[Lee Jong-woo's Economic Reading] The 2021 Stock Market Lifted by Optimism... Prepare for Downside Signals Behind the Hype

The 'KOSPI 3000' Pink Era Opens... Best-Case Scenario Expected This Year
Peak Net Profit Margin Anticipated, But Depends on Financial and Fiscal Policies
Optimistic Outlook Should Be Questioned at Least Once

The most suitable word to summarize the stock market in 2020 in one phrase would be "unexpected." When the novel coronavirus infection (COVID-19) first emerged, the situation was so dire that there were concerns about a bubble burst, but the result was a 30% increase in stock prices compared to the beginning of the year. The disease became an opportunity for a turnaround.

Because of this unexpected outcome, the outlook for the stock market has now improved. Surpassing the milestone number of 3000 is considered natural, and it is expected that a new phase will unfold where various growth factors, which had been overlooked in our market, will be reflected in stock prices.

The factors expected to contribute to the stock market this year are as follows.

First, low interest rates. This year, it is highly likely that central banks of advanced countries, including the U.S. Federal Reserve (Fed), will maintain the benchmark interest rate at 0%. This possibility is already priced in, and calculations using interest rate futures suggest that the Fed will not raise rates at least until 2023. This matches the timeline the Fed promised when it cut rates last year.

Since the benchmark interest rate became a policy tool, statistics show that it takes an average of 33 months from the first rate cut to the next rate hike. This means that once rates start to be cut, they continue to be lowered or remain low for nearly three years. Since the first rate cut began in July 2019, applying the average cut period means there are 15 months left until the next rate hike. This suggests that rate hikes will begin around mid-2022, making this year likely a period free from interest rate increases.

It is uncertain whether liquidity will increase further, but at least there will be no reduction. The scale of liquidity supply depends on how governments implement fiscal policies, and considering the economic situation, reduction is not an option. Since there is no possibility of raising benchmark interest rates and liquidity is expected to remain at levels similar to last year, the financial environment this year is expected to be favorable.

Profit requires careful judgment. Last year, earnings per share (EPS) in global stock markets decreased by 17.3%. This year, due to the lower base effect, it is projected to increase by 27.3%. Among countries, Brazil, Russia, and Japan, which experienced significant slowdowns, are expected to see large profit increases, while Europe is not expected to have a high profit growth rate despite its poor performance in 2020.

The issue is whether profits will be achieved. To assess this, sales and margins must be analyzed separately. Sales in advanced and emerging countries are expected to increase by 7.4% and 11.2%, respectively, this year. These figures assume a V-shaped global economic rebound, similar to the period after the 2008 financial crisis. While this scenario is not impossible, it is an optimistic assumption, so the likelihood of achievement is not high. A bigger problem is the margin rate. Net profit margins relative to sales in advanced and emerging countries are expected to approach the levels seen during the economic boom of 2017-2018, at 9.5% and 6.7%, respectively. Although the global economy is improving this year, this is compared to last year. Profit margins move independently of the fact that last year was a period of economic slowdown, and expecting peak period profit margins during a recovery phase is problematic.

The reason profit forecasts have risen so much is because of stock prices. Since stock prices rebounded sharply after March last year, outlooks became optimistic, raising expectations for profits. The problem is that current stock prices are based on such high profits. If the expected profits are met, stock prices will be maintained, but if they fall short or decrease, the global stock market could perform unexpectedly poorly this year. This happened in 2002. After the 9/11 attacks, stock prices more than doubled thanks to consecutive rate cuts and liquidity supply, and economic and profit outlooks improved, but when reality failed to meet these expectations, stock prices returned to their original levels within six months.

This year, the gap between the real economy and stock prices will be a burden for investors. To meet market expectations, the economy must improve, and financial and fiscal policies must be implemented as the market expects. Using strong stimulus policies during an economic recovery is not an easy task.

The fact that stock prices rose too much last year also burdens this year's market. Since the financial crisis, the Fed has implemented three rounds of quantitative easing. Each time rates were cut and money was injected, stock prices rose, but the increase over up to three years did not exceed 80%. After the rate cuts and liquidity supply started in March last year due to COVID-19, the KOSPI rose more than 80% over 10 months. This means the policy effects have been sufficiently reflected in stock prices, and new forces are needed for further increases. The focus of this year's stock market will likely not be whether a favorable market environment continues, but how to overcome high stock prices.

These concerns also apply to investment sectors. To understand the limits of the stock market, one must consider the degree of concentration in specific sectors or countries, whether stock prices are overvalued relative to the economy, and whether stock prices are cheap or expensive compared to alternative investments like bonds. Among these, the most useful method currently is to observe the concentration phenomenon in specific sectors.

For a long time, the global stock market has been driven by growth stocks. In the past, the top U.S. sector by market capitalization accounted for an average of 20% of total market capitalization. The maximum was 35% during the IT bubble, and currently, the top sector accounts for about 28% of total market capitalization. This is a rare event, ranking in the top 3-4% historically. While not as extreme as during the IT bubble, the concentration phenomenon cannot be denied. Since stock price corrections may occur, caution is advised.

Last year, the stock market rose unexpectedly when it was expected to fall, but this year, despite expectations of a good year, it may unexpectedly underperform. This has happened several times before. In 2000, with economic growth reaching 10% and continuous rate cuts, stock prices were expected to rise significantly, but the market fell nearly 50% that year. Stock prices are driven by people's expectations and inherently have a leading nature. It is time to prepare for another unexpected event.

This content was produced with the assistance of AI translation services.