Horizon Kinetics commentary for the second quarter ended June 30, 2015.
Horizon Kinetics: Market Commentary
More Fun with Non-Predictive Attributes, and Why Perfect Foreknowledge Won’t Help
In last quarter’s review, we threatened to return to the inflammatory statement that many standard macroeconomic factors that are considered necessary elements of the portfolio management process and security valuation models, such as the expectations for GDP growth or interest rates or oil prices, and so forth, are more the source of bad decision making than good, and probably detract from performance more than they help.
That approach is rooted in an unintended departure from the scientific method, the notion that one can bring a systematic, formulaic approach to perhaps the ultimate non-absolute, interactive environment: namely a market-place composed of ever-reacting and anticipating participants called human beings—the stock market. For a work-ing example, let’s start with the understanding that emerging nation stock markets, though riskier (more volatile and less well regulated), perform better than developed developed-nation stock markets because their economies expand faster. It seems most logical. Herewith, the accompanying table lists the 5- and 10-year growth rates of the gross national income of several emerging market nations, with the U.S. included as well, for comparison. They are listed in descending growth order. Our task is to match the growth rate with the nation. These are the nations: China, Brazil, Malaysia, South Korea, and the U.S.
The two easiest to guess are probably China, which is at the top of the list, with almost 18% annualized expansion in national income over the past 10 years, and the U.S. which, as a developed nation, grew at a 3.2% rate and is at the bottom of the list. (These figures are not real growth after de-ducting inflation, in which case the U.S. figure would be about 1.5%.) In fact, for ease, the rest of the figures are in the country order listed above, with Brazil at a 15% annual 10-year growth rate, Malaysia at 10%, and South Korea at 6%, which was still twice the U.S. rate. The difference be-tween South Korea’s 6.1% growth rate and the U.S.’ 3.2% rate meant an 82% increase in the size of South Korea’s economy versus 38% for the U.S.
Now let’s use this data to invent the best investment strategy that has never been invented and the secret dream of so many: true knowledge of the future. Say that you could be presented with this historical data, which comes directly from the World Bank (http://data.worldbank.org), but were given it not on this conference call but, rather, on December 31, 2004, ten years ago. It was around that time and a few years earlier that the first single-country emerging market ETFs were created, so that anyone, not merely an institutional or sophisticated investor, could easily invest, in U.S. dollars in a domestic brokerage account, in an exchange traded, liquid index of Malaysian or Chinese stocks. Incidentally, the emerging markets chosen for this discussion were selected primarily because iShares ETFs for those markets existed in 2004, so a continuous record is readily available. Some other emerging markets indexes, such as for India or Indonesia, weren’t available until several years later.
Horizon Kinetics: Investing in emerging markets
Here’s the real question. Which of the markets listed above would you have chosen, with precise knowledge of the future, down to the fraction of a percentage point, available to no one else? To sweeten the pot, we’ll even make available the iShares MSCI Emerging Markets ETF (ticker EEM), so that you could invest in the higher growth of the worldwide emerging markets index without undue single-country risk.
The actual investment returns are shown below. Also included are a few additional emerging market countries that have 5-year index histories: India, Indonesia and Turkey. It turns out that two of the four single-country emerging market indexes did more poorly than the S&P 500 over the 10-year period and, more to the point, so did the entire Emerging Markets ETF. Perhaps more interesting, for the five-year period, none of the emerging markets came close to the S&P 500 returns. China, with 25% annualized economic expansion, produced 5% stock index returns com-pared to the U.S.’s 17%; India, even with a 12.7% growth rate returned only 3.5% via its stock index. What should one make of that?
The simplest observation is that GDP growth, even for pe-riods of 5 and 10 years, did not have ANY predictive power for stock market returns. Even magic foreknowledge did not help. There must be other factors at work, perhaps a con-founding variable. And that’s one of the problems with the application of even seemingly intuitively obvious investment models – which other factors? How many? How do you know what you don’t know? This level of rule-based decision making does not even take account of the constituents of these ETFs, of the individual businesses, their character or valuations. How many buyers of an India ETF review the holdings with any care? Does an ETF investor really have any idea what they’re buying? We suggest that they do not.
See full PDF below.