Zaks Investment Advisory Service

Factors Behind Economic Development and Economic Ties to Stock Prices

Three weeks have passed since our last program, and the market remained restless the entire time. On October 18, the Dow Jones average dropped by 366 points, and on November 1 – by 363. The market lost about 2.5 percent over the past two weeks. Nonetheless, Dow Jones remains up nine percent for the year, while the broader S&P 500 index has gained just under 6.4 percent. Oil prices have witnessed astounding growth: December futures closed the day Friday at the $96 mark. The record price set in April 1980 is just a stretch away, $5 higher (I mean, of course, in current dollar terms). We will analyze these events over the coming weeks, but now I would like to return to the subject we began in our last program.

And that was the changes witnessed in the world economy over the past 15-20 years. We began with the developing countries, describing how the transformation of planned, socialist economies into market ones made hundreds of millions of people more productive. We also noted that one of the most important elements in this process was global trade: thanks to exports, many countries with relatively small internal markets were able to enjoy growth.

I would like to mention a few other factors that played an enormous role in the international economy’s development. One of them is the Internet and development of Information Technology (IT). The post-socialist transformation coincided with the Internet’s growth. Not everything, of course, relies on the Internet: oil may be sold perfectly well without it. But it becomes extremely difficult to build an export economy that could assume the role of an efficient supplier for the developed countries’ markets without the Internet’s or IT’s help. In order to become a competitive exporter, one must first create a product that meets the overseas client’s specification, and then deliver all components to the client without interruption and by set schedule. This is all hard to achieve without the use of so-called “supply-chain management.” Almost all of these modern systems were developed based on Western experience. This in turn leads to added advantages: export sector growth helps developing countries introduce modern supply-chain management systems – first to the export sector itself, and then the economy as a whole. Of course, this too helps to accelerate their growth.

By the way, on the subject of uninterrupted deliveries – one of the factors that helped change the world economy was the appearance of standardized containers. That very container used to make shipments across the world: from trailer to ship, and from there on to cargo transit and back onto trailer again, and so on. In other words, from supplier to place of destination, the container remains sealed. As strange as it may seem, the container was only a recent invention, and the technology was not commonly employed until the early 1980s. Before then, ships were loaded and unloaded by longshoremen. This was a lengthy and expensive operation. According to some calculations, the use of containers improved the productivity of this process by a factor of 30. Had there been no containers, the price of goods exported by developing countries would have been much higher. This would have hurt China’s and other Southeast Asian countries’ efforts to develop their export production. Now, however, containers are used to transport 90 percent of all cargo, excluding non-bulk cargo such as oil and grain. More than a quarter of all containers in the world begin their journeys in China!

But let us get back to financial matters. We mentioned that economic growth does not automatically lead to higher stock prices, and this is something that interests us investors most of all. Two examples are interesting in this regard: that of China and Europe.

The Chinese economy grew by an annual average rate of 10-12 percent between 1992 and 2005 – which is a phenomenal result. No other major economy grew as fast over that long a stretch. But, up to a certain point, the Chinese stock market refused to budge at all: in mid-2005, the Shanghai and Shenzhen stock market index (SSE) remained at the same level as in 1992. Moreover, between mid-2001 through mid-2005, it lost more than 50 percent. Over those five years, the economy grew by more than 60 percent, faster than any other economy in the world. Yet, over that same span, stocks lost half their value. We will discuss why this happened in a separate program. What interests us now is the following: the fact that the economy is experiencing growth does not guarantee that stock prices will grow as well. By the way, the situation changed sharply at the start of 2006, and continental China’s stock prices have grown by 400 percent since then!

Another interesting example is that of Europe. The situation here is the diametric opposite. We know that the European economy has been growing very slowly in recent years, by about one or two percent a year. And how did the European stock markets behave? Bloomberg collects data on 500 European companies and compiles an index similar to the Standard and Poor’s 500. It is called the Bloomberg European 500. This index has doubled over the past five years (it is interesting to note that the S&P 500 also doubled over those five years). The fact that it doubled means that the Bloomberg European 500 index grew over those five years at an annual rate of 15 percent! And if one takes into account that over the past five years, the Euro, the European Union’s currency, appreciated against the dollar by almost 50 percent, then the Bloomberg European 500 index nearly tripled in dollar terms!

We will analyze this fairly unusual result in our next program. But with this, we will have to draw today’s program to a close. This was Sergey Zaks. Thank you for your attention and until next time.