Why Successful Economies Don't Mean Great Stock Returns

Last Updated May 13, 2011 11:23 AM EDT

If you read this blog regularly, you know that much of the conventional wisdom about investing is wrong. Today, we'll look at another such piece of wisdom: investors seeking high returns should invest in countries that are forecasted to have high rates of economic growth, such as India and China.

It certainly seems logical that if you could accurately forecast which countries would have high rates of economic growth that you could earn abnormal returns. Unfortunately, relying on intuition often leads to incorrect conclusions. In this case, the wrong conclusion is reached because markets are highly efficient in building information about future prospects into current prices. The historical evidence on the correlation of country economic growth rates and stock returns demonstrates this point.

While most people believe that economic growth is good for equity investors, for the period 1900-2002, the correlation of per capita GDP growth and stock returns for 16 countries was actually negative (-0.37) -- countries with above-average growth rates provided below average returns. Another study, covering the period 1970-97, found that the correlation between stock returns and GDP growth was -0.32 for seventeen developed countries and -0.03 for eighteen emerging markets.

A more recent study on the correlation of country GDP growth rates and stock returns focused on the emerging markets. The study covered the period 1990-2005.Jim Davis of Dimensional Fund Advisors chose to study the emerging markets because of the widely held perception is that the markets of the emerging countries are inefficient. At the beginning of each year, Davis divided the emerging market countries in the IFC Investable Universe database into two groups based on GDP growth for the upcoming year:
  • The high-growth group consisted of the 50 percent of the countries with the highest real GDP growth for the year.
  • The low-growth countries were the other half.
He then measured returns using two sets of country weights-aggregate free-float-adjusted market-cap weights and equal weights. Companies were market-cap weighted within countries. The results are shown in the table below.


It seems that there isn't much, if any, advantage to knowing in advance which countries will have the highest rates of GDP growth. The conclusion that we can draw is that the emerging markets are very much like the rest of the world's capital markets -- they do an excellent job of reflecting economic growth into stock prices. In other words, the high expected growth rates were already reflected in prices. The only advantage would come from being able to forecast surprises in growth rates.

For example, if a country was forecasted to have 6 percent GDP growth, and but actually had 7 percent, you might be able to exploit such information (depending on how much it cost to make the forecasts and how much it cost to execute the strategy). Unfortunately, there doesn't seem to be any evidence of the ability to forecast GDP rates better than the markets. One final example that should convince even skeptics. For the period 1993-2009, while China's annual real GDP growth rate averaged over 10 percent, a U.S.-dollar-based investor would have earned negative returns over the 17-year period -- and that's not even accounting for inflation of 2.5 percent. While China's economy grew five-fold, investors lost money.

Now, let's see why this is the case.
  • Larry Swedroe On Twitter»

    Larry Swedroe is director of research for The BAM Alliance. He has authored or co-authored 13 books, including his most recent, Think, Act, and Invest Like Warren Buffett. His opinions and comments expressed on this site are his own and may not accurately reflect those of the firm.

Comments

CBSN Live

pop-out
Live Video

Market Data

Watch CBSN Live

Watch CBS News anytime, anywhere with the new 24/7 digital news network. Stream CBSN live or on demand for FREE on your TV, computer, tablet, or smartphone.

Market News

Stock Watchlist