China vs U.S.: Economy vs stock market

(MoneyWatch) There's an old saying that it isn't what a man doesn't know that gets him into trouble, but what he knows for sure that isn't true. This certainly applies to the belief that you should favor investing in countries that will have the fastest economic growth. Unfortunately, the historical evidence shows that not only is this wrong, but you might miss out on better returns.

The financial media is regularly feeding investors stories about the great growth prospects in some country, with China typically leading the headlines. Even Burton Malkiel, author of A Random Walk Down Wall Street, has been promoting the China story.

The first half of this year provided us with a perfect example. In the first quarter China's GDP grew 8.1 percent. In the second quarter it grew 7.6 percent. The figures for the U.S. economy were just 2.0 percent and 1.7 percent, respectively. Yet through August 31, based on the change in its net asset value (NAV) the SPDR S&P China ETF (GXC) returned 0.7 percent, while Vanguard's 500 Index fund (VFINX) returned 13.4 percent.

Let's take a look now at the data back to 2008. In the four years from 2008 through 2011, China's economy didn't skip a beat. China's GDP grew 9.6 percent in 2008, 9.2 percent in 2009, 10.4 percent in 2010 and 9.1 percent in 2011. During this period, the U.S. not only suffered through a recession, but the ensuing recovery was the weakest in the post-war era. The rate of growth in our GDP was -0.4 percent in 2008, -3.5 percent in 2009, 3.0 percent in 2010 and 1.7 percent in 2011.

Given these results, most investors would be pretty confident that an investment in Chinese stocks would far outperform an investment in U.S. stocks. However, the data tells another story. Based on the changes in the NAV, GXC returned -50.7 percent in 2008, 65.5 percent in 2009, 6.7 percent in 2010 and -17.2 percent in 2011. Each dollar invested in GXC at the start of 2008, would have been worth less than 73 cents by the end of August 2012. For the same period, VFINX returned -37.0 percent, 26.5 percent, 14.9 percent, and 2.0 percent, respectively. A dollar invested in VFINX would have been worth about $1.06 -- 41 percent more than a similar investment in GXC.

The rate of growth of a country's economy doesn't determine investment returns. What determines the rate of return are valuations and whether the market's expectations about future growth are matched:

• If valuations such as price-to-earnings ratios are low, that means investors are demanding large risk premiums and expected returns are high. The reverse is true if valuations are high.
• If the market receives positive surprises (the news is better than expected), the risk premiums investors demand will fall and prices will rise. The reverse is true when the market receives negative surprises.

In the case of China, not only were their valuations much higher (reflecting the expectations for rapid growth), but the growth of the economy was less than what the market expected. In the case of the U.S., our economy weathered the financial crisis better than expected. In other words, surprises can determine a large percentage of returns. And by definition, surprises aren't forecastable.

It's important to note that the same growth story that applies to countries also applies to companies. Keep this tale in mind the next time you're tempted to invest in a country because of some forecast of rapid growth in its economy or some company because of some forecast of rapid growth in its earnings.