"Investors Should Never Base an Investment Decision on Historical Economic Growth in a Certain Region"
Oct. 05, 2012
Gerd Kommer is the London-based author of various best-selling investment guides. He is an advocate of a passive, indexing-based investment strategy. In this interview, he talks about why investors should not believe that markets with high GDP growth are necessarily good investments. He explains how this trap can be avoided and how a rational investor should should consider these insights in his asset allocation.
MyPrivateBanking: Why do you disagree with the conventional wisdom that stock markets returns in the long run should approximate GDP growth?
Gerd Kommer: Because there simply is neither any statistical evidence nor any logical reason for such a relationship in spite of the fact that the fund industry, the financial media and most cocktail party experts have been repeating this platitude for decades. There are plenty of empirical studies published in the last couple of years that show the complete absence of any correlation between economic growth – typically measured as GDP growth – and stock market returns across countries.
Let me illustrate this with an individual example: The case of China and Germany. From 1993 to 2011 – this is the longest available stock market data series for China – China's stock market (the MSCI China) produced – and this may be surprising to some readers – a negative, inflation adjusted return of –2.9% p.a. This equated to a cumulative loss of –44% over 19 years in real terms. During the same 19 years Germany's stock market return (MSCI Germany) returned +5.5% p.a. which equated to a cumulative gain of +180%, all data in DM/Euros and inflation adjusted. Now contrast this with the economic growth rates of the two countries over these nearly two decades: China boasted a real GDP growth rate (in domestic currency) of almost eight times that of Germany; in figures 10.2% p.a. vs. 1.3% p.a. Note that the usage of GDP per capita rather than total GDP or different currency assumptions would not alter this picture materially.
To summarise: A substantial number of emprical studies have shown it and no matter how counter intuitive it may appear to you, there is no meaningful short term or mid-term relationship between economic growth and stock market returns and certainly none that investors could use to guide, let alone to improve their investment decisions.
MyPrivateBanking: What are in your opinion the main causes for the empirical lack of a any relevant positive correlation between stock market returns and GDP growth?
Gerd Kommer: Well, there are a whole range of causes and they are almost too numerous to describe in a short interview. Let me summarise a few of the more pertinent ones.
Firstly, stock market returns are based on subjective forward looking discounted cash flow expectations by all market participants, whereas GDP growth represents backward looking macro-economic accounting numbers. These are different things measured differently.
Secondly, the stock market is related to corporate profits and these corporate profits are only a small component of GDP; the other five components – collectively much bigger – are wages, rents, interest income, indirect business taxes and depreciation. So again, there is a fundamental difference in the basis of the two concepts, stock market returns and GDP.
Thirdly, any economy is made up of unlisted, i.e. privately held or government owned companies on the one side and stock market listed companies on the other. Obviously, only the listed companies determine stock market returns. Trouble is that the listed companies, i.e. the stock market, is not only the smaller part of the economic landscape, it also has a very different composition from the bigger part, the unlisted corporates. Unlisted companies are smaller on average, their ownership interests are less liquid and they represent a different industry mix. All of this matters in terms of risk and return. Bottom line, GDP includes all companies while the stock market includes only a minority of them and a minority that tends to be quite different from the majority regarding a number of factors that influence risk and return.
A forth reason, is that the individual components of GDP - profits, wages, rents, interest income, indirect business taxes and depreciation - represent different degrees of risk, depending on where they are in the so called cash flow cascade of an economy. Profits happen to sit at the bottom of the cascade and therefore are the riskiest GDP component. Assuming that there is a positive relationship between risk and return – a fundamental tenet of economics – you have to conclude that long term stock market returns – all else being equal – should be higher than GDP growth as profits are riskier than GDP in total.
There are more analytical reasons for the missing connection between GDP growth and stock market returns but they are of more intricate technical detail which is why I omit them here.
MyPrivateBanking How should these findings influence the investment decisions and asset allocation of individual investors?
Gerd Kommer: Very simply, investors should never base an investment decision on historical economic growth in a certain country or region, whether high or low, nor on expected forward looking growth prospects. Doing so is about as smart as making investment decisions on the basis of the annual rainfall in a country. If an investor hears his financial advisor telling him to buy or sell a certain investment X due to some supposed relationship with GDP growth, this is unequivocal proof that this financial advisor is a fee pushing dimwit and should be ditched. The same applies to any fund firm that peddles its products, e.g. emerging market funds or strategies, on the basis of some bogus high-economic-growth-causes-high stock-returns- 'theory'.
MyPrivateBanking: Should investors revise their expectations for the stock market returns of emerging markets?
Gerd Kommer: Emerging markets as a group – certainly not every individual emerging market – have had higher stock and bond market returns historically than developed markets. There are, in my opinion, good reasons for this to continue in the long run, but only for emerging markets collectively, not for every individual country. Which individual emerging markets will do well and which ones won't I haven't got the slightest clue. For instance, over the last 16 years Peru was no. 1, China no. 23 out of 24 emerging markets. Would you have guessed this?
In any event, a certain allocation to emerging market stocks should indeed be considered within any, hopefully globally diversified, investor portfolio, bearing in mind that a portfolio also needs to encompass other asset classes such as AAA or AA rated short term bonds. In my view, the emerging market exposure should ideally be in the form of a passive low cost ETF or index fund covering all 20+ emerging markets. Singling out an individual country on the basis of strong growth expectations or even groups of countries such as the BRIC states is a silly and dangerous idea.
MyPrivateBanking: If it's not GDP growth, what is really driving stock market returns and what does this mean for investors?
Gerd Kommer: Returns come from risk, not from historical or future expected growth. This means that any group of countries composed specifically composed of high political risk states – commonly known as emerging markets – will likely generate higher returns than group B which is designed to encompass countries with lower political risk a.k.a. as developed markets. Now the expected return premium of emerging markets over developed markets for both stocks and bonds does not come for free. It is due to additional risk which manifests itself in higher volatility, higher maximum drawdowns and long periods of underperformance. So, the extra returns are clearly not a free lunch. Taking the additional risk of emerging markets does make sense but only within a systematically and rationally diversified portfolio across many different asset classes. This brings me to the overall conclusion: Never invest into a country or region because this country or region has had high GDP growth rates or profits in the past and likewise never invest in a country or a region because some so-called expert forecasts high growth rates in the future and wants to you to 'capture' this high growth. I almost guarantee you, that if you hear it from such expected growth rates by your financial advisor or read of them in the paper, then is already priced in. If it's already priced in, it cannot possibly lead to any risk adjusted return premium. If you have a habit of trading on such 'information' you will likely harm your long-term returns; but at least your advisor will be pleased about his commissions.
I guess the moral of the story is that – here again – we have a situation where almost the entire financial industry and its sensationalist handmaiden, the financial media, have been preaching unscientific baloney for decades as this helps them to peddle their high fee wares at the expense of the long term risk adjusted net returns of their clients.
Dr. Gerd Kommer is a director in the structured finance division of a bank in London. Over the last couple of years he has published a number of investment books directed at retail investors in the German speaking countries among them his latest "Herleitung und Umsetzung eines passiven Investmentansatzes für Privatanleger in Deutschland: Langfristig anlegen auf wissenschaftlicher Basis", Campus Verlag 2012. He can be contacted at firstname.lastname@example.org.