One of the best indicators of global economic growth suggests materials stocks have a long way to rally.
The KOSPI, which is the South Korean equity benchmark, is widely used by strategists and economists as a leading indicator of economic growth. It is highly sensitive to changes in the pace of global economic activity because of its proximity to China – South Korea is a major trading hub and ship building center that benefits from Chinese expansion.
The KOSPI is also dominated by capital goods companies which make up more than 40 per cent of the index. Increased sales of capital goods are one of the first signs of improving global activity.
This chart shows why the KOSPI has been important for Canadian investors – it has functioned as a leading indicator for commodity prices and resource stocks.
From 2006 until the end of 2011 Canadian mining stocks and the KOSPI moved together with an extremely high correlation of 0.91. After that, the relationship started to break down in a way that could be encouraging for domestic resource stock investors. It suggests mining stocks are undervalued relative to current levels of global economic activity.
Investors should always remember that divergences can correct in two ways. In this case, the S&P/TSX Diversified Mining Index could rise, or the KOSPI could fall. This means that a sharp rally in mining stocks is not assured even if the connection between the two indexes is still valid.
But the divergence is likely to correct, one way or another. Recent signs from China suggest that regional economic growth is once again accelerating, which makes a sharp decline in the KOSPI less likely than renewed strength in commodities. The odds, at least for now, favour higher prices for domestic resource stocks.