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Why Successful Economies Don't Mean Great Stock Returns

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.


Why Great Returns Don't Follow Great Economies
Because current investors don't participate in the earnings of new businesses, there's a gap between growth in aggregate earnings (which tend to move in line with GDP growth) and the earnings to which current investors have a claim. Studies by William Bernstein and Robert Arnott (2003) and Bradford Cornell (2010) have found that for the U.S. this gap is about 2 percent. However, for emerging markets the figure is much higher. A 2005 study found that over an 11-year period when emerging market capitalization grew on average 13.1 percent annually, existing shareholders earned returns of just 5.4 percent. The dilution problem tends to be greatest in rapidly growing countries with high capital needs -- countries which tend to be investor favorites.

Why is the conventional wisdom so at odds with the data? There are several explanations. The first is that there's a general tendency for markets to assign higher price-to-earnings ratios when economic growth is expected to be high, which has the effect of lowering realized returns. Countries expected to have strong economic growth can be perceived as safer places to invest. That translates into higher current valuations.

The second explanation is that the conventional wisdom fails to account for the fact that the markets price risk, not growth rates. High expected GDP growth rates of countries are built into current stock prices.

The third reason is that while economic growth is good for people (producing not only higher standards of living, but also those who live in countries with higher incomes have longer life spans, lower infant mortality, etc.), equity investors don't necessarily benefit. For example, a country can grow rapidly by applying more capital and labor without the owners of capital earning higher returns. And productivity gains can show up in higher real wages instead of increased profits.

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