Conventional wisdom can be defined as ideas so ingrained in our belief system that they are accepted without challenge. Unfortunately, much of the conventional wisdom about investing is incorrect.
For example, the conventional wisdom that investors seeking high returns should invest in countries forecasted to produce high rates of economic growth—such as India and China—is simply wrong.
It certainly seems intuitively logical that if you could accurately forecast which countries would have high rates of economic growth, you would be able to exploit that knowledge and earn abnormal returns.
Relying on intuition, however, often leads to erroneous conclusions. In this case, the conclusion that you should look for investment opportunities in countries with high forecasted rates of economic growth is false, because it fails to account for the fact that markets are highly efficient at building information about future prospects into current prices.
Two Types Of Information
In short, investors fail to understand the difference between information and value-relevant information. The historical evidence on the correlation of country economic growth rates and stock returns demonstrates this point.
The latest contribution to the literature on this issue is from Joachim Klement, author of the study “What’s Growth Got to Do With It? Equity Returns and Economic Growth,” which appears in the summer 2015 issue of The Journal of Investing. Using MSCI country indexes, Klement investigated the equity market returns of 22 emerging and 22 developed markets for large-cap, midcap and small-cap stocks. Prior research, which we’ll also review, had examined only large-cap indexes.
The motivation to look at mid- and small-cap stocks is that, if smaller companies are less internationally diversified, the cross-country correlation between mid- and small-cap stock returns should be higher than for large-cap stocks. While the inclusion of small-caps did limit the period covered in the paper to 1997 through 2013, the study does cover two full economic cycles in each country. Thus, the results should be representative of general tendencies.
GDP vs. Equity Market Returns
Klement found there was a large variation between growth in GDP per capita and equity market returns. For example, Singapore and Hong Kong show the highest growth in GDP per capita of all developed countries, but also some of the lowest equity returns. Conversely, Australia and New Zealand had some of the highest equity market returns, with average- or below-average growth in GDP per capita.
In general, the cross-country correlations for the three market-cap segments were comparable in size and also negative across markets. Importantly, Klement was unable to find any meaningful and statistically significant correlation between real stock returns and real GDP per capita growth for any size index.