Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
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Back to The Future

August 29, 2012 - 0 comments

Two smart folks disagreeing is a learning opportunity. Over the past few weeks we have had Bill Gross at PIMCO pronouncing the “Death of Equities” and a riposte from Jeremy Siegel, Professor of Finance at Wharton.

At the core of the debate was the relationship between a country’s economic growth and equity returns.  This doesn’t seem too complicated. Surely it is better to invest in growing economies than those that are stagnating or shrinking?  China, for example, is the poster child for rapidly growing economies and France is often ridiculed as the epitome of “Old Europe”. Over the period, 1985-2009, China’s economy grew, on average, 9.9% every year and France’s economy grew by 1.9%1. Over the same period the average annual equity return from China was 2.6% and from France 8.7%. Thus a Chinese investor who invested at the start of 1985 would have seen an investment return of 90% by 2009. Her French colleague would have seen a total investment return of 705%! 

Why is this data so contrary to intuition? One explanation lies in the different population growth of the two countries. China’s population grew by 468%2 compared with France’s 13%3 from 1985-2009. So let’s remove the impact of population growth by using economic growth per person (most commonly GDP growth per capita) as our measure of economic strength.  While we are at it, we can remove another distraction, the impact of inflation. This leaves us comparing real GDP growth per capita with real equity returns. One of the most comprehensive long term studies1 shows clearly that there is no clear relationship between changes in real GDP per capita and stock market returns (in fact the data shows a slight tendency for countries with a high real GDP growth per capita to have a low real stock market return).

So, an investment strategy that advocates loading up on “growth countries” is likely to do rather worse than picking countries at random.  Worth remembering when you are told that Country X is the next China. There are a number explanations1 offered for this surprising result but we are investors, not economists, so we can skip that step.

The same authors also wondered whether there might be some lag between GDP growth and equity returns. Indeed there was, but not what you might hope: They found that prior year market returns were a statistically significant predictor of subsequent GDP growth. In the words of the authors (which should be on every investor’s desk)

“ Buying growth markets fails to outperform because markets anticipate (my emphasis) economic growth”

Note that this does not imply that investors should not own stocks in high growth countries nor does it suggest that low growth countries will offer better stock returns. It simply states that a country’s current economic  growth is of no use for anticipating future stock returns.  

If markets anticipate economic growth then couldn’t we use a perfect forecast about tomorrow’s economy to choose stocks today and make a fortune.  And so we could.  Unfortunately, economists are making as much progress on the perfect forecast as physicists are making on time machines. Next time you sit through an economic forecast from your favourite bank economist visualize him as Doc Brown inviting you to take a time trip in his plutonium powered  DeLorean.  Better yet, stay at home and enjoy the movie.

In the next blog we will take a few more steps and look more closely at investor returns and whether there is a deeper link to economic success.


  1. Elroy Dimson, Paul Marsh & Mike Staunton, London Business School.(2010)
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