How to Trade the Krazy Korean Kospi after +54% in 2005

By: Gary Dorsch | Sat, Jan 7, 2006
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Try to imagine for just a moment, the Dow Jones Industrials climbing by 54% or 5,842 points to set a new all-time record high of 16,670. Absurd, unthinkable, just plain crazy, you might say. But that's precisely what occurred in the Krazy Korean Kospi index in 2005, to earn the honor as the best performing stock market in the world. The doubling of Kospi juggernaut from two years ago is all the more impressive, when one considers the Korean won's sizeable gains against the Chinese yuan, the Japanese yen, and the US dollar over that time period.

Watching the Kospi climb day after day, without much hesitation, to complete its stunning 54% gain, reminds us to never underestimate the Asian penchant for high-stakes risk-taking, especially at home. But in dealing with the Kospi index in 2006, remember the advice of the legendary trader Jesse Livermore, "Stocks are never too high for you to begin buying, or too low to begin selling. But after the initial transaction, do not make a second unless the first shows you a profit."

Korean ordinary shares are expensive to trade. Including dealer markups for local exchange fees, currency conversion fees, and broker commissions, the foreign retail investor can pay a round-turn commission of 7% to trade in Seoul. However, there are a handful of blue chip ADR's listed in New York, such as Kookmin Bank (KB), Shinhan Financial (SHG), Posco Steel (PKX), and LG Philips LCD (LPL). There are also two Exchange Traded funds, iShares Korea (ticker EWY) and the Korea Fund (KF) that closely track the Kospi index, and can be traded online.

To trade the broader EWY and KF successfully, one needs to know what makes the Korean Kospi tick. It is important to know that Samsung Electronics, 005930.KS is the big gorilla on the Kospi Composite index, accounting for 20% of the market's total capitalization. Samsung Electronics soared by 50% in 2005, taking the world's largest memory chip maker above $100 billion in market value, to become one of four Asian companies to have reached that market scale.

Samsung is expected to earn a handsome profit of 2.84 trillion won in the first quarter, thanks to an ever-increasing demand for its NAND flash memory chips and liquid crystal display panels, which account for 70% of its profit. Samsung and other heavy hitters, such as Hyundai Motors and LG Electronics are leading the Kospi juggernaut to stratospheric heights with booming exports to China and Asia, Europe, and to a lesser extent, the United States.

Unlike US economic growth, which is heavily dependent upon asset inflation in the stock market and real estate to sustain consumer spending, Korea's income gains were fueled by manufacturing and exports. South Korea 's industrial production rose by 5% in November 2005, to stand 12.2% higher from a year earlier, and the fastest expansion in six years, as automakers and chipmakers hustled to meet record export orders and rebounding domestic demand.

Exports account for 40% of Korea's $680 billion economy, which reached an all-time high of $284.7 billion in 2005, up 12.2% from $253.8 billion a year earlier. Those impressive gains followed a whopping 31% increase in exports in 2004. South Korea's electronics exports rose 6.5% to $102.9 billion in 2005, ranking fourth behind Japan, the US and China, and creating a net profit of $46.7 billion. Electronics shipments were 38% of the nation's total exports, compared with 8.7% in 1972.

The South Korean government expects Asia's fourth largest economy to export as much as $320 billion in 2006, despite unfavorable foreign currency rates, and assuming that the global economy will grow 4 % , the same as in 2005.

The Korean Kospi index is tracking the level of the nation's exports, which have risen steadily from $11 billion in February 2001 to a record high of $25.8 billion in December 2005, and elevating the profits of Kospi blue-chip stocks. The Kospi's rising fortunes are in large part due to booming exports to China, which soared 25% last year on top of a 42% jump in 2004. China's economy grew 9.8% last year, and accounted for 22% of South Korea's total shipments abroad.

For the moment, the surging Chinese economy is fueling steady demand for parts, components and intermediate goods from Korea. But as China becomes an ever-more-capable manufacturer, it can also become a big threat to its tiny neighbor. This is especially true in one of Korea's key industries, high-tech, where China is making deep inroads. China is rapidly building its own steel, shipbuilding, electronics and semiconductor industries that happen to be Korea's major export items.

China has already trumped the US in 2004 as the world's leading exporter of high-tech goods, and emerged as an economic power that other industrialized countries can no longer ignore. China exported $180 billion worth of information and communication technology goods in 2004, compared with US exports of $149 billion, the OECD said. China was likely to have kept its newly conquered top spot in 2005, but confirmation must await more date collection.

Still, last year's big growth in Korean exports means that the quality of Korean-made products, particularly semiconductors and ships, are world-class, and it could take many years for China to compete with the likes of Samsung. Semiconductors had the biggest share of South Korea's exports at 10.6 percent. Automobiles made up 10.4%, and wireless equipment, including mobile phones, were 9.7% of exports.

