When What's Down Is Up

Troubled economies may result in soaring markets.

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Zimbabwe's runaway inflation makes it appear that its stock market is soaring.

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You wouldn't want to bet on a sick, underfed horse. So when it comes time to invest overseas, it makes sense to focus on the countries with the healthiest economies, such as oil-rich countries like the United Arab Emirates. Right?

Not quite. The growth of a nation's gross domestic product is only one factor influencing the returns generated by a country's stock market. And in the short term, economic growth and stock returns have little relationship. In fact, there's some evidence that betting on weak economies can pay off handsomely for those willing to take a big risk.

Take the list of the past year's worst- and best-performing stock markets, as tracked by the MSCI Barra country indexes. The UAE, where economic growth has been booming at more than 7 percent a year since 2000, has seen its stock index drop by about 9 percent in the past 12 months. Other bottom-dwellers with seemingly strong economies include Bahrain, Sri Lanka, and Ireland.

The country with the single best-performing index over the past 12 months? Peru, which has returned 130 percent even though FSP growth has averaged less than 4 percent a year.

What gives? Paul Marsh, a London Business School professor, says it's simple: Investors look ahead, not back. Stock markets do a fairly good job of predicting future economic growth. Yet, he warns, even that "doesn't work perfectly."

Noneconomic factors can be better predictors of future returns. Kai Li, a professor at the University of British Columbia, found that a country's protection of shareholder rights, openness to trade, and sophistication of financial institutions were key. Horacio Valeiras, manager of Nicholas-Applegate International Growth Opportunities Fund—which Morningstar says has one of the best 10-year records for international funds—says anyone considering investing in oil-rich Venezuela, for example, has to consider the possibility that his investment could be nationalized. "We can't be investing," he says, "in a place where our assets can be taken away."

Sometimes, he says, lower-growth countries can boom when forced by investors to make reforms that free up markets. But betting on reform is not for the faint of heart. One of the world's worst economic basket cases, Zimbabwe, might seem attractive to vulture investors who have watched the Zimbabwean Stock Exchange skyrocket in recent months. But when calculated in U.S. dollar terms, the ZSE is falling because runaway inflation is destroying the value of the Zimbabwean dollar. The country last month dropped the official exchange rate from 250 Zimbabwean dollars to the U.S. dollar to 30,000. But the reality may be even worse: The United Nations estimates that hyperinflation has doubled the real price of one U.S. dollar in the past month from 160,000 Zimbabwean dollars to 350,000.