Stock Market as Economic Indicator
The stock market is often referred to as the economic barometer, a phrase we frequently hear but also often question. When looking at economic data, one might assume that China's GDP is performing well, suggesting that the stock market should be in a prolonged bull phase. However, this is evidently not the case. Wherein lies the issue? It is clear that there are factors related to the construction of indices and the economic data itself, and we may not fully grasp the long-term influences affecting the market. Besides, the economy is not solely defined by GDP; there are numerous factors at play. Only by understanding these can we comprehend the future trajectory of the stock market.
Link between U.S. GDP growth and the stock market
The stock market reflects the economy, but this does not imply a linear relationship; rather, it is more complex. Take the United States as an example: from 1993 to 2022, U.S. GDP grew by only 101%, while corporate pre-tax profits soared from $2 trillion to $14 trillion. Adjusting for inflation, in 2022, total pre-tax profits amounted to $6.9 trillion, reflecting an almost 245% increase over the past 30 years, far exceeding the economic growth during the same period. This means that for every $1 increase in GDP, U.S. corporations reaped $2.4 in pre-tax profits, which helps explain the strength of the U.S. stock market—an indication of the high quality of its publicly listed companies.
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In the realm of stock markets, as of the end of 2023, the S&P 500 index has risen a cumulative 1255% since 1993 (when measured in Renminbi), while the Shanghai Composite Index has only increased by 288% during the same period. This disparity might lead some investors to declare that A-shares are underperforming. In reality, the construction of the Shanghai Composite Index is not fixed, which significantly affects the IPO aspects. Observing the changes in market capitalization reveals the essence of the financing market; in fact, the CSI 300 index, which is also fixed in number, better reflects the quality and activity of companies in the A-share market. Since 2005 (with a base date of December 31, 2004, for the CSI 300), its performance has been quite comparable to that of other major global markets, effectively mirroring the S&P 500.
The significance of capital markets is to enable corporations to go public for financing and improve capital operational efficiency. One of the core missions of a company's existence and development is to create value for shareholders. However, the A-share market, as a whole, tends to focus more on extraction than reciprocity. The prevalence of financing markets, instances of fraudulent listings, and extreme phenomena—such as high-priced IPOs followed by major shareholders shorting their own companies—have become common. Certainly, we are working to change these aspects, which provides hope for the future. The U.S. stock market has maintained a continued bull run since the 2008 financial crisis, not merely due to the nurturing from the Federal Reserve, but also because U.S. listed companies genuinely care about their shareholders, consistently engaging in share buybacks (which involve repurchasing and canceling shares, thus boosting earnings per share). This practice effectively enhances ROE and genuinely prioritizes shareholder returns.
The true meaning of the stock market as an economic barometer
This brings us to ponder the phrase, "the stock market is an economic barometer." While it is a well-known statement, how many people have truly studied it? Most merely echo what they hear, claiming that A-shares are notoriously inaccurate, while many overlooked hidden factors in this judgment. Firstly, the stock market's barometric function reflects the operational dynamics of the economy through changes in corporate profitability, which is then manifested in stock prices through market valuation.
Thus, we can understand that the Shanghai Composite Index is not the core index of A-shares; rather, the CSI 300 is more representative, just as the S&P 500 serves as the core of the U.S. stock market. Core indices of major markets are fixed capital indices, and over the years since the emergence of the CSI 300, its overall performance has been comparable to that of the S&P 500, albeit with significantly greater volatility. Simply put, the experience of holding these shares may be less than favorable, but this does not undermine the long-term benefits.
Analyzing index investment data over the past decade, we find that when investing in the CSI 300 ETF across different valuation ranges for periods of one to five years, annualized returns increase significantly when avoiding overvalued areas. A notable example is during the peak in February 2021, when the CSI 300 PE was 17.59. Investors who entered at that time faced three years of ongoing adjustments. With the adjustments at the beginning of 2024, the potential for index returns to significantly improve has become apparent.
Therefore, we should not exclusively focus on GDP, but also consider the underlying economic drivers. Take the real estate cycle as an example, where fixed asset investment is a primary driver, creating relevant market hot spots. Even if the market remains around 3000 points, the structural differences behind this number, as well as the economic environment, are entirely different, leading to different profit models for investors. In simple terms, comparing the SSE 50 and the CSI 2000 reveals stark structural changes in market hot spots over the years.
Currently, the domestic economic pressure arises from the demand in the real estate sector, impacting both real estate investment and consumption, thereby triggering long-term deflationary concerns. The push for further fiscal policy and a continued relatively loose monetary policy may help provide additional impetus for economic recovery. However, the growth rate is still fraught with challenges, especially under the guidance of policies aimed at stabilization. Thus, even after the recovery in February 2024, the market still faces considerable tests.
