- Faster-growing economies don't necessarily lead to higher returns.
- Relying on intuition can lead to incorrect conclusions.
- Coventional wisdom on the correlation between demographics and stock returns carries little weight.
I recently came across an article on Seeking Alpha by The Statistical Investor entitled "Demographics Are Destiny: World Population Trends". The article begins: "As they say, demographics is destiny. Just ask Japan. The longer your investment horizon, the more exposed you are to demographic trends." The author continues with what we might call "conventional wisdom" - ideas that are so well accepted that they go unquestioned: "Population trends are important because they help us to estimate a growth rate in our valuations. Putting a valuation on growth is probably one of the most important tasks in valuing a company." While the author does acknowledge that "population growth does not guarantee significant economic growth," he goes on to state that assuming productivity growth continues in countries with growing populations "you can expect sizable returns from companies that operate there [in those countries]." While it's true that population growth and productivity determine the rate of growth in a country's economy, the conventional wisdom that faster-growing economies lead to higher investment returns isn't true. What's more troubling is that there isn't any logic to that idea. Let's explore why economic growth rates and stock returns have actually been negatively, not positively correlated.
It 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, such as economic growth and stock returns are positively correlated. 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. And there are several other 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 - and higher valuations forecast lower, not higher returns.
The second explanation is that the conventional wisdom fails to account for the fact that the markets price risk, not growth. High expected GDP growth rates of countries are built into current stock prices. The expected return is a function of the discount rate applied to future expected earnings. The lower the discount rate (reflecting lower perception of risk), the higher the current price, but the lower the future expected return.
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, and so on), equity investors don't 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.
There's yet a fourth reason, one that applies especially to emerging markets, where birth rates and population growth tend to be highest.
Don't Confuse Market Cap Growth with Investor Returns
Because current investors do not participate in the earnings of new businesses, there is a gap between growth in aggregate earnings (which tend to move in line with GDP growth) and the earnings to which current investors have a claim. Studies by William Bernstein and Robert Arnott (2003) and Bradford Cornell (2010) have found that for the U.S., this gap is about 2 percent. However, for emerging markets, the figure is much higher. A 2005 study found that over an 11-year period when emerging market capitalization grew on average 13.1 percent annually, existing shareholders earned returns of just 5.4 percent, a gap of 7.7 percent. The dilution problem tends to be greatest in rapidly-growing countries with high capital needs - countries which tend to be investor favorites.1
If you're not yet convinced by these arguments, we can examine some of the historical evidence on the correlation of country economic growth rates and stock returns.
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 sixteen countries was actually negative (-0.37) - countries with above-average growth rates provided below-average returns.2 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.3
A more recent study was on the correlation of country GDP growth rates and stock returns focused on the emerging markets. The study covered the period 1990-2005.4 Jim Davis of Dimensional Fund Advisors chose to study the emerging markets, because 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.
Average Annual Return
Average Annual Return
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 forecast to have 6 percent GDP growth, and it actually experienced a rate of growth of 7 percent, you might 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.
We also have evidence from Credit Suisse's Global Investment Returns Yearbook 2012. Elroy Dimson, Paul Marsh and Mike Staunton found that countries whose real GDP per capita grew faster than average over the 110-year period 1900-2009, did not produce higher real equity returns than their slower-growing peers.5
The following table, covering the 22-year period 1988-2009, presents further evidence.6
Real GDP Growth (%)
Real Equity Return (%)
Our final example comes from Antti Ilmanen's wonderful book, Expected Returns. It should convince even the strongest of skeptics. For the period 1993-2009, while China's annual real GDP growth rate averaged over 10 percent, a U.S. dollar-based investor would have earned negative returns over the 17-year period - and that's not even accounting for inflation, which ran 2.5 percent. While China's economy grew five-fold, investors lost money. We can update Ilmanen's example. For the latest five-year period (2009 through 2013), while the Chinese economy grew more than four times faster than did the U.S.', Vanguard's 500 Index fund (VFINX) returned 17.8 percent and outperformed the China ETF FXI's return of 7.9 percent by 9.9 percent a year.
The bottom line is that the conventional wisdom on demographics and stock returns has as much validity as the one-time conventional wisdom that the Earth is flat once had. At least when it comes to stock returns, demographics aren't destiny.
- Larry Speidell, Greg Stein, Kate Owsley and Ingrid Kreuter, "Dilution Is a Drag…The Impact of Financings in Emerging Markets," The Journal of Investing (Winter 2005), Vol. 14, No. 4: pp. 17-22. (p. 332 of Expected Returns).
- Jay R. Ritter, Economic Growth and Equity Returns, November 1, 2004.
- Jeremy J. Siegel, Stocks for the Long Run (1998, Second edition) McGraw-Hill.
- Jim Davis, "Economic Growth and Emerging Market Returns," August 2006.
- Antti Ilmanen, Expected Returns, Wiley (2011). p. 331.
- Ibid, p. 332.