The JSE continues to trade at record levels alongside a depressed South African economy. David Leslie, a director of Belmont Asset Management, explains the logic behind this apparent contradiction.

It’s no secret that the South African economy is on shaky ground owing to deep-seated structural problems. In contrast, the JSE continues to trade at near-record levels. How does one explain this logic – or apparent lack of logic?

Investors would usually expect the share market to perform well when economic activity is flourishing and to come under pressure when the momentum or growth in economic activity declines. After all, it is reasonable to expect companies’ profit growth to correlate with local economic growth – it seems like perfect logic. Yet reality paints a different picture.

Our criterion for measuring the performance of the SA market, the ALSI Top 40, is highly concentrated, with the top 10 shares accounting for over 60% of the index. When you drill down, you will find that each of these 10 companies earns the bulk of its profits abroad. Therefore it is not the local economic environment that is driving profits, but rather what is happening in the rest of the world and specifically in those countries where these companies are earning their profits.

The share prices of companies such as Richemont, SAB Miller and British American Tobacco are largely determined offshore, so the prices of these shares will generally correlate very well with movements in stock exchanges abroad. For example, the Dow Jones and Nikkei Dow indexes have been performing very well over the last few years.

In contrast, JSE-listed shares earning most of their profits in SA have been underperforming the rest of the market. Since the beginning of 2013, retailers have been underperforming the Top 40 Index.

There is also another factor at play. Global share prices tend to anticipate economic conditions 18 months or two years in advance, leading to a timing-related mismatch between current economic conditions and stock values. Shrewd investors buy when bad news abounds and prices are depressed. This takes a lot of courage, but explains why bull markets often start during a recession. Interest rates are very often cut to stimulate economic growth and this has a positive effect on companies’ profits. The market anticipates this and reflects expected future profit growth roughly two years in advance.