Last week, I wrote about a possible bubble developing in the Chinese stock market. If you missed it (we experienced some technical difficulties) you can read it here. Every great bubble is accompanied by a great story. In the dot-com stock bubble, investors were mesmerized by the awe-inspiring potential of the Internet. Consumers were expected to do all of their shopping online. Bricks-and-mortar retailers were considered outdated and obsolete. Dot-com start-ups and telecom equipment stocks were what investors bought for growth. And the growth was expected to compound at exceptional rates for decades. We were told the information technology revolution was ushering in a new economy that was immune to economic booms and busts. In the recent real estate bubble, legend had it that house prices never fell on a nationwide basis (this was actually untrue, but widely believed). House prices always rose. Why pay down your principal? Take out an option-adjustable interest-only mortgage and refinance or sell when the value of your house rises. The stories are always convincing and sprinkled with half-truths.
The story that I am most concerned about today is the China / emerging markets economic growth story. You’ve likely heard this story by now. Economic growth in China, India, and other developing nations will far exceed economic growth in developed markets for decades. And if economic growth in emerging markets is going to exceed economic growth in developed markets, emerging-market equities are where you want to invest for growth. Developed-market equities are outdated and uninspiring.
I agree that economic growth in emerging markets will exceed economic growth in developed markets. Does that mean I believe emerging market equities will return more than developed market equities? No.
The historical record is clear on this point. Economic growth and stock market returns are not correlated. In fact, there is a slight negative correlation. My table shows the compounded annual growth rate for stocks, nominal GDP, and real GDP for 22 countries from 1975 to 2007. GDP data comes from the World Bank, and stock market performance is measured by MSCI country indexes for developed markets and the S&P/IFCI country indexes for emerging markets. Economic growth over the 32-year period varies widely across countries. In nominal terms, Argentina experienced growth of only 5%, compared to growth of 12.6% in South Korea. In inflation-adjusted terms, the Asian tigers of Singapore, Malaysia, and Taiwan experienced economic growth on the order of 7%, while Switzerland, Sweden, and Argentina experienced growth closer to 2%. In terms of stock market performance, Malaysia and Taiwan, which are numbers one and two in terms of real growth and in the top third in terms of nominal growth, experienced the worst stock market returns over the 32-year period. And the country with both the worst nominal and real economic growth, Argentina, experienced the second-best stock market returns over the 32-year period. See any correlation here? I don’t.
| 12/31/1975 to 12/31/2007 | |||
| Country | Stock Market Returns (US$) | Nominal Growth (US$) | Real Growth (US$) |
| Chile | 23.6% | 10.2% |
5.3% |
| Argentina | 21.0% | 5.2% | 2.2% |
| Mexico | 17.0% | 8.0% | 3.3% |
| Hong Kong | 16.3% | 9.9% | 6.2% |
| Sweden | 16.2% | 5.7% | 2.1% |
| U.K. | 14.0% | 8.0% | 2.4% |
| Brazil | 13.9% | 7.7% | 3.0% |
| South Korea | 13.6% | 12.6% | 5.1% |
| Switzerland | 13.5% | 6.3% | 1.7% |
| France | 13.5% | 6.4% | 2.3% |
| Australia | 13.4% | 7.0% | 3.2% |
| Germany | 12.6% | 6.3% | 2.2% |
| Canada | 12.4% | 6.6% | 2.9% |
| U.S. | 12.4% | 6.9% | 3.1% |
| Austria | 11.7% | 7.3% | 2.5% |
| Singapore | 11.7% | 11.0% | 7.2% |
| Italy | 11.7% | 7.3% | 2.2% |
| Spain | 11.4% | 8.3% | 2.8% |
| Thailand | 10.9% | 9.2% | 6.2% |
| Japan | 10.0% | 7.0% | 2.6% |
| Taiwan* | 8.8% | 9.1% | 6.9% |
| Malaysia | 5.5% | 9.6% | 6.5% |
| *GDP growth from 1979 to 2007 |
| Sources: MSCI indexes for developed markets and S&P/IFCI for emerging markets. World Bank and EcoWin for GDP data. |
Many variables determine the performance of a country’s stock market, but economic growth is an insignificant one at best. Before you buy into the emerging-market growth story, I would advise you to consider the stock valuations, political environment, currency fundamentals, shareholder rights, monetary policy, and legal structure of the country in which you are investing.
Jeremy Jones, CFA
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