German stocks soar despite weak economy

Serious Money Chris JohnsNews that the EU Commission has cut its 2005 growth forecast for the second time in six months will not surprise most investors.

Recent economic data for Europe has been poor, particularly for Germany, Italy and France. Most smart investors would not have been expecting too much good news, at least not from the overall economy. The dichotomy between performance of individual companies and economies has been spectacular.

Germany, for example, which seems to spend at least half the year in recession, has a stock market which nevertheless has been able to deliver reasonable returns to shareholders.

Over the last two years, an investment in the 30 companies comprising the German Dax index would have returned around 65 per cent, an astonishing performance given the unrelenting bad news about Europe's largest economy.

Part of this spectacular rise occurred because the fall in the market over the previous three years had been overdone and shares were at undervalued levels, but a strongly performing stock market does not sit easily with arguments that link equity prices with the economy's health.

German companies that have been sound investments have tended to have engaged in some form of restructuring.

The ability to move production to lower-cost countries in Eastern Europe and Asia was a powerful bargaining tool with trade unions, and Germany's "structurally rigid" labour market has been more flexible than its critics supposed.

Several academic studies have shown that, historically, the link between economies and stock markets is not that strong. At least, there does not appear do be a strong correlation between economic growth and share prices in any given year.

What is less clear is whether or not stock markets are doing their job as predictors of economic activity: sooner or later, the economy - or at least profits - must validate prior movements in equity prices.

The emphasis on profits rather than economic growth is important, since profits can move along a very different path to GDP, at least for a while. Companies can boost their earnings at the expense of labour and also increase the money they make overseas.

Both of these factors appear to be at work in Germany and have acted to give the stock market a lift, at a time when the economy has been languishing.

At the same time as weak economies were accompanied by strong stock markets, the world's mightiest economies delivered woeful returns to shareholders. Over the last two years, the US market has struggled, with the Standard & Poor's 500 index barely reaching a 10 per cent return for the whole period.

The world's biggest growth story, China, has not been good for equity investors either and returns over the past few years have been around -35 per cent.

This proves that stock markets are not necessarily good barometers for the economy, at least not over relatively short time periods (two years is a very short time in stock market terms). It shows that the appropriate focus of investors should always be profits, not GDP - although there should be some link between these variables, particularly in the long-haul.

In Germany's case, we have identified a stock market that has done well in spite of dreadful economic conditions. Some companies had to restructure or die. Just imagine how much more successful these businesses would be if the macro environment was friendlier.

Where are profits likely to come from over the next couple of years? The recent German experience is instructive. We should look to companies that have restructuring potential and management that has the desire to achieve that potential.

We should be wary of stocks that are exposed to high oil prices. Hopes of a recovery in European consumer spending will one day be realised, but that does not look imminent and businesses that make money by selling to depressed consumers will continue to struggle. Could Germany provide spectacular returns over the next couple of years? I doubt it, but I would still expect a decent return.

Perhaps the economy and profits are best seen as joined by a rubber band - one that is currently stretched about as far as is possible. The gearing of many German companies is such that only a modest upturn in growth should see a healthy impact on profits.

Restructuring is laying the seeds of resumed growth, but is having a short-term impact on things like unemployment.

Given time, I expect a modest positive growth surprise in Germany over the next year. Many German companies are exposed to the world rather than the domestic economy. Perhaps one source of worry about German equities, therefore, is the impact on world growth of a rising oil price.

Here, it is well to remember why the oil price is so strong: global growth is still booming. While the high oil price could be the source of a significant world economic slowdown, there is little evidence, as yet, that anything untoward is imminent.

For those of a contrarian nature, German equities offer an unfashionable home for your money. Valuations are relatively undemanding, notwithstanding the market's rise of the last two years. It won't take much of a positive surprise on growth - or possibly more restructuring - to produce more outperformance from German stocks.

Chris Johns is an investment strategist with Collins Stewart. All opinions are personal.