Shorting Socialism

Market returns have been lower in Latin American countries governed by socialists
 

By: Clark Dean

Last year, Colombia elected its first left-wing president since the early 1980s, Gustavo Petro, a former M-19 guerrilla. His first year hasn’t exactly gone well: his disapproval ratings have risen from 20% to 60% among Colombians. This socialist guerrilla hasn’t been great for Colombia’s stock market either. Colombian stocks are down 37% in local currency and 34% USD in a little over one year. How should we think about this episode of market history?
 
It can be tricky to measure socialism’s performance across a variety of metrics due to poor data quality. Take for example the market for literature. The Guiness Book of World Records lists the Bible as the best-selling book in human history at around 5 billion copies, and they gave a runner-up mention for Mao’s Little Red Book at 800 million copies “sold.” But ask other sources, and Mao’s Little Red Book bested the Bible at 6.5 billion copies.     
 
When social organization is based on state or collective ownership and regulation of the means of production, distribution, and exchange for the common benefit of all members of society (OED definition of socialism), this is often accompanied by a similar regulation of historical facts, thereby making scientific study challenging after the fact. But despite these challenges, we will endeavor to fulfill the wishes of early visionaries in the field: “Socialism, having become a science, demands the same treatment as every other science, i.e., it must be studied” (Friedrich Engels, 1874).
 
In the case of Latin American markets, similar stories as Gustavo Petro’s have played out over the past few decades that we can measure. We studied each of the six largest Latin American markets, and we determined what percentage of the last 35 years each country spent under capitalist governments as opposed to left-wing socialist regimes. We then compared equity returns by country relative to the percentage of the time each country was governed by capitalists.
 
Figure 1: Inflation-Adjusted Equity Market CAGR vs. % Capitalist Administration Tenure

Source: Global Financial Data
 
Equity returns are often driven by a small number of outsize winners, and that type of inequity is toxic to socialists, who favor an equality of outcomes. Moreover, stock market returns are rarely a top priority for dictatorships of the proletariat. The socialist president of Mexico Andrés Manuel López Obrador perhaps best captured the sentiment when he said, “The stock market is a great den of thieves, and I don't like it."
 
Our findings are consistent with other broader research. Relatively higher levels of broadly defined “democratic norms” in a nation have been shown to yield superior returns with less volatility than autocratic regimes, across a sample size of 74 countries between 1975 and 2015. Perth Tolle, the founder of Life + Liberty Indexes, has even turned this insight into a successful investing strategy through her ETF, ticker FRDM. Tolle, having grown up both in the United States and China, recognizes the negative impact that the lack of economic freedom has on market returns. Tolle’s Freedom 100 Emerging Markets ETF has zero exposure to China, compared to the MSCI Emerging Market ETF, which has between 34% and 38% of funds allocated to the People’s Republic. Her fund has outperformed the broader emerging markets index since inception.

In May of 2021, we wrote about the risks an investor must take and the premium they must pay to invest in Chinese equities. The 10-year trailing performance of Chinese equities at the time of that piece roughly matched that of Japanese equities, but we think it came with much greater regulatory risk in a public-equity market where stocks were (strictly speaking) neither “public” nor “equitable” to the extent we could measure. Fast forward to today and our thesis is playing out, as the two markets are separating, with Japan being the better of the two, in our opinion. LTM performance of the Japanese and Chinese MSCI indexes are shown in Figure 2 below.
 
Figure 2: China vs. Japan LTM MSCI Index Performance

Source: Capital IQ
 
Not surprisingly, the country whose leaders were “capitalist roaders” outperformed the country whose five development concepts include the words “coordinated” and “shared.” More broadly, we would expect to see countries with long-tenured socialist regimes experience poor equity returns.  While concrete data for some of these countries is hard to come by, we can look to the examples of the Soviet Union, Venezuela, or Cuba for anecdotal evidence. We believe these have not exactly been success stories for stock pickers.     
    
Recent literature findings on private property rights, economic efficiency, and market returns may help explain one interesting data point: Pinochet, the autocratic but capitalist leader of Chile from 1973 to 1990. Pinochet’s Chile enjoyed a 29% average CAGR throughout his rule. While this market success seems to fly in the face of research predicated on a democracy-autocracy dichotomy, Pinochet varied greatly from the common socialist autocrat (and democratic socialist ruler) in that he aggressively privatized previously state-owned businesses, having 90% of SOEs privatized by 1980.
 
A few years before Pinochet’s rise to power, the late Nobel Prize-winning economist FA Hayek noted that “Liberalism [classical] and democracy, although compatible, are not the same…. It is at least possible in principle that a democratic government may be totalitarian and that an authoritarian government act on liberal principles.” Both Hayek and fellow Nobel Prize winner Milton Friedman were subsequently criticized for visiting Pinochet in Chile.
 
Regardless of one’s moral views on the curious anomaly of a libertarian dictator, in studying the divergence in equity market returns, a better variable to operationalize than how people come to power may be the policies they are likely to pursue when there.
 
Our research into the market experience of recent Latin American regimes seems to support the broader research on democratic norms, private property rights, and resulting market returns for countries that kept their distance from collective ownership whether via vote or vanguard. We continue to believe that investors trying to discern where to invest their capital over the decades should significantly discount markets that seem prone to policies advancing objectives that are mutually incompatible with those of capitalism.