Economic Growth and Equity Returns

December 05, 2007

Swedroe debunks conventional wisdom: High GDP growth doesn't equal high stock returns.

Conventional wisdom can be defined as ideas that are so ingrained in our belief system that they go unchallenged. Unfortunately, much of the conventional wisdom about investing is wrong. One example of conventional wisdom being wrong is that investors seeking high returns should invest in countries that are forecasted to have high rates of economic growth (e.g., India, China). It certainly seems intuitively logical that if you could accurately forecast which countries would have high rates of economic growth that you would be able to exploit that knowledge and earn abnormal returns.

Unfortunately, relying on intuition often leads to incorrect conclusions. In this case, the wrong conclusion is reached because it fails to account for the fact that 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.

Historical Evidence

While most people believe that economic growth is good for equity investors, for the 103-year period 1900-2002, the correlation of per capita GNP growth and stock returns for 16 countries was actually negative (-0.37)—countries with above-average growth rates provided below-average returns.1 Another study, covering the period 1970-97, found that the correlation between stock returns and GDP growth was -0.32 for 17 developed countries and -0.03 for 18 emerging markets.2

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 1990-2005.3 Jim Davis of Dimensional Fund Advisors chose to study the emerging markets because of the widely held perception 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.



Market-Weighted Countries

Equally Weighted Countries


Average Annual Return

Average Annual Return

High-Growth Countries



Low-Growth Countries



It seems that there is not 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 it actually experienced a rate of growth of 7 percent, you might have been 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 does not seem to be any evidence of the ability to forecast GDP rates any better than do the markets.

Conventional Wisdom: Sure, But Often Wrong

Why is the conventional wisdom so at odds with the data? There are several explanations. The first is that there is 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 that are 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 do not 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.

Perhaps the best illustration of this point is the airline industry. While it has completely transformed world travel patterns and created an enormous new industry, the question is, who has received most of the benefits: airline passengers getting cheap flights to distant cities or owners of airline firms? It appears that essentially all the benefits have gone to airline customers and employees, not owners. The list of bankrupt airlines is a very long and sad one. Thus, identifying an industry with enormous growth prospects over the next 50 years offers no assurance of above-average investment returns.  

Conventional Wisdom: Growth and Value Stocks

Investors make the same mistake about growth rates and stock returns when they buy stocks that have high expected earnings growth, because they believe that the high growth in earnings will result in high returns. Once again, there is no such connection. Companies with high rates of earnings growth (growth stocks) actually produce lower returns than ones with low earnings growth rates (value stocks). Again, the reason is that markets price risk, not growth rates. High expected growth rates are already built into current prices, just as high expected GDP growth rates of countries are built into current stock prices.


Markets are highly efficient at pricing information about growth rates into current prices. Therefore, growth rates (be it the rate of GNP growth of countries or the rate of earnings growth of companies) do not forecast future returns. And thus, as Jim Davis demonstrated, even if you had a clear crystal ball as to country growth rates, that would have provided no benefit in terms of generating above-market returns.

If growth rates do not forecast future equity returns, what does? The answer is valuations—in the form of current earnings yield (the earnings-to-price ratio). That valuation reflects not only the forecast of future earnings but also the market's perception of the riskiness of the company. The more perceived risk, the lower the current valuation and the higher the expected return. And that is why value stocks, despite having lower earnings growth rates than growth stocks, have produced higher returns than growth stocks.

  • 1. Jay R. Ritter, Economic Growth and Equity Returns, November 1, 2004.
  • 2. Jeremy J. Siegel, Stocks for the Long Run (1998, Second edition) McGraw-Hill.
  • 3. Jim Davis, "Economic Growth and Emerging Market Returns," August 2006.

Larry Swedroe is the author of Wise Investing Made Simple (2007), The Only Guide To A Winning Investment Strategy You Will Ever Need (2005), What Wall Street Doesn't Want You to Know (2000), Rational Investing In Irrational Times: How to Avoid the Costly Mistakes Even Smart People Make Today (2002), The Successful Investor Today: 14 Simple Truths You Must Know When You Invest (2003) and co-author of The Only Guide to a Winning Bond Strategy You'll Ever Need (2006). He is also a principal and director of both Research of Buckingham Asset Management and BAM Advisor Services—a Turnkey Asset Management Provider serving CPA-based Registered Investment Advisor (RIA) practices—in Clayton, Missouri (

His opinions and comments expressed within this column are his own, and may not accurately reflect those of the firm.


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