Local investors are coming back

For much of this year, the Korean stock market has been completely shut out of the global stock rally. Korea’s decoupling from the developed markets of the U.S., Japan and Europe is puzzling to many investors.

This decoupling can be explained by how investors feel about fundamentals driven by policy action. The U.S, and Japan are implementing unprecedented quantitative easing, and Europe is also pumping liquidity into the system.

In contrast, policy action effects are missing in Korea, and investors’ confidence in Korea’s economic growth momentum in the second half of this year remains subdued.

Korea is not alone in decoupling from global stock markets. Emerging markets are also decoupling from advanced markets.

The BRICs (China, in particular) are stuck in the rut like Korea. That is not surprising because emerging markets were relatively unscathed by the economic crisis.

Foreign investors are getting excited about Japan’s aggressive quantitative easing. While Japan is seeing massive money inflows, Korea is experiencing money outflows. Foreign investors have sold a net 6 trillion won worth of Korean stocks so far this year. When will foreign sell-offs end? When will they ever return to Korean stocks?

We believe we should lower our expectations for foreign investment. Foreign investors’ aggressive and sustained net buying in Korea stocks coincided with the following market patterns.

High GDP growth: Korea delivered strong economic growth in the wake of the 1998 Asian financial crisis and the 2008 global financial crisis. Korea is not likely to post sharp GDP growth in the latter half of 2013 and throughout 2014.

Korean companies’ long-term earnings growth outperformance over developed markets: According to the Thomson Reuters consensus as of May, Korean companies’ long-term earnings growth potential is weaker than that of U.S. and Japanese companies.

In a similar vein, foreign investors buy Korean stocks when Samsung Electronics grows: that was the case for the periods from the Asian financial crisis to the first half of 2004 and from the global financial crisis until recently. It is uncertain whether Samsung Electronics will start to grow again in 2014.

Foreign investors buy Korean stocks when the won stays above 1,100 won per dollar: If Korea’s economic growth recovers in the second half of 2013, the won will strengthen with the exchange rate falling below 1,100 won per dollar

Gone are the days when foreign buying led the Korean stock market higher. Vanguard Funds’ sell-off during its benchmark transition that started in July is winding down, but the positive impact will be felt only briefly. Is there any hope for the Korean stock market in the latter half of this year?

This author is optimistic about the Korean stock market, believing that the KOSPI will rise in the second half.

Korea’s economy and stock market seem to be losing comparative advantages over developed country economies and stock markets, particularly in terms of momentum. Foreign fund inflows into Korean stocks look unlikely, but there is no need to be pessimistic. The KOSPI will rise in the second half of this year, led by Korean investors.

The Korean stock market’s heavy dependence on foreign money is just a habit formed over the past four and half years.

Once evidence of an economic growth momentum recovery begins to emerge in the second half (quarterly economic growth and monthly composite index of leading economic indicators), investors’ risk preference will rise along with higher interest rates. The credit risk of Korean companies will ease, and cyclical stocks will stage a rebound.

The KOSPI will chalk up significant gains even if economic growth and earnings momentum falls short. If history is any guide, stock market P/E multiples go higher when interest rates rise. Korean investors’ increased risk preference will offset the lack of economic and earnings growth momentum.

Domestic investors led Korea’s stock rally in 2005-2007. The same thing can happen this time around. That is why hope stays alive for Korean stocks.