|Forbes.com, Spring, 2014. This article was written with Jim Cahn, the Chief Investment Officer at Wealth Enhancement Group. It was part of a series of articles developed under an agreement with Forbes to work with a variety of contributors and assist them in delivering actionable investment ideas each week. The site forbes.com is one of the top 500 sites in the world with nearly 10 million subscribers and nearly 100 million page views a month.|
It’s dangerous to make assumptions, especially when it comes to investing. When assumptions that seem so “obvious” are proven to be untrue, it’s a reminder to me and all of us that we cannot make all financial decisions based on “gut” or “common sense.”
Recently I was reminded of this when I read an article in the Economist about the disconnect between economic growth and future stock market returns.
According to a report by London Business School’s Elroy Dimson, Paul March and Mike Staunton (produced in association with Credit Suisse), there is no statistically provable link between economic growth per person and stock market returns.
In fact, the professors identified that “The correlation between equity returns and economic growth per person since 1900 has been negative.” That’s a shocking conclusion! For example, Ireland’s superior per capita growth of 2.8% yielded real equity returns of just 4.1% and was trumped by South Africa, which had a lower per capita GDP growth of 1.1% but long-term equity returns of 7.4% [over the same 1900-2013 period].
Furthermore, the authors found that investing in equities in countries which grew the fastest over the previous 5 years, starting in 1972, would have led to a 14.5% annualized return, while investing in countries with the slowest growth would have earned 24.6%!!!
Stop and pause a minute. What the research is telling you is that as people in a country get richer, the stock market doesn’t necessarily do better. Why? There may be lots of reasons, but most likely is that as people get richer, euphoria enters the markets and the prices of stocks soar too high.
Buying stocks of slower growing countries, with less euphoria, is basically a value strategy and buying the stocks of fast growing countries is a growth strategy; as Fama and French discovered in their groundbreaking 1992 paper, value usually beats growth.
So, what to do with all the hype around emerging markets? Does the rapid growth of the last decade doom emerging markets to decades of underperformance? Not necessarily.
What the professors did find was that the correlation between equity returns and aggregate GDP growth was positive, or a growing but not necessarily richer population is better for equities. During the decade from 2000 to 2010 when the annualized return on the MSCI Emerging Markets Index was 10.9%, it was just 1.3% for developed markets.
Now there are many reasons for why emerging markets may have outperformed during the period. According to the report, one major reason might be the rapid population growth experienced during the preceding 60 years.
We are not advocating investing in the countries with the highest birth rate. The engines of economic growth and the direction of stock markets are very complicated and no single factor is enough to justify making an investment. What we are suggesting is that — despite all the economic analyses you hear on the news, read in the paper or study on your own – none of it may be particularly useful in predicting the future of stock market returns.
As humans, we have a strong need to understand. We try to find patterns even where no such patterns exist; some call this the Gambler’s Fallacy. We look to the economy for explanations as to why the markets are up or down.
Where does this leave the seminal question, “Can investors expect to experience future emerging market returns comparable to those achieved at the start of 2000?” Unfortunately, the authors can’t answer this. All they can say is that they have debunked one very logical theory — tying together “economy” and “growth” — about why the markets took off in the first place.
Both “economy” and “growth” seem to be things we can understand. Drawing connections between the two seems to offer answers to tough questions. In reality, equity markets are relatively random and cannot be predicted or even explained day to day no matter how much economic analysis we, or the experts, do.
International and emerging market investing involves special risks such as currency fluctuation and political instability and may not be suitable for all investors. Stock investing involves risk, including loss of principal.