Summary
- Economists project real GDP growth for 2024 around 1.5%, while analysts expect the S&P 500 (SPX) to be up 6.5-8% on an 11% rise in earnings.
- That seems incongruous, but history suggests that there is little relationship between GDP growth and equity returns.
- For what it is worth, equity returns have skewed either high (10%+) or low (<0%) in this economic environment.
- The risk for equities comes not from a soft economic outlook but high valuations based on optimistic earnings outlooks and hopes for rate cuts.
Market Implications
- Far more important for investors is Q4 2023 earnings season, revised earnings forecasts for 2024 in mid-February, and the evolving inflation outlook and likely Federal Reserve (Fed) response.
- The super-charged rally in the Russell 2000 (or ETF IWM) has probably run its course for now but we still like it as a medium-term hold.
Equity Forecasts Defy Slow GDP Outlook
As we roll into the new year, the Fed expects a real GDP growth of 1.3% in 2024, down from a respectable 2.3% in 2023. Other forecasters are in the 1.5% range. For our purposes, we call it 1-2%.
Meanwhile, equity market mavens predict the S&P 500 will rise about 6.5-8% to the 5,000- 5,100 range with earnings growth of
Do these forecasts jive with each other? Like many other answers in the realm of economics and finance, it depends.
Something for Everyone…
There is a rough and ready relationship between year-over-year GDP growth and SPX returns (Chart 1) [1]. As GDP grows faster, SPX returns tend to rise. But the R^2 is a paltry 0.14, implying no meaningful correlation. Indeed, SPX returns are highly dispersed. Most of the GDP observations are in the 1-5% range, but SPX returns range from -20% to over 20%.[2]
The regression equation implies that SPX returns range from 2.9-5.1% for real GDP growth of 1% and 2%, respectively, or a bit slower than forecasters project.
Digging deeper, there are 35 observations where GDP is in the 1-2% range (Table 1, boxed). SPX returns during those periods skew either high or low – 40% are greater than 10%, 43% are less than zero. Only 17% fall in the range of forecasters’ expectations.
In other words, those forecasts seem to fall into a meaningless average of high and low estimates.
Other insights from Table 1:
- High SPX returns are unlikely for GDP growth of less than 1% – but only increase materially when GDP exceeds 4%. Even then, one-third of observations are less than 5%.
- Looking across all GDP growth scenarios (far right column), SPX returns tend to be either less than zero or over 10%; middle ground returns account for only a quarter of all observations.
- This breakout highlights again how dispersed equity returns are across GDP growth scenarios.
Earnings Show Little Link to GDP Growth
What about earnings? Do 12-month trailing earnings track GDP growth in a meaningful way? Based on data since 1955, apparently not (Chart 2). The R^2 is 6% – even lower than SPX returns. In our target 1-2% GDP growth range, 12-month trailing earnings have been up over 20% and down more than 10%. The regression equation implies earnings growth of 3.6-5.1% in that growth scenario – far short of the 11% analysts now project.
Analyst Forecasts Tend to Be Reliable
Analysts’ earnings projections for the year ahead tend to be very good if there are no unexpected disruptions, such as a recession or pandemic. That is, 12-month trailing earnings tend to converge to forecasted year-ahead earnings. Clearly, the GDP growth outlook is a minor factor in producing earnings forecasts.
We are inclined to pay more attention to the earnings forecasts than the results of Chart 2 – with the proviso that earnings projections for 2024 will likely be revised in mid-February after Q42023 earnings season is largely finished.
Forget GDP – What to Watch For
Economist and New York Times columnist Paul Krugman is fond of pointing out that the stock market is not the economy. This effort to identify links between GDP growth and SPX returns certainly bears that out. Clearly, equity returns and company earnings are not key inputs to GDP.
Given that the GDP growth outlook is around 1.5%, it is particularly difficult to parse what that might mean for equities. As we have seen, returns in that scenario skew high or low.
One issue that could depress returns in 2024 is that equities are already trading at historically high P/E valuations (Chart 3). Investors are pricing in a veritable Goldilocks outlook of robust earnings and rate cuts. If they face disappointment on either of these fronts, valuations will likely downshift.
Until or unless there is a meaningful change in the GDP outlook, equity returns will depend on other factors, including:
- Q42023 earnings and company outlooks.
- Earnings projections for 2024, due around mid-February.
- The evolving inflation outlook and the Fed’s likely response.
- A continued robust labour market.
[1] This analysis is based on rolling quarterly year-over-year real GDP growth and SPX returns beginning in 1947.
[2] Arguably, equity returns are forward looking. We ran the analysis comparing SPX returns with GDP one and two quarters forward. The R^2 improved to 26% – not enough to change our conclusions.
Over a 30-year career as a sell side analyst, John covered the structured finance and credit markets before serving as a corporate market strategist. In recent years, he has moved into a global strategist role.