Bowie is dead and a bull market seems as far away as Mars. We are only in the second week of 2016 and it’s already proven to be a difficult year.
It’s true that bearish sentiments have been crashing the market. Fundamentals in growth and commodities are not all that better.
However, investors must realise the current dip is a continuation of the problems from the end of 2015.
Despite having a terrible time right now, 2016 will see better days in the months to come.
Let’s start with China.
Last year, I helped New Frontier Investors to sail through some pretty rough waters in the Chinese market, and the emerging markets in general.
As volatile as things were, I timed the upper bound of the Chinese market rally quite correctly, as well as calling a bottom in the market.
But did I see the current collapse coming? No, I didn’t.
When the market is around the upper bound or lower bound, it’s easier to predict. With the latest falls, the Chinese market was stabilising between the lower bound and its fair pricing. Therefore, it was much harder to predict what the market would do.
My guess was for the market to eventually revert to the mean or pick up more in line with broad economic growth. I still believe that. However, the market has decided to revisit the 3,000 points low.
The good thing is at the current terrible level, a bottom is very close for the Chinese market.
Click to enlarge
The above chart is a chart I often show the New Frontier Investor readers. To start with, you must realise the Chinese market generally heads up over the long term.
The last few years have seen the market sticking to the lower bound range, with the exception of the market bubble last year.
However, we are once again ‘touching’ the lower bound. I expect the Chinese market to rebound towards its fundamental pricing.
Chinese financial reform risk
The global market is very sensitive to the PBOC’s moves on the yuan currently. Investors also seem to be using delayed numbers on capital flows, foreign exchange reserves and GDP numbers to price the stock market. Worst of all, they are using survey numbers in manufacturing activities to price risks.
A falling yuan and a rising dollar also add to the gloominess over commodity pricing and Chinese corporate debt sustainability.
It is true that the market overreacts and almost always misprices assets, but the market is not ‘stupid’. The market adjusts expectation to new information relatively quickly.
Read the CNBC survey below to see what the market believes when it comes to the current sell-off.
The truth is, many investors believe that the bearish sentiment is overdone.
With a level like 3000 points on the Shanghai Composite, risk has been mostly if not completely priced in already.
However, as I mentioned in several notes to the New Frontier Investors readers, the Chinese regulators’ tinkering with policies remains the biggest risk to global market sentiment.
Chinese regulators should improve their communication, to manage expectations better without delivering nasty surprises. Then we can largely discount the ‘financial reform risk’ component, and refocus on the Fed.
However, if the Chinese regulators continue to behave erratically, we will continue to see downward volatility. And unfortunately, I believe they will. Though probably less than they have so far.
To be (in the market) or not to be (in the market)
I wrote to New Frontier Investors readers about whether they should remain in Aussie stocks or not, given the current bear market.
By the end of 2015, the risk in the market was edging closer a level where investors may as well just get out of the market altogether.
Yes, it’s certainly a way to go. But today, I’ll tell you that my strategy is simply to reduce exposure relative to risk.
What do I mean by that?
I mean, when the risk to your portfolio gets to a high enough level, the best thing to do is to reduce your exposure to the market without completely stopping all trades.
The reason is simple. If you stop your trades because your risk has reached an unacceptable level, when would you get back into the market again?
You probably can give a very quick answer to that: I will get back in when things have calmed down and prices are picking up again.
While that is a valid strategy to calm the nerves, it’s not a clearly-defined enough.
The rebounds in a market are usually as big as the falls. This means if you get out after you were caught in the sell-off, you would miss the rebound and the chance to redeem your losses.
So what you can do is start to limit your exposure after your loss reaches a certain point. That way, you limit the potential of further losses, but won’t completely lose the potential rebound.
And always remember this philosophy about the market: the closer you are to the bottom, the higher the chance for a rebound.
How do you know if you are close to a bottom? Just look at historical data.
For China, we are close to the lower bound. For the Aussie market, losses are by no means close to the lows of the Global Financial Crisis. But it is somewhat close to the other stock market collapses in the last 30 years. This means that, unless you are expecting another GFC, you are probably wise to limit your exposure but expect a possible rebound.
Editor, New Frontier Investor
From the Port Phillip Publishing Library
Special Report: You probably already sense that stocks might be in for another bumpy ride in 2016. But that doesn’t have to mean that you have to miss out on making great money. Because, according to small-cap analyst Sam Volkering, certain stocks could rise hundreds of percent no matter what happens in the next 12 months. In this special report, Sam reveals the simple principle behind that success. And you’ll also discover his top three small-cap picks for 2016, which could bring you gains as high as 338% over the next 12 months. (more)