The market's rise is primarily driven by monetary factors
We must recognize that GDP does not encompass the entire economy; monetary factors also hold critical importance, as the devaluation of currency is increasingly clear and certain. For instance, over fifty years ago in 1971, gold was priced at $35 per ounce; today, it exceeds $2000 per ounce, representing a staggering increase of 57 times. This indicates that the dollar has depreciated to merely 1.75% of its former value over 50 years. Similarly, the Dow Jones Industrial Average was at 900 points in 1971; it now exceeds 38,000 points (considering factors like dividends and rights offerings), translating to a 42-fold increase. While this may seem impressive, when accounting for currency depreciation, the actual appreciation is just adequate to offset the devaluation effects.
In 2023, despite GDP growth reaching 5.2%, the GDP measured in dollars showed negative growth. This emphasizes the importance of stabilizing exchange rates in maintaining a share of global GDP. Concurrently, we notice the United States pouring money into households, leading to a significant rise in inflation, yet the U.S. dollar index remains strong while the yen, euro, and Australian dollar are depreciating. What does this indicate? The comprehensive competitiveness of a country dictates the direction of its currency; exchange rates, much like stock prices, reflect expectations for the future.
Thus, can we deduce that the long-term orientation of the market is not solely driven by companies' intrinsic value but rather by monetary factors? When the economic fundamentals are weak, monetary easing becomes essential to stimulate growth, leading to currency depreciation, which in turn pushes the stock market upward. Therefore, the stock market can be viewed as a compensatory response to currency devaluation. A notable example is Japan's "lost three decades," where currency depreciation resulted in a recovery of the territory lost over thirty years, marking new highs; this was not merely about GDP but also manifested a clear compensatory effect due to currency devaluation.
This financial logic explains why the Hong Kong stock market, an alternative market, has seen declines. The pegged exchange rate of the Hong Kong dollar to the U.S. dollar means that during the period of dollar tightening, the Hong Kong dollar should significantly depreciate to counteract this cycle. In such a scenario, financial assets could either strengthen or at least offset substantial pressure due to currency depreciation. However, the Hong Kong dollar cannot depreciate like a floating currency, leading to increased pressure on financial liquidity, consequently causing persistent declines in the stock market until the U.S. concludes its current interest rate hike cycle and liquidity pressures on the Hong Kong dollar are alleviated. This is why we pay close attention to the actions of the Federal Reserve, which significantly influence the main profit drivers in the market.
In 2020, the Federal Reserve led a global central bank response that released unprecedented liquidity, giving rise to a new wave of activity in financial markets. The A-share market also experienced similar dynamics, with institutions engaging in an epic bubble-blowing behavior. Many company valuations reached bubble levels typically only seen during super bull markets, such as Moutai at a staggering $3 trillion and Tencent at $7 trillion, continuously breaking historical highs along with investor perceptions. In 2020, the median return for public funds in A-shares reached 55%, which was the second highest yield in history, only after 2007 (therefore, subsequent market conditions were essentially about settling these debts).
As we broaden our perspective, we see that loose monetary policy and fiscal expansion are crucial. However, similar interventions occurred during the Asian financial crisis in 1998, the subprime mortgage crisis in 2008, and pandemic responses in 2020, all involving unlimited liquidity releases. The subsequent recovery in ROE has been markedly different. Monetary easing does not necessarily lead to a rebound in ROE; for example, in the first half of 2012, monetary easing was evident, yet a clearly observable divide emerged between financial exuberance and real-sector stagnation. Monetary policy adjustments in the second half of 2012 led to a downtrend as stimuli continued to underperform expectations, resulting in the market accelerating downward until December 2012 before it began to rise. Similar patterns occurred with monetary easing in 2014-2015 and 2022-2023, which also failed to drive an increase in ROE. Even during periods of significant stock market increases without ROE improvement—like the explosive liquidity driven by excessive leverage in 2014-2015—the market surged without an accompanying increase in ROE.
Additionally, it’s noticeable that U.S. monetary policy influences Chinese monetary policy through the interest rate differential between the two countries. When U.S. policy rates rise, the differential widens, adding depreciation pressure to the RMB as international funds move from emerging markets to the U.S. for higher returns. At the same time, U.S. fiscal policy, primarily aiming to stimulate domestic economic growth, impacts Chinese exports and, consequently, corporate profits. A recent example is the substantial fiscal stimulus in the U.S. from 2020 to 2021, resulting in an unprecedented boom in the U.S. real estate market—home price indices in 20 major U.S. cities rose over 30% during this period, while Chinese exports also saw significant increases.
The current hope lies in anticipating interest rate cuts by the Federal Reserve in 2024, prompting a focus on sectors that have experienced the "Davis double whammy effect" and may witness industrial turning points in the future. Sectors such as semiconductors, innovative pharmaceuticals, and electric vehicles fall under this category, which began experiencing the "Davis double whammy effect" in the latter half of 2021. Currently, these sectors are at the bottom of fundamental and price-to-book value metrics, while also exhibiting attributes of external demand and innovation. If U.S.-China relations develop stably, there’s a potential for benefits arising from this. Moreover, as China continues to pivot its economic engine from traditional export and real estate models towards more research-driven growth, the emergence of new sectors will provide additional growth momentum. The trajectory of this shift will ultimately shape both the economic landscape and the future direction of the stock market. Therefore, 2024 remains a formidable challenge ahead.
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