On a Strategy for Turbulent Times; A China Update; How Much is Enough?

From: aditya rana
Date: Sat, Jul 25, 2015 at 2:05 PM
Subject: On a Strategy for Turbulent Times; A China Update; How Much is Enough?

Hi!,

It’s been a turbulent month for global assets with Grexit fears and the China stock market correction dominating headlines. What are investors to do in an environment like this? The investment advisory firm Wealthfront (which has Burton Malkiel, the author of the investment classic “A Random Walk down Wall Street”, as their CIO and the well known financial advisor and investor Charles Ellis as an advisor) wrote a note recently which offers some helpful guidance for investors. In addition, the highly reputed research firm 13 D headed by Kiril Sokoloff (established in 1983 and researching on China since 1990) provides a very insightful perspective on the China stock market correction. To summarise:

Wealthfront- on what should Investors do?:

-After a tremendous run-up, China’s stock market corrected by 30% in a few weeks, while Greece hovered on the brink of default and an exit from the Euro. What should an investor do in such a trying environment? Nothing.

-“Staying the course” is a timeless piece of investment advice and Jeremy Siegel in his bestselling book “Stock for the Long Run” looked at the performance of stocks from 1802 until 1997 and found that actual long term returns on stocks are remarkably consistent over different periods.

-As he noted: “Despite extraordinary changes in the economic, social, and political environment over the past two centuries, stocks have yielded between 6.6 and 7.2 percent per year after inflation in all major sub-periods. The wiggles on the stock return line represent the bull and bear markets that equities have suffered throughout history. The long-term perspective radically changes one’s view of the risk of stocks. The short-term fluctuations in market, which loom so large to investors, have little to do with the long-term accumulation of wealth.” (see chart below).

-Siegel observed that despite events like the Civil War, WWI, WWII, the Great Depression, stocks provided a 7% return after inflation (over almost any multi-decade sub-period) and these events were relatively minor drops in the overall long-term trend.

-This phenomenon applies to other market as well – for example, German equities fell by 90% during WWII but had completely rebounded by 1958 – rising by 30% per annum from 1948 to 1960. Over the long run they provided a real return of 6.6% per annum. Other markets like Japan and the U.K. also produced a similar pattern.

-The best strategy would, of course, be to sell when markets are about to collapse and buy when they start to recover – one might say “Greece has been a disaster for years, surely, if I had been paying attention, I would have sold and avoided its recent fall.” “China’s stock market was clearly a bubble, the economy is slowing; reforms are stagnating; any idiot would have sold out before things got bad!” This is the pitch made by almost every investment manager in the world and is intuitively compelling.

-Unfortunately, the data does not support the validity of trying to time the market – both for investment managers as well as for retail investors (who perform even worse than managers).

– In a study published in early 2015, Morningstar looked at the difference between the average return of mutual funds and the actual returns that investors enjoyed. While the average U.S. equity mutual fund returned 8.18% for the decade ending 2013, the average dollar invested in U.S. equity funds returned just 6.52%. For international equity funds, the situation was worse: an 8.77% return for the average fund, but a 5.76% return for investors. Other studies looking at rolling 20 year periods, show that investors have underperformed the market by 4.2% over the last 20 years.

-The reason is that investors tend to get in and out of an asset class at the wrong time – i.e. buy high and sell low. And in more volatile markets, they fare worse as investors are prone to panic.

-Long-term investing, and the futility of trading, does not get much support in the media and research as it’s boring and cheap. The financial media and most of the financial industry thrives by making one panic – it sells newspapers and increase brokerage commissions.

-It’s hard to stay with an investment plan in the face of sharp corrections. However, if you invest regularly, rebalance your portfolio and be patient it will really pay-off over the long haul.

13 D update on the China stock market:

-The Chinese government implemented QE and “do whatever it takes” policies (with Chinese characteristics) to stem the market rout. This was the first internet based online asset gathering (i.e. on the HOMS platform) crisis in history – made worse by the resulting algorithmic selling. All this was beyond the watch of the central government. The margin leveraged peaked at about 2.5 trillion RMB and is now down to around 1.0 trillion RMB, and is now quite manageable given China’s vast resources.

