As the director of research for Buckingham Strategic Wealth, The BAM Alliance and Loring Ward, a question I’m frequently asked relates to the view that the U.S. is a safer place to invest because of our capitalist system—while much of the rest of the world (Europe, in particular) is “doomed” to underperform because of their more socialist policies.
That view is probably influenced by the well-known bias of recency, with U.S. stocks far outperforming international stocks over the past decade. As anecdotal evidence supporting that view, I wasn’t getting that question during the period from 2003 through 2007. Perhaps the reason was that, while the S&P 500 Index provided a total return of 83%, it dramatically underperformed the 171% return of the MSCI EAFE Index and the 391% return of the MSCI Emerging Markets Index.
I thought it worth sharing how I address the issue. I begin by pointing out that it is important to not make the mistake of confusing information with value-relevant information. If the market (investors in aggregate) knows something (such as a country having socialist policies that might dampen economic growth and corporate profits), that information must already be embedded in prices. Thus, it has no value to you.
It’s also important to understand that markets don’t price for growth, they price for risk. Informed investors know not only that growth companies (with faster rates of growth in earnings) have produced lower returns than value companies (with slower growth in earnings), but also that there is a slightly negative relationship between growth rates of country GDP and stock returns.
For example, in his study “Economic Growth and Equity Returns,” Jay Ritter found that, over the 103-year period of 1900-2002, the correlation of per capita GNP growth and stock returns for 16 countries was actually negative (-0.37)—countries with above-average growth rates provided below average returns.
We find the same evidence in the returns of individual stocks. For example, growth stocks, which have higher growth in earnings than value stocks, have produced lower returns. Using data from Fama-French (FF) research indexes, from 1927 through 2017, the FF U.S. large growth research index returned 9.7%, while their large value research index returned 12.1%. We see the same thing in small stocks, with the FF U.S. small growth research index returning 8.9% versus 14.8% for the FF U.S. small value research index. To repeat, markets price for risk.
Prices Reflect All Known Information
The bottom line is that, in an efficient market (the annual SPIVA results demonstrate that the markets are highly efficient), current stock prices reflect the aggregate expectations of market participants—the “wisdom of crowds.”
In other words, when setting prices, investors consider many issues, including a country’s commitment (or lack thereof) to market-oriented institutions and policies as well as how changes to those institutions and policies might impact future cash flows and discount rates. In addition, prices change almost instantaneously as new information becomes available, often well in advance of when a policy is finalized or implemented.
That’s the theory. Now let’s look at the historical evidence.
Using the economic freedom scores from the Fraser Institute’s Economic Freedom of the World Report as a proxy for the degree of government intervention in the economy, Dimensional Fund Advisors analyzed the relationship between a country’s commitment to market-oriented policies, institutions and stock returns in that country. The report measures economic freedom across five broad areas—size of government, legal system and property rights, sound money, freedom to trade internationally, and regulation—and produces rankings in those areas as well as an overall ranking of economic freedom. Annual scores are available for most countries from 2000 through 2016.
Exhibit 1 below illustrates average annual stock market returns versus average economic freedom score for developed and emerging markets over the 2000-2016 sample period.
As you might expect, emerging market countries tend to score lower than developed markets on economic freedom. Emerging market countries have also had higher returns on average. That’s consistent with the notion that emerging markets expose investors to greater political and economic risk than developed markets, which investors demand a premium to bear. As the chart demonstrates, within developed and emerging markets, there’s little discernable pattern between economic freedom score and average returns.
(For a larger view, click on the image above)
Includes all countries in the MSCI World and Emerging Markets Indices, as of December 2018. Economic freedom scores are from the Economic Freedom of the World: 2018 Report. Equity returns are represented by each country’s MSCI standard index (net dividends). MSCI data © 2019 MSCI Inc., all rights reserved.
Exhibit 2 below shows the market performance for high and low economic freedom groups formed from sorting countries annually on current year economic freedom score. Dimensional defined high (low) economic freedom countries as those whose economic freedom score is above (below) the median score for a given year.
In developed markets, high economic freedom countries had, on average, higher average returns than low economic freedom countries. In emerging markets, average returns were higher for countries ranking lower on economic freedom. But in both cases, the t-statistics for the return spreads indicated the differences were not reliable. These results suggest that even perfect foresight of future developments in economic freedom may not be useful for timing equity markets.
(For a larger view, click on the image above)
The core investment philosophy should be that, in liquid and competitive markets, where capital is free to move around the globe, security prices reflect the aggregate expectations of all market participants. Among the many considerations by market participants when setting prices are political risks, information about government spending in the economy, the strength of the rule of law and the regulatory framework under which the private sector operates.
Thus, investment decisions should not be based on countries’ economic freedom—the knowledge of which is already embedded in prices. A truly global perspective offers a broader opportunity to manage idiosyncratic risks of countries.
The bottom line is that your global equity allocation should look similar to how the “wisdom of crowds” (in aggregate, all investors) allocates capital. Today that is about one-half U.S., three-eighths developed non-U.S. and about one-eighth emerging markets. For those interested, the year-end 2018 CAPE 10 earnings yields (as good a predictor as we have for future expected real returns) was as follows: U.S., 3.6; Developed non-U.S., 5.8, and Emerging Markets, 7.3. (Data provided by AQR Capital Management.)
Larry Swedroe is the director of research for The BAM Alliance, a community of more than 130 independent registered investment advisors throughout the country.
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