Tuesday, March 15, 2011

GMO - The Gratuitous Use of Statistics

GMO release and interesting white paper today entitled "The Gratuitous Use of Statistics", written by Arjun Divecha.  The full article can be found at http://www.gmo.com/.

To quote from the article.

Indeed, when one looks at the correlation between the FT Developed Multinational Index and the FT Emerging Markets Index over the last 10 years, the correlation of monthly returns was an amazing 87%. In fact, over the last 5 years, the correlation has risen to 92%!

Mr. Divecha then goes on to say a picture is worth a thousand words.  The statisticians often fail to mention the correlation is between the month to month changes and not in the total returns. 

Now for my comments.  I would totally agree with the author with the fact one must be careful when dealing with statisticians because you can make statistics say anything you want if you massage them enough.  My problem is why do you expect multinational companies to have similar total returns to the emerging market index?

First, the multinationals only have a portion of their sales from the emerging markets so to expect a 1:1 relative return ratio is simply unreasonable.  Their returns should be a combination of emerging and develop markets in their appropriate amounts.  Secondly, the relative valuations of the local markets compared to the large multinationals may be vastly different.  Many of the large multinationals in the Dow Jones Industrial Average are selling for very reasonable levels while many emerging markets can get well ahead of themselves in the short term. 

Lastly, the correlation definitely gives you confidence that you are getting some exposure via the large multinational companies.  Over the long term the growth in emerging markets will represent real returns.  Many of the large multinationals in the US have had their stocks go sideways for the past decade despite sales and earnings going up two or three fold.  Many of them have seen their P/E ratios drop from 30 to 10.  The emerging markets have likely seen the relative valuations go the opposite direction. 

Best Regards,


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