-China’s market-cap-to GDP ratio of 60% is less than half of its 2007 peak (see chart below) and implies that the bull market has not ended but only paused., and also compares very favourably to the U.S. ratio of 132%. Additionally, Western media and financial advisors are uniformly bearish adding further support for the bull case.

-Analysing the greatest bull markets over the last 100 years, the Chinese market does not fit the characteristics of these bubbles – whether in duration or appreciation with the exception of the ChiNext index (see table below) . The ’87 crash in the U.S. is a more likely comparison where the market dropped by 33.5% and then went on a bull run until its 2000 peak.

-The ChinNext index remains overvalued despite its drop, and a style-shift in favour of undervalued blue chip, financials and industrials may take place down the road – similar to what happened in May, 2007.

-The extraordinary measures taken by the government has raised concerns amongst foreign investors. A very knowledgeable source of theirs in China says that the underlying rationale was the important role that the stock market has played in terms of mobilizing the population to overcome the difficulties in achieving their social and political objectives. The radical measure were required as more suitable means were not readily available – the stakes were to high to worry about political appearances and niceties.

-Stock market participation by households – at 6% – remains very low. At the peak of Taiwan’s 1990 bull market – the participation rate had reached 23% of the total population. The total number of accounts held by individuals (adjusted for accounts opened at both exchanges) amounts to about 8% of the total population. Equities are only 13% of total household assets (see chart below) , still below a peak of 15% in 2007 and that of peaks in other equity markets.

-Numerous articles are predicting an adverse impact of the stock market correction on the economy – however, the wealth impact of the market since its late 2013 lows is very much intact . As David Mahon, who runs one of the oldest (since 1984) and most successful PE firms in China notes:

-“Today, China’s stock market still constitutes no more than 15% of the combined Chinese banking and insurance sectors, so a rise or fall does not reflect the core economy and is not critical to economic stability. For over 20 years, stock-market movements have been primarily the result of changes in regulations and tax policies rather than the performance of specific companies or sectors. “

-“Many of the same commentators now fixated on the stock market wrongly predicted that the housing downturn in 2014 and the increases in bank debt over the last five years of stimulus would

spawn a slew of bankruptcies and job losses. The property market is recovering steadily and growth in consumer demand in China is slow but fundamentally firm, with services now accounting for over 50% of total consumption.”

-“President Xi Jinping has built considerable goodwill among ordinary Chinese people. His anticorruption campaign remains popular, and he has undertaken a range of tough economic reforms. But now his government needs to do more to reinforce economic confidence, and following recent events, it will be the stability of capital markets by which it is, in part, measured.”

-“The Chinese stock market will continue to recover, and those brave enough or possessing enough cash to invest again soon will be able to buy cheaply and possibly even make good returns over the remainder of the year.”

-Some very interesting perspectives on the Chinese stock market which further bolster my view (as expressed in the July 4 letter) that the recent downturn is an attractive opportunity to add exposure to China (if you are underweight and looking to get long) or to do nothing if you are already fully invested. The long-term bull case for China remains compelling: an asset allocation by Chinese households away from bank deposits and property towards equities; strong policy support for a healthy stock market as part of the structural reforms to boost consumption and deleverage the economy; still attractive valuations for the large cap blue chips, financials and industrial stocks; and increasing participation by institutions (both domestic and – eventually – foreign) over time.

-Much has been made about the dramatic measures taken by the government to support the market. A few things to note on the subject:

1)This is the first time the government has forcefully intervened to support the market (which only started in 1992!) as equities were not so important to their strategy during last two busts (in the late nineties and 2007) as they are now (for reasons detailed earlier). Their lack of experience, in both regulating the shadow margin lending route and in the market support measures, was to be expected.

2)By intervening to support markets they are merely playing by the rules established over 200 years of global financial history. It’s just that their means differ from more developed financial markets – by being more direct than indirect. QE policies pursued by developed market central banks that suppress rates force investors into risky assets – in China that transmission mechanism is probably not as efficient and readily available.

-Going forward, as Goldman notes, the deleveraging of the shadow margin lending is now largely complete and the deleveraging of the official margin lending is 2/3rds complete. While the market may take a few more months to digest the correction, the next leg up should follow and hopefully be less dramatic than what we have seen over the past year given the regulatory clampdown on shadow margin lending.

