Stock markets at record highs while growth is down

In fact, credit ratings agency Standard & Poor's has downgraded South African government bonds to one notch above junk status, while industry peer Fitch kept its rating unchanged but downgraded its outlook for the country from stable to negative.

However, our stock market does not seem to be following suit. Despite the bleak economic picture, the South African stock market has hit record highs. The market returned over 20% in 2013 and almost 10% so far this year. In fact, it recently broke through the psychological 50,000 level for the first time in history.

When considered in real terms (after accounting for inflation), recent market returns seem a little less impressive. If your spending is in line with the average South African's, you will experience an inflation rate of around 6%. This means that the buying power of your money is lowered by roughly 6%, and the effective value of your market returns drops by the same amount.

Effect of weaker rand

If your personal inflation is higher, the value of your market returns drops even further. For example, had you bought goods priced in dollars you would have earned a negative return from the local stock exchange in 2013. This is because the rand weakened over this period and made foreign goods more expensive.

We also need to consider individual stock picks. If you had invested only in the five biggest shares of 2013 (BHP Billiton, SAB, Richemont, Naspers and MTN), your return would have been about 75% of that of the overall market. While the market as a whole may be at an all-time high, this will therefore not be true of all shares on the market.

In the long term, economic growth and stock market growth are linked. Theoretically, there is a limit to how fast a company can grow its earnings (and consequently its share price). A company can't grow its earnings by more than the economy forever, as it would then eventually become the economy.

Markets affected by emotion

However, in the short term, this relationship breaks down. While economic growth is backward-looking and considers actual growth achieved, stock markets are forward looking and consider expectations of future growth. As a result, markets are easily swayed by emotion, running excessively when investors are too optimistic or falling significantly when investors are too pessimistic.

In addition, global authorities have kept interest rates at record lows since the 2009 recession. This has been done to facilitate easier access to money and encourage economic activity. As investors could no longer earn decent interest rates, there has been a greater demand for equities and stock market prices have risen.

We shouldn't be surprised that there is no immediate relationship between economic growth and equity market returns. This is highlighted by the graph below, which shows that while economic and market growth generally align over the long term, short-term deviations are not uncommon.

Economic growth (Gross Domestic Product) vs Market levels (All Share Index): 1960 - 2014

(Source: I-Net)

However, we should always understand the price we are paying for a company's shares to evaluate whether this is fair. As it currently stands, there are very real concerns that the South African stock market is overvalued - especially while the economy delivers lacklustre economic growth.

In such times it becomes particularly important to invest with asset managers that have confidence in the equities they purchase. Ultimately, you are looking to avoid expensive stocks (for which prices may drop if the market corrects itself) and invest in those that are likely to offer good long-term value.