Who was it?
So, of all the stock markets comprising the MSCI World Index, which enjoyed the best return in 2011? The answer is Ireland. Yes, Ireland. The country famous for being an “I” in among the so-called PIIGS of Portugal, Ireland, Italy, Greece and Spain. In local currency terms, the Irish share market finished last year with a return of 0.58 per cent, slightly better than the US with no return and a lot better than the Australian market’s return of minus 10.54 per cent (see figure 3). Of course, the result in Australian dollar terms depended on each investor’s hedge ratio, which will vary from portfolio to portfolio.
In contrast, the equity market return from China, the country most people instinctively associate with economic growth, was minus 21.68 per cent. Other popular emerging markets also performed worse than developed markets. Brazil returned minus 18.11 per cent, Russia returned minus 16.93 per cent and India produced minus 24.64 per cent.
Why might Ireland have outperformed so many other countries? Let’s answer this question by using the revised model in figure 3. First, corporate profits are probably only a fraction of Ireland’s economic growth, so GDP figures may not be of much help. Second, I doubt there is much appetite for Irish equities at the moment, so issuance and earnings dilution are unlikely to be a problem.
That brings us to valuation. With so much bad news already factored into the price, all that was needed for Irish shares to limp along was for things not to turn out as badly as everyone expected. Perhaps as the focus shifted to the downgrade of the US and worsening situation in Greece, suddenly Ireland didn’t look so bad. It seems that the cheapness of Irish shares provided investors with a margin of safety or an increased reward for the risks of investment.
But there is a caveat. While I don’t believe that there’s a link between economic growth and share market returns, I do believe that there is a definite link between economic growth and market sentiment. (Nobody said investing would be easy.) How can we understand market sentiment? That will be the topic of next month’s article.