Investing: GDP growth and stock returns

Many investors think that they should over-allocate to countries who are experiencing or are expected to experience high economic growth, such as China, India, etc. The evidence however, suggests current economic growth is not a good metric for guidance on where to invest. In fact, most studies suggest a zero to slightly negative correlation between expected GDP growth and stock market returns.

Vanguard has a great, easy to understand article called "Investing in emerging markets: Evaluating the allure of rapid economic growth."

A few takeaways:

1) Zero correlation: "Our analysis shows that the average cross-country correlation between long-run GDP growth and long-run stock returns has been effectively zero. We show that this counter-intuitive result holds across the major equity markets over the past 100 years, as well as across emerging and developed markets over the past several decades." -Vanguard

2) Unexpected growth matters: There is, however, is relationship between unexpected GDP changes and stock market growth. This suggests that markets are informationally efficient. Expected growth rates are already priced into the markets. By their very nature, the unexpected changes are not and therefor affect stock returns.

3) Valuation matters: If a country is expected to grow rapidly it's stocks will be expensive relative to their earnings. If a country is expected to have slow growth, stocks will have lower valuations. There is a relationship between valuation and market returns.

DFA produces this every year and I thinks it's pretty fascinating. It shows the global market capitalization for stocks.