in China are honing in on its stock markets. These include proposals for the wider availability of short selling and the suggestion China’s pension funds should increase share purchases. Skeptics point out that while China is the world’s most rapidly growing major economy, its stock market index is lower than in 2007 and almost no higher than 10 years ago. Consequently ordinary people putting money into shares have suffered loses – a recent survey found that 86.6 percent of investors were “very dissatisfied.”
　　For three decades now China has been the world’s best performing economy. But this does not mean every individual policy enacted by its government has been a success. Of course, many policies have been effective – for example, authorities are currently implementing a great social housing program to deal with the demands of middle and low-income families. But some issues remain to be resolved, and the prevailing misinterpretation of share market dynamics is certainly one of them.
　　The central issue is simple. Many commentators appear to believe that if a country’s economy enjoys healthy growth, this will be reflected in strong share market performance. But evidence garnered internationally shows the exact opposite. Rapid economic growth leads to worsening stock performance, i.e. economic growth is negatively correlated with returns on shares. In short, China’s share market performs badly not despite rapid economic growth but because of rapid economic growth. Let’s look at the evidence and analysis.
　　Before dealing with the explanation, however, the facts should be clearly understood. This involves getting slightly more numerical than usual, but this relationship between economic growth and share prices is of such importance both for individual investors and economic policymakers that it should be clearly understood. Furthermore, because of its importance, the problem has been extensively studied. Studies have all arrived at the same conclusion.
　　Jeremy Siegel’s standard reference work, Stocks for the Long Run, surveys 200 years of share market returns and finds that “real GDP growth is negatively correlated with stock market returns. That is, higher economic growth in individual [developed] countries is associated with lower returns to equity investors. Similarly,[when] the stock returns for the developing countries against their GDP growth are plotted... there is a negative relation between returns in individual countries and the growth rates of their GDP.”
　　Dimson, Marsh and Staunton’s study Triumph of the Optimists, covering a 100-year period, found this regarding the real return on shares and GDP per capita growth: “Statistically, the correlation is -0.27 for 1900-2000 and -0.03 for 1951-2000” – i.e. the higher the economic growth rate the lower the return on shares.”
　　Ritter’s study Economic Growth and Equity Returns, regarding the relation between GDP per capita growth and share price increases, notes “My calculations for 16 countries over the 1900-2002 period arrives at a correlation of -0.37.”
　　Jain and Kranson’s survey The Myth of GDP and Stock Market Returns notes, “The data shows clearly that stock market returns and GDP per capita growth are negatively correlated.”
　　Goldman Sachs recently commented on this negative correlation between GDP per capita growth and share price growth and concluded:“Our analysis for emerging market countries since 1991 shows the equity markets of the slowest growing countries within emerging markets outperformed those of the fastest growing countries by nearly five percent a year.”
　　Rapid economic growth is associated with poor performance by shares, and China, the world’s most rapidly growing major economy, is no exception. Goldman Sachs noted: “China probably provides one of the best examples of the lack of correlation between strong economic growth and equity returns. Whether it is one year, three years or 18 years, economic growth has not translated into better investment returns in China. Evidence shows that faster economic growth rates do not result in higher equity returns. In fact, if faster growth is priced into the equity markets, the equity markets are most likely going to lag those of slower growth economies.”
　　The reason for the negative correlation between return on shares and economic growth is clear. The return on shares is ultimately the dividend stream expected from them and its reflection in their price. Therefore, as would be expected, Dimson, Marsh and Staunton noted “a high correlation (0.87) between real equity returns and real dividend growth.”
　　But dividends are part of a company’s profits that are not invested, and research shows investment is the most important part of economic growth. Therefore high dividend payments, while creating high returns on shares, result in lower investment and therefore lower economic growth. Low dividend payments, leaving more funds for investment, are correlated with high economic growth but low returns on shares.
　　It is important to be clear on the implications of this. It does not predict whether shares will rise or fall. It merely establishes that shares in high growth economies, such as China, will underperform shares in slowly growing economies. That China’s share prices are lower in inflation adjusted terms than 10 years ago is in line with the fact that shares internationally have been a terrible investment – in real terms the U.S. S&P 500 is 36 percent below its peak. China’s shares have simply underperformed share markets that themselves been losing money for over a decade.
　　What are the practical conclusions?
　　First, it is no surprise that China’s rapid economic growth is associated with a poor comparative international performance by its share markets. Commentators explaining this by bad market regulation and etc. miss the fundamental point that this poor performance is not due to secondary factors but is to be expected from rapid economic growth.
　　China cannot aim for slow economic growth to boost stock prices – the overwhelming majority of the population relies on rising incomes from economic growth for its living standards and not on returns on shares. For living standards to rise quickly the economy must grow strongly – a side effect of which is relatively poor return on shares.
　　This reality must be factored into policies. China’s rapid economic growth means inward investment in the productive economy can yield good results, but returns on inward investment in shares will be poor when compared internationally. Pension funds must factor in that China’s shares will perform poorly.
　　It is therefore important both for individual finances and economic policy that the actual relation between economic growth and share prices is understood.