Korea's rising exports are all the more remarkable when on considers that the dollar fell by 30% against the Korean won since early 2001, making Korean exports more expensive for US consumers. And because China pegged it currency to the dollar, Korean exports became 30% more expensive in China. Yet, South Korea's five automakers sold a record 5.2 million vehicles worldwide in 2005, up 16% from 2004.

Korean monetary authorities have long lived in fear of a weaker dollar that could undermine its economy and issued tens of billions of foreign exchange stabilization bonds, using the proceeds to buy dollars in the foreign exchange market. The Bank of Korea amassed $210 billion of foreign currencies, mostly held in dollars, but has only bought some extra time for Korean exporters through its massive intervention effort. The central bank has not been able to reverse the dollar's bearish trend.

Displaying amazing agility, Korean exporters reacted to the weaker US dollar and a 15% drop in sales to the American market, by ramping up sales to Europe by 18.6% in 2005, on top of a 17.6% gain the year before. The European Union has replaced the United States as South Korea's second-largest export market after China, the Ministry of Commerce said on December 11 th 2005.

South Korea exported $36 billion worth of goods to the United States in the first eleven months of 2005, whereas its shipments to the EU totaled $38 billion. South Korean exports to China during the same period amounted to $55.4 billion. In 2004, Korea shipped more goods to the US than to the EU, with exports to its respective trading partners adding up to $42.8 billion and $37.8 billion.

With the world's second largest economy in Japan emerging from seven years of deflation and showing signs of sustainable growth, Kospi exporters might have hoped to take advantage of this burgeoning market. But the Japanese yen's 24% devaluation against the won since the beginning of 2004 will make Korean products a very tough sell in Tokyo, and more importantly, create big difficulties in competing with Japanese exporters elsewhere.

So what could possibly go wrong for the Krazy Korean Kospi index in 2006, with its Chinese neighbor poised for another spectacular year of 9% or more growth?

Kospi exporters were gripped by anxiety on January 5th, when the US dollar fell below the psychological 1000-won level, caused by exporters themselves, who dumped dollars because they feared the dollar had no bottom. If the dollar goes below 950-won, small and medium sized exporters will be hit particularly hard.

Hyundai Motor chairman Chung Mong-koo warned in his New Year address that the company could face a crisis from a weaker dollar. Every 100-won loss against the dollar causes Hyundai Motor and Kia Motors to lose a combined 1.65 trillion won ($1.65 billion) in revenues and 800 billion won in operating profits. Samsung Electronics thinks a 100-won loss for the dollar to 950-won, would reduce its sales by 2 trillion won, and LG Electronics expects a loss of 400 billion won in profits.

But a stronger won would put Korea's largest steelmaker POSCO at an advantage since it imports most raw materials, including iron ore. The won's 30% appreciation against the dollar helped to partially offset a 40% rise in Abu Dhabi crude prices and sharply higher base metal prices in 2005. Still, Korean imports of natural resources including energy rose 21.9% in dollar terms. The country imports almost all of its oil.

Seoul hasn't abandoned its interventionist ways, despite losing billions of dollars in taxpayers' money when it tried to prevent the dollar from falling below 1150-won in 2003-2004. Korea plans to sell 19.2 trillion won ($19.2 billion) in Treasury bonds in 2006 to fund any foreign exchange intervention. But Korean policymakers appear to have few options other than outright intervention, and of course, "jawboning" to halt the dollar's slide, which can only buy time and can't reverse a trend.

While Korea's domestic institutions were wildly enthusiastic about the Kospi in 2005, foreign traders who bought Kospi stocks in 2003-04 were net sellers of 3.2 trillion won of blue-chips last year. Instead, foreigners were net buyers of $91.8 billion of Japanese stocks, and pumped $22.2 billion into Taiwan. Still, foreigners are not abandoning Korea, and hold 39.7% of outstanding shares on the main bourse. Foreigners account for about 20.5% of the daily trading volume.

The won's exchange rate, China's economic growth rate, Korean exports, and the price of crude oil, are the key variables to watch for the Krazy Korean Kospi index.

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Gary Dorsch

Author: Gary Dorsch

Gary Dorsch

Gary Dorsch

Mr Dorsch worked on the trading floor of the Chicago Mercantile Exchange for nine years as the chief Financial Futures Analyst for three clearing firms, Oppenheimer Rouse Futures Inc, GH Miller and Company, and a commodity fund at the LNS Financial Group.

As a transactional broker for Charles Schwab's Global Investment Services department, Mr Dorsch handled thousands of customer trades in 45 stock exchanges around the world, including Australia, Canada, Japan, Hong Kong, the Euro zone, London, Toronto, South Africa, Mexico, and New Zealand, and Canadian oil trusts, ADR's and Exchange Traded Funds.

He wrote a weekly newsletter from 2000 thru September 2005 called, "Foreign Currency Trends" for Charles Schwab's Global Investment department, featuring inter-market technical analysis, to understand the dynamic inter-relationships between the foreign exchange, global bond and stock markets, and key industrial commodities.

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