Using the Stock Market to Predict GDP?

A reader asked: “I recently read where David Rosenberg, former chief economist at Merrill Lynch, now chief economist at Gluskin Sheff, indicated that the stock market is pricing 4.25% GDP growth. How would one use the stock market to understand the GDP growth that is priced into it?”

You could connect the level of the stock market to Gross Domestic Product (GDP) growth with the following two assumptions:

1. The level of the stock market derives fundamentally from expected aggregate corporate earnings. The level of the stock market therefore reveals the aggregate earnings growth expected by investors.
2. In an economy that is predominantly capitalistic (government sector fairly small) with much of the capital supplied via corporate stock, the aggregate earnings growth of publicly held corporations (the stock market) and GDP growth must be closely related. (For example, see the arguments in “One Up on the Fed Model?” and “The Required Yield Theory of Asset Valuation”.)

From the first assumption, you could infer the expected aggregate earnings growth rate by postulating a “typical” price-to-forward earnings ratio for the overall stock market.

Then, from the second assumption, you could say that this expected aggregate earnings growth rate and the expected GDP growth rate must match. Alternatively, you could use a regression on historical data to estimate a linear relationship between aggregate earnings growth and GDP growth and use that relationship to calculate an expected GDP growth rate from an expected aggregate earnings growth rate.

For some idea of how unreliable this process might be, see “GDP Growth and Stock Market Returns”. It is arguable that there is too much emotion in the pricing of stocks for the above approach to be useful.

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