Conventional wisdom holds that investors must look to emerging markets for healthy returns over the coming decades. BRIC markets, including Brazil, Russia, India, and China, are frequently mentioned as holding the most potential given projections for rapid and steady economic growth. However, GDP growth is not necessarily a solid indicator of stock market gains to come. We'll discuss the relationship between the two and look at other useful metrics to consider when hunting for overseas investment opportunities. (For a background on this topic, see our Economic Indicators Tutorial.)

Contrarian Studies
An analysis by Goldman Sachs concluded that there was no correlation between real GDP growth in emerging markets and their stock market returns from 1976 to 2005. A 2005 study by the Brandes Institute, the research arm of famed value investor Brandes Investment Partners, actually showed that the countries with the highest GDP growth - including emerging markets - posted the worst stock market returns, while countries with the lowest GDP growth experienced the highest returns. The study covered 53 countries and included 105 years worth of data. Professors undertaking the Brandes study concluded that "the total return from buying stocks in low-growth countries has historically exceeded the return from buying stocks in high-growth economies."

GDP Isn't Everything
A key takeaway from the above studies is that it's not enough to simply equate rapid GDP growth with a surge in stock returns. The Goldman study stresses the importance of not getting caught up with optimistic GDP growth trends. Instead, focus on the fundamentals of a specific country or the individual equities in that market. Brandes' conclusion from its study is to focus on low growth markets because investors underestimate the growth potential of underlying firms in these countries.

Sheep for Shearing
Conversely, high-growth markets tend to attract too much attention. Investors follow a herd mentality and pile into stocks with an excessive degree of optimism that outstrips the fundamental growth rate of the economy. During the 1970s and 1980s in the United States, quarterly GDP growth exceeded the quarterly return of the S&P 500. This dynamic shifted in the late to mid 1990s, due primarily to the dotcom bubble and irrational exuberance regarding the growth prospects of many individual companies. (To learn more, see Why Did Dotcom Companies Crash So Drastically?)

Brandes did conclude that investors stand to benefit from diversification into foreign markets as they have historically shown low correlations with the U.S. market. Additionally, it's important to note that stock market gains do tend to track GDP growth over the long term even though there are short-term fluctuations - because of excessive fear and greed - where the relationship breaks down. Another issue is that private firms may be accounting for a high proportion of GDP growth in smaller or less liquid markets. This type of growth is not available to investors in publicly traded securities.

Alternative Measures
Given that the relationship between GDP growth and stock market gains is hazy at best, here are some other statistics to track in regard to identifying appealing markets to invest in. As with stocks, a study of historical price-to-earning (P/E) ratio ranges is essential. The 20-year average P/E of emerging markets was approximately 14 for the period ended 2007. Markets with lower overall earnings multiples may have above-average, long-term return potential.

Cash Is Better Than Credit
In regard to individual economies, statistics indicating underlying strength include the extent of current-account deficits, levels of inflation, growth in credit and budget deficits. Capital flows are also important. Asian countries learned this lesson in the late 1990s as foreign investment plummeted during economic crises. This explains the reason for significant current-account surpluses since then; surpluses that helped them fight off the worst aspects of the 2008 credit crisis. (To learn more, see Market Crashes: The Asian Crisis.)

Global Investing Close to Home
Once appealing markets have been identified, a bottoms-up process toward finding individual equity opportunities could prove profitable. A focus on value-investing principles, including investing in firms with low P/E, price-to-book, price-to-free-cash-flow ratios and high dividend yields is advisable. For U.S. investors, investing in domestic-based stocks is a lower risk approach to gaining overseas exposure. Studies estimate that nearly half of S&P 500 sales and earnings now stem from foreign markets. (For more, check out Where Top Down Meets Bottom Up.)

Conclusion
Despite the fact that GDP growth is a poor predictor of stock market returns over shorter term periods, the relationship does hold loosely over the long haul. Foreign markets are appealing simply for the diversification benefits they can bring domestic portfolios. For the enterprising investor, an understanding of the drivers of GDP growth as well as individual economy and company performance can help in identifying lucrative investments across the globe. (To learn more, see Re-Evaluating Emerging Markets.)

Related Articles
  1. Stock Analysis

    The Best Stocks to Buy for Less than $10 before Year End

    Learn about the best stocks to buy under $10. These stocks are speculative but have considerable upside given their valuation and market conditions.
  2. Economics

    A Look at Greece’s Messy Fiscal Policy

    Investigate the muddy fiscal policy, tax problems, and inability to institute austerity that created the Greek crises in 2010 and 2015.
  3. Mutual Funds & ETFs

    ETF Analysis: iShares MSCI South Africa

    Learn more about the iShares MSCI South Africa fund, which is an NYSE-listed exchange-traded fund offered and managed by BlackRock.
  4. Mutual Funds & ETFs

    ETF Analysis: WisdomTree International Hdgd Div Gr

    Review an analysis of the WisdomTree International Hedged Dividend Growth Fund ETF, which offers investors broad international exposure.
  5. Mutual Funds & ETFs

    ETF Analysis: WisdomTree SmallCap Earnings

    Discover the WisdomTree Small Cap Earnings ETF, a fund with a special focus on small-cap and micro-cap stocks with positive earnings.
  6. Mutual Funds & ETFs

    ETF Analysis: iShares US Regional Banks

    Obtain information and analysis of the iShares US Regional Banks ETF for investors seeking particular exposure to regional bank stocks.
  7. Technical Indicators

    Key Financial Ratios to Analyze the Mining Industry

    Discover some the most important financial ratios used by investors and analysts to evaluate companies in the metals and mining industry.
  8. Technical Indicators

    Key Financial Ratios to Analyze Retail Banks

    Learn about key financial metrics that investors use to evaluate retail banks, and how the industry is fundamentally different from most other industries.
  9. Technical Indicators

    Key Financial Ratios to Analyze Airline Companies

    Examine some of the most important financial ratios and performance metrics investors use to evaluate companies in the airline industry.
  10. Stock Analysis

    The 5 Biggest Canadian Oil Companies

    Obtain information about some of the largest and most successful major integrated oil corporations that are headquartered in Canada.
RELATED TERMS
  1. Profit Margin

    A category of ratios measuring profitability calculated as net ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis ...
  3. Cost, Insurance and Freight - CIF

    A trade term requiring the seller to arrange for the carriage ...
  4. Brazil, Russia, India And China ...

    An acronym for the economies of Brazil, Russia, India and China ...
  5. Discount Bond

    A bond that is issued for less than its par (or face) value, ...
  6. International Monetary Fund - IMF

    An international organization created for the purpose of standardizing ...
RELATED FAQS
  1. Is Argentina a developed country?

    Argentina is not a developed country. It has one of the strongest economies in South America or Central America and ranks ... Read Full Answer >>
  2. Is Brazil a developed country?

    Brazil is not a developed country. Though it has the largest economy in South America or Central America, Brazil is still ... Read Full Answer >>
  3. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  4. Are Social Security payments included in the US GDP calculation?

    Social Security payments are not included in the U.S. definition of the gross domestic product (GDP). Transfer Payments For ... Read Full Answer >>
  5. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  6. When has the United States run its largest trade deficits?

    In macroeconomics, balance of trade is one of the leading economic metrics that determines the trading relationship of a ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!