Great economies don't usually mean great returns

(MoneyWatch) Regular readers of this blog know that there are no good economic forecasters, just overconfident ones. But imagine you had a perfectly clear, but limited, crystal ball. You foresee the following year's rate of economic growth around the globe, though you can't see stock returns. Your crystal ball tells you that China's GDP would grow at more than 7 percent while the eurozone would be in recession. If you're like most investors, you'd want to invest in China and avoid Europe. Let's see how such a strategy has played out.

Despite the eurozone recession, Vanguard's European Index Fund (VEURX) has returned about 21 percent through Dec. 19, and outperformed the S&P China ETF (GXC) by about 2 percent and the iShares FTSE China 25 Index ETF (FXI) by more than 4 percent. And while the U.S. economy was growing in excess of 2 percent, VEURX has also outperformed Vanguard's 500 Index Fund (VFINX), which has returned 14.8 percent. To understand why this outcome came about, you need to understand two important points.

• Understanding "momentum" in stock returns
• Projections show smaller future stock returns
• Can we predict stock returns over the long term?

The market is highly efficient at processing information. That means everything knowable about stocks is already incorporated into prices. Thus, if the market expects China's economy to grow faster than Europe's, that's already reflected in prices. What matters to future returns is how the actual outcome differs from the expectation.

In this case, while China's GDP did grow at a rapid pace, the rate of growth was less than expected. And in Europe's case, the recession they've experienced wasn't as bad as expected. In addition, the worst outcome that people feared as a result of the fiscal crises in Greece, Italy, Spain and Portugal didn't happen.

The historical evidence actually shows that there has been a negative correlation between economic growth rates and stock returns -- countries that have faster economic growth tend to have lower stock returns. A logical explanation is that the faster economic growth rates are already incorporated into prices. Thus, markets price for risk, not growth. And countries that experience slower economic growth might be seen to be riskier places to invest. Thus, investors demand a higher expected return to compensate them for taking the incremental risks.

The lesson to take away is to be sure to tune out the next guru's recommendation to increase your investments in some country or region because their economy is expected to grow rapidly. The reasons are:

• There are no good forecasters.
• The market has already built into current prices whatever is knowable about the country or region. (If you're reading or hearing the forecast, it's not a secret.)
• There's a negative relationship between growth rates and stock returns.