Emerging Equities Markets Divorce Economic Growth Correlations

by: William Gamble

Every investor is bombarded by massive amounts of numbers every trading day. Analysts are unusually fond of coming up with all sorts of strange correlations to help predict the rise and fall of markets within the coming months. For example, in the US we have correlations as to rises and falls of the market for certain months, presidential elections year, the party that wins the election and even which league wins the national championship for various sports.

Most of these correlations are not very helpful in terms of their ability to accurately predict a rise or fall in the markets. But one would assume that there would be one correlation that would be absolutely accurate. The economic growth of the economy would seem to be a pretty good indicator of equity market returns. The market should rise in times of business expansion and contract during recessions. For most of the past 110 ten years in the US this has been the case. Expansion in the US lasts on average about 37 months. Contractions last about 15 months and the Dow Jones Industrial average falls about 31% during that time. Usually recessions start about two to three months from a market peak. The US market reached a peak on September 15th and the economy has been expanding for 40 months.

Like recurrent plagues, recessions are considered to be a bad thing. Like doctors utilizing antibiotics, central bankers have been trying to control them. In the past it was considered adequate just to lessen their impact by controlling the interest rate. Recently the bankers have gone further and made it clear that they are trying to stamp them out. In addition to central bankers, despite the views to the contrary, governments around the world are taking larger shares of the economy either through direct ownership or indirectly by providing stimulation through state owned banks. In either case governments are manipulating the economy and the markets. So the state of the economy may or may not be reflected in the market itself.

For example the US experienced two recessions in the past ten years. The economy went into recession in March of 2001 and started growing again in November. The market hit bottom in the fall of 2002. The most recent recession started in December of 2007 and lasted until June of 2009. The market hit its peak in October of 2007 and fell until March of 2009. But such correlations are not so accurate in emerging markets.

Brazil has had short periods of contraction in 2001, 2003, 2006 and 2009. India has had short periods of actual contraction in 2004 and 2010. It did slow dramatically in 2009. Neither Indonesia nor China has had any period of contraction over the past ten years. Yet despite the short slowdowns or consistent enviable growth, the markets in these countries have had either dramatic swings or periods of no growth at all.

Despite some growth in the early part of the decade all of the markets in China, India, Brazil and Indonesia were basically flat. In 2004 something happened. Emerging markets, despite the evidence, became a safe investment. Emerging markets in general and the BRIC markets in particular were no longer risky and volatile. Instead they were considered part of a necessary diversification for every portfolio.

The emerging markets returned the compliment. From 2004 to 2008 the Chinese market went up 600%. The Indian market went up 400%; Brazil 350%. Indonesia was up 300% while the US market was up only 40%. Although growth rates in these countries were good, they weren't that good. Everything changed in 2008. China hit it high in 2007. India, Brazil, and Indonesia all hit their highs in 2008. Then the crisis hit the US and all of the markets collapsed between 50 and 60%.

Since emerging markets were supposed to grow faster than the old developed markets, the emerging markets bounced back quickly. India and Brazil were back up almost 200% by early 2011 near their pre-crash high, but so was the US. Indonesia was on a roll. Its economy continued to grow along with its market.

But something odd has happened. The rate of growth for India and Brazil has been declining since 2010, while their markets remain relatively high. Even more interesting is the Chinese market. Like the Saudi market after its collapse in 2006, it has never come close to its old highs despite the fact that its economy is still experiencing one of the fastest growth rates in the world. Meanwhile the US market, despite lackluster economic growth, is only 7% from its all time high.

This is troubling. The main purpose of any market is price discovery. In their pursuit of active management all governments have tampered with the process. It also should stand as a warning for all those economists, financial analysts, commentators and money managers who desire to install the financial tools created for developed markets and apply them wholesale to emerging markets. These markets are very different from developed countries and very different from each other. Investors cannot just utilize assumptions that work in countries with transparency and good legal frameworks to markets that have neither. The reasons for a rise and fall may or may not have to do with underlying fundamentals. In a world where governments have exacerbated the problem, often with the best of intentions, the markets could correct dramatically when the fundamentals reassert themselves, which, in time, they always do.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.