Stock market fluctuations often seem far removed from what’s happening in the wider economy, especially in a crisis. But historically, share prices have been able to explain some changes in key economic measures and they could hold clues for the UK’s post-pandemic recovery.
Fluctuations in the prices of financial assets in the stock market can sometimes seem to be inconsistent with what is happening in the rest of the economy – what’s sometimes referred to as the ‘real economy’.
For example, in 2020, US GDP fell by 3.5% – the largest contraction since the end of the Second World War (Furman and Powell, 2021). But the S&P 500 – a weighted index used to measure the US stock market – increased substantially during this period, more than recovering any temporary losses and ending the year 15% higher than its pre-pandemic level.
How do we explain this apparent disconnect?
Economic news and the stock market
The market value of a company should reflect how much cash investors believe the firm will make in the future. If changes in the broader economy are likely to affect company performance, then this should lead to changes in share prices. But it is important to emphasise that investors will consider not only what is happening now, but also what is likely to occur in the future.
Research has shown that a considerable proportion of the variation in share prices can be explained by key economic variables such as industrial production, inflation and interest rates, as well as changes in the dividends that companies pay to shareholders (Cutler et al, 1988). The evidence suggests that expectations about future changes in the economy play an important role in current pricing, although there may be some feedback effects involved, as changes in the stock market may actually cause changes in the wider economy.
But it has been has argued that share prices fluctuate more than they should – they exhibit ‘excess volatility’ (Shiller, 1981). What this means is that asset prices fluctuate more than is justified by changes to the fundamental characteristics of the underlying companies, which suggests that share prices may not always predict accurately what will happen in the future.
Prices are also affected by changes in the interest rate that is used to ‘discount’ future cash flows (Cochrane, 2011). Again, this means that prices may not necessarily reflect only predictions about company growth.
Historical experiences
An analysis of historical returns on stock market investments and GDP growth suggests that there is not always a close contemporary relationship. Table 1 shows the ten largest declines and increases in asset markets worldwide since 1870, using data compiled by Jorda et al (2017, 2019).
Major stock market crashes have typically been associated with extreme events such as defeat in the Second World War (Japan, Italy), monetary concerns (Germany in 1924 and 1948) or financial crisis (Belgium, Norway and Finland). Some of these episodes also saw large declines in GDP, but in other cases there was actually positive growth in output that year.
Many of the largest stock market increases seem to reflect recoveries from previous declines (Germany in the 1920s and 1949, Italy in 1946 and the UK in 1975), or unique factors such as Nokia’s dominance of the Finnish market during the ‘dot-com’ boom of 1999. During these periods of strong price increases, GDP growth has tended to be positive, but the scale of the changes in the stock market were typically much greater than those in GDP.
Table 1: Largest annual changes in equity returns versus GDP growth
| Year | Country | Equity Returns | GDP Growth | Year | Country | Equity Returns | GDP Growth |
| 1945 | Japan | -90.3% | -21.7% | 1999 | Finland | 163.6% | 3.7% |
| 1948 | Germany | -90.0% | 17.0% | 1923 | Germany | 149.7% | -13.7% |
| 1924 | Germany | -87.4% | 10.8% | 1926 | Germany | 136.1% | 0.6% |
| 1945 | Italy | -72.9% | -22.0% | 1949 | Germany | 121.3% | 19.1% |
| 1918 | Finland | -60.8% | -13.3% | 1886 | Japan | 120.6% | 8.0% |
| 2008 | Belgium | -57.9% | 0.0% | 1946 | Italy | 120.5% | 25.2% |
| 1974 | UK | -57.0% | -1.4% | 1954 | France | 115.9% | 4.4% |
| 2008 | Norway | -55.7% | -0.8% | 1975 | UK | 103.4% | -0.6% |
| 1947 | Italy | -54.5% | 13.9% | 1951 | Germany | 102.3% | 8.6% |
| 2008 | Finland | -53.1% | 0.3% | 1919 | Belgium | 101.0% | 23.2% |
Notes: Calculated from Jorda et al (2017, 2019). Equity returns and GDP growth are both expressed in real terms after controlling for inflation.
