MONEY MATTERS: Counterintuitive truth about investing in emerging markets

By David Peartree The Daily Record Newswire The conventional wisdom about expected equity returns in the emerging markets is wrong. Conventional wisdom says that the higher expected rates of economic growth in the emerging markets should lead to higher equity returns. The connection between economic growth and equity returns seems so intuitive and obvious that most investors never question it. Numerous studies have, however, and have found the connection to the tenuous and misleading. This has significant implications for investors making decisions about their asset allocation. Expectations for rapid economic growth in the emerging markets and subpar economic growth in the developed markets are often cited as reasons to boost the allocation to emerging market stocks. The assumption is that higher economic growth in the emerging markets will lead to better returns for those stocks than for developed market stocks. The allure of this argument is easy to understand. The Vanguard study points out that investable emerging markets economies account for more than 25 percent of global GDP, but their market capitalization represents something less than 15 percent of global equities. Both are expected to increase significantly, suggesting an investment opportunity. Moreover, for the 10 years ending 2009, the MSCI Emerging Markets Index produced an average annual return of 10.2 percent versus an average annual return of -1.2 percent for the MSCI USA Index. Why not, therefore, allocate portfolios more heavily toward the emerging markets, if their economies are expected to grow more rapidly than the economies of developed markets in the U.S., Europe and elsewhere? The answer is that the correlation between long-term economic growth and long-term equity returns is extremely weak if not nonexistent. Economic growth, by itself, is not a reliable predictor of equity returns. This conclusion holds true across both developed and emerging markets. The 2010 study by the authors from the London Business School concludes that there is no clear relationship between changes in GDP of the major developed economies and their stock market performance over the period 1900-2009. In fact, the correlation is actually slightly negative at -0.23. Data for the emerging markets is more limited but reaches the same conclusion. Reliable economic and market data for the full range of emerging markets only dates back to the late-1980s and, for some markets, the mid-1970s. Even so, the data leads to the same conclusion: The correlation between economic growth and equity returns is essentially nonexistent. One study addressed the argument that the effect of higher economic growth shows up, not immediately, but in the long-term equity returns. The study split the emerging market economies into two groups, one-half with the highest rates of economic growth and the other half with the lowest rates of economic growth. It found that the equity returns for the two groups over the period 1990-2005 were virtually identical at 16.4 percent. The disconnect between economic growth and equity returns was illustrated by the Stanford University authors by comparing the performance of the developing economies of Latin America and Asia between 1985 and 2005. Over this period, economic growth in Asia was much higher at 7.41 percent versus 2.91 percent per year for Latin America. The return on Latin American stocks, however, was far superior at 14.68 percent versus 7.01 percent per year. Why the apparent disconnect between economic growth and equity returns? The 2010 Vanguard study nicely draws together the conclusions of the collected studies. It's not that economic growth is unimportant for equity investors. There are, however, other important factors at play. First, valuation is a major determinant of equity returns. The price at which an investor buys into the market or, as the Vanguard study puts it, "the price investors pay for a market's expected growth" is critical. Expectations for higher economic growth quickly get built into the price of stocks, and buying overvalued stocks leads to disappointing returns. Economies with high GDP growth potential present a good investment opportunity only if equity valuations are low. Second, growth surprises seem to matter more than absolute growth. Economic growth better than the consensus expectations seems to have a much stronger correlation with subsequent market returns. This goes a long way to explaining, for example, the outperformance of Latin American stocks over Asian stocks during the period cited above. Latin American economies began the 1980s with very low expectations and, even though they underperformed the Asian developing economies over the next 20 years, the fact that Latin America performed better economically than expected helped produce much stronger equity returns. Latin American stocks also started out undervalued relative to the developing markets in Asia. Third, globalization means that it is harder to separate developed and developing markets. The Vanguard study points out that a large share of emerging world investments are funded by investments from developed economies. Not surprisingly, therefore, an increasing share of US corporate earnings comes from overseas markets. Between 1999 and 2008, the percentage of US corporate profits derived from overseas investments doubled to approximately 40 percent. Global businesses, therefore, both contribute to and share in the benefits of higher GDP growth in the emerging markets in the form of higher corporate earnings. Increasingly, U.S. investors have indirect exposure to emerging markets simply by investing in S&P 500 companies. Economic growth by itself is not a reliable indicator of subsequent equity returns. Investors should be cautious about over-allocating to emerging market stocks based on conventional wisdom that doesn't stand up to the data. ---------- David Peartree, JD, CFP is the principal of Worth Considering, Inc., a registered investment advisor offering fee-only investment and financial advice to individuals and families. Offices are located at 160 Linden Oaks, Rochester, N.Y. 14625, or email david@worth considering.com. Published: Thu, Mar 1, 2012