Question

What are the issues with using GDP growth to predict stock prices?

Answer 1

GDP consider overall growth of the economy in terms of value of goods produced. In theory the GDP growth is predicted to have a high positive correlation with the share prices. But generally stock price tend to oscillate in a range even if there is positive GDP growth continuosly.

Some of the reasons for the same are given below;

• Many major firms are highly leveraged or contains debt in their capital structure due to which value reaching to share holder will be a fraction of the company's cashflow. Whereas GDP include products and service values as a whole including that is produced through debt and equity.
• Firm specific risk, GDP is a macro indicator and this means that the market overall is positive, but it doesnt mean that all the companies are doing well or producing more. There will be n number of companies that are in loss. Even for companies that contributes to GDP there might be some firm specific risk like change in management, fraud etc which brings down the overall value.
• Share market prices are reflection of future cashflows, which mean even if the current GDP growth rate is higher, if market expect worst economic condition in coming years, share prices decreases rather than appreciating as per GDP growth.
• Eventhough GDP growth is high, governments decision on other macro economic factors like interest rate, inflation rate etc can affect share prices.

From this we can understand that, share prices doesnt only factor in GDP for its appreciation whereas it includes many factors to balance its supply and demand which creates a price equilibrium.