Expectations about the future
The stock market and the real economy may not move together at the same time if investors think that something might change in the future. One way to explore the role of expectations is to analyse whether changes in share prices can predict what might happen next.
Table 2 shows the correlation between GDP growth and returns on investments. The percentages (R2 values) listed in the table illustrate the extent to which share prices can explain subsequent growth in the real economy, with an R2 of 100% suggesting that changes in share prices perfectly explain GDP changes, while an R2 of 0% indicating no explanatory power. The results are shown for different countries and different time periods, using data from Jorda et al (2017, 2019).
Table 2: How much of GDP growth is explained by the current and past three years of equity returns?
| Country | 1870-1913 | 1914-1945 | 1946-1976 | 1977-2017 |
| Australia | 9% | 12% | 39% | 21% |
| Belgium | 42% | 38% | 24% | 36% |
| Denmark | 15% | 20% | 38% | 42% |
| Finland | 19% | 55% | 39% | |
| France | 10% | 33% | 7% | 34% |
| Germany | 13% | 4% | 35% | 31% |
| Italy | 34% | 24% | 42% | 32% |
| Japan | 9% | 43% | 15% | 29% |
| The Netherlands | 9% | 40% | 53% | |
| Norway | 26% | 18% | 4% | 34% |
| Portugal | 13% | 6% | 32% | 57% |
| Spain | 30% | 34% | 53% | |
| Sweden | 16% | 31% | 24% | 48% |
| Switzerland | 34% | 32% | 26% | |
| UK | 22% | 12% | 33% | 30% |
| US | 53% | 16% | 54% | 37% |
| Average | 22% | 22% | 32% | 38% |
Notes: Calculated using data from Jorda et al (2017, 2019). Uses R2 from regression explaining GDP growth in terms of current and past three years of equity returns.
There is considerable variation across countries for different periods. But on average, previous equity market returns have been a fairly good predictor of future economic growth. In the period before 1913 and in the period up to 1945, returns explained an average of about 22% of GDP growth, rising to 32% in the period to 1976 and 38% thereafter. This suggests that for all periods, particularly recently, there is evidence that stock market movements at least partially predict future changes in economic output.
What are the implications?
Figure 1 illustrates the returns on various stock market measures from before the Covid-19 pandemic began to the end of April 2021. The historical relationship between equity returns and future GDP suggests that these changes in the stock market may be a useful indicator of what might happen in the real economy.
Figure 1: Equity returns (31 December 2019 to 30 April 2021)
Notes: Data from Bloomberg and MSCI country stock market indices. Returns expressed in terms of local currencies and include dividends.
The strong increases that have been observed in share prices over the past year in the United States and China suggest that economic output is likely to grow faster in these countries than would have been the case pre-pandemic – possibly due to fiscal and monetary stimulus from emergency policies. Additional growth is likely to be more modest in Europe, but still positive.
Despite the success of the vaccine rollout, the stock market in the UK remains below its pre-pandemic level, possibly reflecting concerns about how long it will take to make up for the losses associated with the particularly severe nature of the crisis in this country.
But the predictive power of the stock market is far from perfect and there has been considerable volatility in prices over the past year, suggesting uncertainty about the future. Historical patterns suggest that the stock market can be a useful indicator of the real economy, but we should be cautious in making bold predictions given the heightened uncertainty that has arisen due to Covid-19.
Where can I find out more?
- How do changes in asset prices affect the real economy? This post discusses how share prices may not only reflect expectations about the economy, but also have an impact on it.
- Coronavirus: Impact on Stock Prices and Growth Expectations This research paper uses data from the stock market and dividend futures to estimate investor expectations about economic growth during the pandemic.
- China is wrong to think the US faces inevitable decline: This article notes that the stock market value of a company should be a relatively impartial assessment of its prospects, and uses this information to consider the innovativeness of different companies and regions.
