IS THE EQUITY MARKET REPRESENTATIVE OF THE REAL ECONOMY?

Abstract

1.IntroductionOur paper is an attempt to empirically compare both the geographical and industry composition of the global real economy and public equity markets. This exercise is relevant for an investor who aims to create an equity portfolio that is exposed to global economic growth. If such investor is unaware how the composition of his equity portfolio compares to that of the real economy, differences in economic growth rates across geographies or industries might negatively affect the correlation between his portfolio returns and global economic growth. At the same time, it may also help an investor in private equity to target regions or industries that are underrepresented in public equity markets - see Lerner et al. (2016).The geographical differences between public equity markets and the real economy have also been the subject of investigation. For example, Chambers, Sarkissian, and Schill (2015) mention that already during the period 18661913 several domestic U.S. railroad companies listed on foreign exchanges in London, Amsterdam, and Paris, effectively decoupling the country of listing and the country's economic exposure. In that historical era of financial globalization, it were mainly locally operating companies in need of capital that were seeking a listing abroad. Their foreign listing could meet the demand from foreign investors seeking international portfolio diversification with limited ability to directly invest in assets listed abroad.1 In the current era of globalization, investors do have the possibility to invest internationally, either directly or through internationally diversified mutual or exchange traded funds. However, this time around it are multinational companies that seem to have increasing international economic exposures that are only to a limited extend related to the country in which they choose to have their public equity listed.2 Early research by Jacquillat and Solnik (1978) indicates that investing in a portfolio of multinational companies gives less diversification benefits than investing in international financial markets. However, more recently, Chai and Warnock (2012)'s empirical results suggest that US multinationals give significant exposure to foreign equity markets, and that this exposure is increasing with the share of foreign sales.3 In addition, O'Hagan-Luff and Berrill (2016) find that foreign sales are time-varying, as many US firms experienced a decline of foreign sales in the credit crisis.Other researchers have investigated the time-variation in the industrial composition of equity markets. For example, Dimson, Marsh, and Staunton (2002) show that in the U.S. certain industries were a small part of the public equity market in 1900, but a large part of the public equity market a century later. For example, the Information Technology industry was virtually nonexistent in 1900, but comprised about one-third of the equity market in 2000. On the other hand, the Railroads industry was about two-thirds of the equity market in 1900, and almost disappeared a century later. These figures show that the industrial exposure in equity markets changes dramatically over time. However, it does not link these changes to the composition of the real economy. It is possible that the Railroads industry contributed more to economic growth in 1900 than in 2000, while Information Technology contributed more in 2000 than in 1900. Musmeci, Aste, and Di Matteo (2015) compare different clustering methods to link equity returns to industrial activity in the United States. Qadan and Yagil (2015) investigate co-movement of real economic activity and equity market returns. However, we are not aware of any research trying to connect the composition of the global real economy and global public equity markets.The contribution of our paper is that we compare the composition of the real economy, measured by its gross domestic product, with the composition of the public equity market. …