3%

2012

7.8%

2013

7.7%

Source: World Bank; Reuters

But despite such stupendous growth in China’s economy, the SHSEC has dropped by almost 60% since the start of 2008. Powerful economic growth is no panacea for stock market gains if valuations are over the roof, as the SHSEC did when it sold for almost 80 times its trailing normalised earnings (i.e. earnings that are adjusted for unusual corporate activities like merger & restructuring charges, or accounting changes etc.) at the start of 2008.

This relationship between stock market returns and valuation has also played out in Singapore. In 2009, our nation’s GDP declined by 0.8% only to see the Straits Times Index (SGX: ^STI) jump by 58% in that year to 2,898 points because of the low valuations it reached back then (for instance, the index was being sold for around 6 times earnings in March 2009).

And, if we look at individual shares, they provide even stronger examples of why valuations matter. The marine engineering firm SembCorp Marine (SGX: S51) has seen its shares decline by 15.8% since the start of Oct 2007 despite its earnings per share growing by 58%. The reason? Its shares were valued at 29 times trailing earnings back then – such high valuations meant that its eventual profit growth couldn’t be captured by commensurate share price increases.

The logistics and data centre service provider, Keppel Telecommunications & Transportation (SGX: K11), was also in a very similar situation as SembCorp Marine found itself in. Back in Oct 2007, the former carried a trailing price-to-earnings (PE) ratio of 54 and even though its earnings have grown by 38% since, its shares have fallen by 59% from S$4.46 a share back then to S$1.815 today. And again, its valuation was the key attribute for its share price decline.

In essence, the economy can be important in determining our quality of life among other things and it does receive a considerable amount of attention in the financial press. But, it’s not what’s necessarily important when it comes to determining investor’s returns in the stock market, as we’ve seen. The price investors pay, matters too.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore writer Chong Ser Jing doesn’t own shares in any companies mentioned.