The great Yankees philosopher, Yogi Berra, once said, “In theory there is no difference between theory and practice. In practice there is.”
So true. And we’d be well served to remind ourselves of this reality before considering any investing strategy. Why? Simply because Wall Street loves to peddle misinformation, disguising it as plausible theories.
There’s no greater example of this than decoupling.
Leading up to the financial crisis, pundit after pundit sounded the “all clear” for emerging markets. (For the record, I was not one of them). They said many Latin and Asian emerging markets were “developed” enough that they no longer relied on the United States for economic growth. Therefore, they would be insulated, perhaps even immune, to a U.S. recession.
Of course, we ended up experiencing a global recession, immediately invaliding the theory.
Now that decoupling has been proven a farce, though, another lie is being spread through the investing public concerning emerging markets. It goes like this…
Since GDP growth in emerging markets is faster than GDP growth in developed areas, emerging markets should provide higher investment returns. Or, more simply, higher GDP growth translates into higher stock market returns.
Again, sounds perfectly plausible. GDP is the sum of all economic activity. So double-digit growth for an entire economy should result in similarly heady growth for individual participants and, in turn, their stock prices, right?
Let’s Go to the Charts!
In 2002, and then again in 2010, Credit Suisse (NYSE: CS) – along with three London Business School professors – studied the relationship between stock market returns and GDP growth in 83 countries.
They first looked at the long-term relationship (1900 to 2009).
Then they evaluated more recent performance (1972 to 2009).
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As they concluded, and as we can clearly see, “There is no evidence of outperformance by high-growth economies. Historically, the total return from buying stocks in the low growth countries has equaled or exceeded the return from buying stocks in the high-growth economies.”
A more recent analysis corroborates their findings, too.
In an August 2012 white paper, Ben Inker of GMO LLC, a global investment manager with almost $100 billion under management, notes, “The first point to understand about stock returns is their relationship with GDP growth. In short, there isn’t one.”
What’s his basis for such a bold statement? The returns for developed and emerging market stocks versus GDP growth rates from 1980 to 2010.
For simplicity’s sake, I’ve combined his findings into one chart for you. As you can see, the majority of the high returns are clustered in countries with GDP growth rates of less than 3.5%.
Bottom line: Contrary to what you’ve been told by Wall Street, fast economic growth doesn’t automatically translate into higher investment returns. I’ll explain why in greater detail in a future column. I’ll also provide an intriguing insight about profiting in emerging markets.
Here’s what we need to understand for today: Economic growth may be slowing in the United States and Europe, but that doesn’t mean we should run for cover and invest all of our assets in high-growth emerging markets. As always, a well-diversified portfolio is our best bet.
Ahead of the tape,
P.S. – Just like I always feature charts on Fridays, I’m considering making Mondays a time to routinely prove (or disprove) conventional wisdom on Wall Street. Would a regular column like that interest you? If so, are there any widespread theories or strategies you would like me to consider for evaluation? Drop me a line at firstname.lastname@example.org to let me know. While you’re at it, feel free to share any other comments, questions or biting criticisms about our work here at Wall Street Daily.