A frequent point of discussion around investment circles is to consider the strength of national economies and make investment decisions based on the relative strength of these economic. i.e. invest more in economies with strong economic growth and less in those with lower levels of growth. If only it was that simple. Research on this topic shows that there is no clear correlation between per capita economic growth as measured by gross domestic product and share market returns. A study published in 2005 by Jay Ritter, Economic Growth and Equity Returns, showed that for 16 countries there was actually negative correlation - countries with above average growth provided below average share market returns.
Jim Davis from Dimensional in the USA has also produced his own analysis looking at Emerging Market economies. Larry Swedroe in his blog - Why Successful Economies Don't Mean Great Stock Returns - explains Jim's results:
Jim Davis chose to study the emerging markets because of the widely held perception is 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.
The results show that there is very little difference in share market performance between high growth and low-growth countries.
Both studies suggest that economic growth potential was factored into the price of shares. This reminds us that it is events in the future which we really can only guess at, that will determine which markets perform better than others.
We in Australia all too well understand this outcome seeing the returns of the Australian share market over the past year providing disappointing results from what is widely referred to as one of the strongest developed market economies in the world. (NB - In US dollar terms the Australian share market has performed in line with but not significantly out-performed the world dominating, in terms of size, US market.)
So what should we take away from this?
These results suggest that investors should take care basing investment decisions on whether an economy has strong economic growth, rather we believe it is better to develop a wide diversification of investments across all the available world share markets.