Practical analysis for investment professionals
28 November 2012

International Investments: Is There a Discrepancy between the Economic Growth Rate and Equity Returns?

Conventional wisdom holds that if a global stock investor is able to identify which countries’ economies will grow briskly and which will lag, he has conquered half of the investment battle. Economic growth should translate into higher corporate earnings per share and thus rising stock prices, so the investor should favor the economies where he anticipates zippy economic growth. Sound simple?

Actually, it’s not. In theory, over long time frames, earnings growth should track economic expansion and equity returns should reflect that earnings growth. But over shorter time frames, these relationships can break down. When Gerstein Fisher analyzed the historical relationship between GDP growth and stock price performance in eight major developed and developing countries between 1 January 1994 and 31 December 2011 (see graph), the results were quite startling. We found that the correlation between annual stock returns and economic growth was actually pretty tenuous — typically quite low and sometimes even negative, as in the cases of China and South Korea.

Moreover, there was a huge discrepancy in terms of the ratio of compounded stock returns to compounded GDP growth. For example, China’s economy expanded by an impressive 16.90% annualized (in nominal, U.S.-dollar terms) during the 18-year period we studied, yet its stocks actually declined by 3.63% per year over the same period. Brazil stocks returned 12.17% atop a lower compounded economic growth rate of 10.10%. The United States had a comparatively modest economic growth rate of 4.72% but a respectable annualized stock return of 7.62%, or 61% higher than the underlying economic growth rate. The only country with a greater stock return per unit of economic growth was South Africa, where the market returned 12.04% annualized against 6.55% annual economic expansion.

Pay Attention to Valuations
How do we explain the gap between economic growth and market performance? There are a number of possible explanations, of which we’ll offer a few. One has to do with valuations: Expected economic growth is already built into current prices, thus reducing future realized returns. For example, when Japan’s Nikkei 225 soared to almost 39,000 in late December 1989, investors were overly bullish about the economic growth prospects for the Japanese economy. When that growth did not materialize, the stock market collapsed (today, nearly 23 years later, the Nikkei still languishes at 8,757). By contrast, in 1993 Brazil’s stocks were relatively cheap because the country’s economy was racked by high debt, hyperinflation, and the effects of political instability. Brazil’s government, however, managed to turn it around, and the stock market took off.

In other words, investors should be careful not to confuse a good story with a good investment. Whether it’s a glamorous stock or a high-growth economy, a high price implies low expected returns (e.g., Japan in 1989) and a low price implies high subsequent returns (e.g., Brazil in 1993). Or think of it this way: For a country (such as China) with a good story and high economic growth to be a lucrative investment, it would actually need to perform even better than everyone already expects. By contrast, a “bad story” at a good price, such as the U.S. market in 2008–2009, is most likely a better investment.

Another issue is the discrepancy between corporate earnings and earnings per share (EPS). EPS is what matters to shareholders. If companies issue new shares and dilute existing shareholders or if young companies go public, capital increases and the economy grows, but shareholders are not receiving any increase in EPS. If a stock market has a plethora of new share issues and IPOs, the market capitalization (number of shares outstanding times the price per share) may grow much more than shareholders’ returns.

Economies vs. Markets
In his book Breakout Nations, emerging market investor Ruchir Sharma has a plausible explanation for the strong performance of stock markets in such developing countries as Mexico and South Africa amid relatively weak economies. In both countries, he writes, highly profitable oligopolies control many industries, which is lucrative for shareholders but not necessarily good for the economies. In Mexico, for instance, “the top-ten business families control almost every industry, from telephones to media, which allows them to extract higher prices without much effort and to enjoy unusually high profit margins. That explains why Mexico has had one of the hottest stock markets and one of the most sluggish economies in the emerging world.” South Africa, the market return per unit of GDP growth champion of our study, posted economic growth rates similar to South Korea’s during the 18-year period — but stocks returned 62% more annualized.

Finally, another factor — and one that is growing in importance with globalization — is the disconnect that sometimes exists between the structure and composition of an economy and that of its domestic stock market. Take the examples of the United States and China, the world’s two largest economies. One reason profits of S&P 500 Index companies in industrials , technology, and consumer staples have surged the past few years despite a mediocre U.S. economic recovery is that overseas sales and profits have burgeoned. The United States happens to be very rich in globally competitive multinational corporations. A U.S.-based company building a factory in China and selling to Chinese consumers doesn’t add to U.S. GDP, but assuming the project has a positive net present value, it will increase profits for the company’s shareholders. Increasingly, S&P 500 companies are global businesses that just happen to be listed on a U.S. exchange.

China’s problem is almost the reverse of the United States’ situation: impressive macroeconomic numbers but much less impressive investor returns. The Chinese state still controls the banking system and the commanding heights of the economy. As a result, bank credit flows to state enterprises (many of which are listed on domestic stock exchanges) for political and social reasons rather than flowing to promising entrepreneurial companies. The economy is investment dominated (capital spending is nearly half of the economy); the domestic consumer economy is underdeveloped; and interest rates are held artificially low, which encourages inefficient allocation of the country’s enormous domestic savings.

A country’s stock market performance very often does not match that of its underlying economy — a good story is not always a good investment. Investors need to look carefully at factors such as valuations and the structure and composition of a country’s economy as compared with those of its equity market. And don’t forget that these environments are dynamic: Not many observers foresaw the rise of Brazil’s economy and stock market or the precipitous decline of Japan’s. If all of this sounds too complicated, then one solution would be to simply hold a globally diversified portfolio, rebalanced periodically. To provide more diversification, I prefer capping country weights, which also provides a tilt toward value and can help prevent money flowing into the most popular markets — such as Japan in the late 1980s.

Source: Gerstein Fisher, Bloomberg. The US market is represented by the S&P 500 Index. All other stock markets are represented by the relevant MSCI country indices

If you liked this post, don’t forget to subscribe to the Enterprising Investor.

All posts are the opinion of the author. As such, they should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute or the author’s employer.

Photo credit: nihatdirsun

About the Author(s)
Gregg S. Fisher, CFA

Gregg S. Fisher, CFA, is chief investment officer of Gerstein Fisher, an independent investment management and advisory firm that he founded in 1993. Gerstein Fisher’s investment strategies are focused on what has been proven to have a meaningful impact on investor returns: global diversification, smart portfolio structure, proactive tax management, investor behavior, and risk management. Through the Gerstein Fisher Research Center, which he established in 2009, he has partnered with leading academics in the areas of finance, risk engineering and economics to conduct research that has immediate, real-world applicability to the practice of investing. Fisher is a Certified Financial Planner. To read more about him, visit

2 thoughts on “International Investments: Is There a Discrepancy between the Economic Growth Rate and Equity Returns?”

Leave a Reply

Your email address will not be published. Required fields are marked *

By continuing to use the site, you agree to the use of cookies. more information

The cookie settings on this website are set to "allow cookies" to give you the best browsing experience possible. If you continue to use this website without changing your cookie settings or you click "Accept" below then you are consenting to this.