Foster Group

How bad does Europe have to get before an investor should get out?

Question: “Does slow or negative economic growth in Europe guarantee poor stock returns?”

The short answer appears to be, “No”. “Really?” you ask. “It seems to me that every time there is more bad economic news out of Europe, their stock markets and ours go down.”

At a May, 2012 Vanguard investment and economic outlook conference in Chicago, Chief Investment Officer Gus Sauter was asked how concerned he was about slowing economic growth leading to lower stock market returns. Here were his basic comments.

1. Financial theory tells us that investors get rewarded for taking risk.
2. To get the returns associated with equities, investors are required to bear the risk associated with equities.
3. Nowhere in financial theory does it tell us that we are rewarded for investing in equities based on economic  growth.
4. Historically this has been demonstrated in various examples, one cited by Sauter with a comparison of the US and UK during the 20th century when:
    a. U.S. economic growth averaged 3.2% per year from 1900 to 2000, a 17 fold increase.
    b. U.K. economic growth averaged 1.8% per year from 1900 to 2000, a 7 fold increase.
    c. Equity markets in BOTH countries returned an average of 10.1% per year over the exact same 100 year period. 
5. Statistically speaking the correlation between economic growth and a country’s stock market return is zero, meaning there is no direct cause and effect relationship.

Sauter’s theoretical explanation and the historical example can seem entirely counter intuitive. I had to admit I found it both surprising and at the same time encouraging, given the current crop of economic numbers coming out of Europe. But it was Sauter’s final comment that really brought the point home. He said that stock investors should remember that ultimately they are investing in companies, not countries. And though taxes and regulations affect the marketplace, company decision makers, whether in Europe, Asia or the America’s will put practices in place to re-create and sustain profitability.

This is what occurred in 2008 and 2009 in the US and it will likely occur in some fashion throughout Europe as companies fight to survive and thrive. Of course there is no guarantee of when or even if profitability will return to individual companies. Likewise, there is no certainty as to when specific stock markets will rise. But for investors who are interested in equity returns, that uncertainty, that risk, must be accepted to some degree. Both financial theory and stock market history concur.