According to the CIA World Fact Book, China's real GDP growth last year was 10.3%. Yet, The Shanghai Composite Index, which tracks the largest stocks trading in China, was down 14% in 2010. How can the economy do so well and the stock market so poorly at the same time?
The "experts" believe stock market declines were specifically due to economic growth; mainly, the Chinese government had to keep taking measures to rein in inflation and cool perceived asset bubbles. The divergence between economic growth and stock market declines in China brings to mind two points.
The "economy" is an aggregate of all economic activity in a country but with specialization, free trade and free flow of capital cross borders, it is hard to describe the economy as a monolithic entity in this day and age. For example, high oil prices reward resource sectors but punish manufacturing. If you were in social media in 2009-2010, you would describe the economy as good to great but the opposite is probably true if you were in traditional retail. As such, it is a little simplistic these days to ask how the economy is doing since, depending on where you sit, it could be the worst of times or the best of times.
Just as the economy cannot be thought of as a monolithic entity, neither can the stock market be thought as a perfect proxy for a country's economy. Stock markets do not have stocks in every single sector of the economy (when was the last time you heard of an analyst covering the education sector?) and, even those stock markets with good sectoral coverages, tend to have larger clusters in certain industries. For example, most exchanges will be over-weight in financial stocks even if the economy is not as heavily dependent on the same sector.
Accordingly, the stock market may only be tracking certain parts of the economy which are doing better or worst than other parts of the economy. While there is a connection between economic growth and stock market gains, it would be analytically lazy to think economic growth in a country must automatically lead to stock market gains in that country.
This is the type of thinking that would lead one to buy an ETF tracking the Chinese stock market based on its economic growth and finding out the market was down 14%. The better approach would be to analyze the sectoral coverage of the local exchange and see if there is a strong correlation between the sectors it is over-weight in and the economic strength of those industry.
Have a great long weekend.