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Why investors should stop fretting about the economy

A trader talks on the phone during a Spanish bond auction in Madrid, Oct. 18, 2012.

Andrea Comas/Reuters

Most investors figure quite reasonably that economic growth is the elixir that makes stocks go up.

The thinking is as simple as it is seemingly obvious: if the economy is firing on all cylinders, that can't help but be good for companies. But think again: conventional wisdom is wrong.

Academic research is making the surprising finding that stock market returns don't seem to be correlated to economic growth rates. One study has even found that stock returns and economic growth are inversely linked, so that the stronger the economy, the lower the profits to be made by investing in shares.

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The paradoxical finding has led one Canadian forecaster, Murray Leith, director of investing at Vancouver-based broker Odlum Brown, to advise clients that fretting about the state of the economy is a waste of time.

In his view, the biggest determinant of how well people do in the market is whether they're able to get in at a good price when they make an initial investment.

"Starting valuation is the key driver of stock returns and people lose focus on that and get caught up in a whole bunch of other noise, including the economic noise," he said in an interview.

"What drives me nuts is we talk non-stop about what the global economy is going to do, but there is no evidence from history that says if we know the answer to that question it tells us what the stock market is going to do," he said.

One of the best examples of the principle that growth and stock profits aren't necessarily related comes from China, which has one of the world's quickest paced economies in recent years. Yet stocks on the Shanghai market have lost about half their value since the early days of 2008.

In a recent letter to clients, Mr. Leith looked at North American stock returns and found that between the end of the Second World War and the turn of the century, the 1950s and 1990s were the two slowest growing decades in the U.S., yet also had the best stock gains.

He cited another example from research by portfolio manager and financial author James O'Shaughnessy that found companies with slow revenue growth typically have better investment returns for shareholders than businesses growing rapidly.

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The reason: investors typically chase growth stocks and pay too much for them, cutting down on long term profits.

One of the most recent academic studies on the topic by University of Florida finance professor Jay Ritter, whose paper "Is Economic Growth Good for Investors?" appeared this summer in the Journal of Applied Corporate Finance.

He found that investors made better profits in countries with slower rates of growth in GDP per person than in higher growth countries.

"This seems surprising since economic growth is generally assumed to be good for corporate profits," the paper said, explaining the tendency partly by investors overpaying for expected growth.

Chalking one up for yield hungry investors, Mr. Ritter found that dividend growth is a better predictor of high stock market returns.

Mr. Leith says growth is likely to muddle along around 2 per cent, hardly a high number compared to the 3 per cent and 4 per cent rates that have been common in previous upturns.

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He says that given the amount of indebtedness that has been accumulated, it isn't surprising that growth is anemic as businesses and consumers use income to repay debt. Still, he says stock values among big, brand named U.S. multinationals appeal to him because these companies can continue to grow profits even when economic growth is around current levels.

Among the names he likes are Starbucks, Coca-Cola, General Electric, United Parcel Service and 3M.

"To me, what matters and what makes my job easy or hard is whether or not I can find good companies trading at reasonable prices," he said.

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