-Moving onto Greece, as I have argued in previous letters (since 2012!), the base case has always been a deal to allow Greece to remain in the Euro. The underlying rationale for this is simple – the Greeks want to remain in the Euro! So given that premise, no European country (and certainly not Germany given their history) will take the risk of kicking Greece out and potentially shoulder the responsibility of causing a break-up of the Euro. Looking forward, the Greeks have no choice but to implement the first stage of the reforms which would allow a rescheduling of their debt (by year-end) thereby achieving the creditor imposed target debt reduction ratios. This should allow for more growth focused policies – i.e. a relaxation of requirements to run primary surpluses thereby boosting GDP growth (which they had already begun to see last year).

How much is enough?

Taking a departure from my usual piece on diet and its impact on health I provide below a wonderful story which I came across recently. The story is part of common folklore in India – and rather than spending mental energy to ascertain its veracity – it would perhaps be more rewarding to reflect on its underlying message.

“Legend has it that Alexander III of Greece, commonly known as Alexander the Great, sent one of his messengers to invite the quiet yogi Dandini for a discourse and discussion on philosophy. After conquering the world at the cost of countless lives, he was making rapid progress in his territorial coups. He had heard a great deal about this yogi. Dandini, however, turned down the invitation and chose to stay back in his hermitage in the woods. Alexander didn’t take it too kindly. But, being a pupil of none other than the brilliant Aristotle, he well knew that mystics and philosophers could rarely be lured or coerced.

He sent his helmsman, Onesicritus, to invite Dandini one more time who praised the yogi lavishly and offered him gifts. When Dandini didn’t change his stance, Onesicritus threatened him saying Alexander had ordered his beheading should the orders of the emperor be disobeyed. Dandini refused all gifts, remained unmoved, and said he had no fear of death. Onesicritus couldn’t muster the courage to kill him, and, instead, paid his respects to the yogi and went back to report the incident.

Livid at being rejected by a forest-dweller, Alexander decided to teach Dandini a lesson. As he, along with his marshal and the royal entourage, made way into the deeper forests, a sense of calm began to engulf him. His anger took a backseat as soon as he looked into Dandini’s piercing eyes but when the sage did not get up to welcome him, he was furious once again.

“How dared you refuse my gifts?” Alexander asked him sternly.

“They were smeared in blood.”

There was something in Dandini’s voice, a chilling truth, a fearless conviction that shook Alexander from within. Yet, he wasn’t prepared to let his expressions betray his feelings in front of his men. Alexander dismounted his horse and stood tall before the sage who was sitting calmly.

“Do you know who I am?” Alexander roared.
“I don’t think you know who you are.”

This ticked off Alexander who took yogi’s cryptic answers as an insult. Pulling out his shining sword, he raised it in the air and brought it close to Dandini’s neck.

“I am Alexander, the world conqueror,” he shouted. “You are sitting on my land. Surrender or I’ll kill y­ou”

“Your land?” Dandini chuckled as he cut him off. “The land belongs to no one, O King!”

“Before you, there were others who claimed it as theirs,” he continued. “After you, there’ll be others who will say it’s theirs. All creation belongs to the creator alone, Alexander. And no one has any right to destroy what they haven’t created. You have blood on your hands, O Emperor. You may have a temporary claim on the land, but you have permanent scars on your soul.”

Alexander lowered his sword and adjusted his posture uncomfortably. Signalling his men to wait at a distance, he cleared his throat.

“The whole world is mine, Dandini,” Alexander exclaimed. “History will remember me as the mightiest king! My men can die for me!”

“What good is your ambition or their remembrance, O King? You drown yourself in alcohol every evening so you may forget about your sins. These men who surround you, they are tired of you. They’ll give up on you one day very soon.”

“Besides,” Dandini continued, “what will you do with the world? All you need is two yards. Two yards long and two yards deep. That’s all that will belong to you ultimately.”

Deeply moved, Alexander put his sword back, bobbed before Dandini and left immediately.

Barely a few months had passed when his army mutinied bringing an abrupt end to his campaign in India. Three years later, Alexander died at the age of thirty-three in Babylon.”

Here’s to simplifying your wants and life!

Regards,

Aditya

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