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.)
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.
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.)
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.)