The gyrations of equity markets around the world have prompted observers to declare that stocks are suddenly divorced from the real economy.

In an op-ed for the Financial Times published Monday, economist Mohamed El-Erian warned against buying assets that have “stunningly decoupled” from reality.

According to Jay Ritter, economist and professor of corporate finances at the University of Florida, the idea that the two were ever correlated long-term is a fallacy. His research examines real stock returns and per capita GDP growth dating back to 1900.

“The surprising pattern is, in the long-run, [the relation between] economic growth on a per capita basis and stock returns — both inflation-adjusted — is essentially zero and it can even be negative,” he said in a phone interview.

Ritter is set to publish a third version of his academic paper Economic Growth and Equity Returns next month.

“China has outstanding economic growth but stock investors have not done great. Mexico has actually been a much better place to invest over the last 30 years,” he said.

Using a very long investment horizon, the country with the best returns over the last 120 years is South Africa. According to Ritter, “it’s something that nobody ever guesses.”

On one end of the spectrum, South African stocks have, on average, a low price-earnings (PE) ratio combined with “very high dividends” – and a faltering economy.

China, on the other hand, has seen strong economic growth over the last three decades yet its stock market participants haven’t benefited accordingly.

“The Chinese economy has grown by a massive amount but a lot of it has been [due to] more companies going public, investors pouring money in and buying new shares. Market cap has gone up but it’s not because the value of existing shares has gone up, it’s because more shares have been issued by more companies,” said Ritter.

In Credit Suisse’s Global Investment Returns Yearbook 2020, which compiled the performance of global equities over the past 120 years, South Africa’s 7.1 per cent annualized real return takes the top spot. Second place goes to the U.S. (6.5 per cent), followed by Australia (6.8 per cent), Sweden (6.0 per cent) and Canada (5.7 per cent).  

Countries that haven’t had stock markets for that long aren’t among the contenders in this list, but Ritter sees a familiar pattern even among emerging nations.

“A country’s economic growth is not something that determines stock returns. What matters is current price-earnings ratios and earnings-per-share (EPS) growth. A country can grow rapidly without companies’ EPS growing,” he said.

Key factors that contribute to economic growth include labour force participation, high personal savings rates and technological advances — which don’t necessarily drive corporate profits higher. Ritter’s research finds that technological change alone doesn’t boost a company’s bottom line unless the firm has a lasting monopoly, which is rare.

Government intervention is also a factor, and so is central banks’ stimulus which has kept interest rates low in advanced countries. Monetary policy has disproportionately helped corporate interests.

Additionally, companies that make up the stock market tend to be medium and large-sized, and dominated by a select group of industries (energy, materials, industrials, consumer discretionary, consumer staples, health care, financials, telecommunications, utilities, real estate and technology).

The COVID-19 pandemic has benefited tech firms, Ritter said. And lockdown restrictions were a boon to retailers that remained open and were deemed essential services, like Walmart Inc., while shutting rival businesses out.

“COVID has benefited companies that use technology, and big companies which are publicly traded, whereas a lot of restaurants are local, family-owned,” said Ritter. “My brother has a plumbing business and I don’t know of any plumbing business that’s listed in the stock market in the U.S. or Canada. His business is down 50 per cent from six months ago.”

Another reason equities and the economy are out of sync is the fact that stock markets are forward-looking but digesting data from the recent past, and moving based on performance versus expectations, according to Ritter. 

Although U.S. stocks are pricing in an expectation of future profitability, Ritter worries about what may be in store several business cycles from now.

“One thing that I’m concerned about is school closures and the effect on children,” he said. “Both education and social development are being affected and that’s something that will have long-term consequences that doesn’t necessarily show up in profits immediately.”