How to Take Advantage of the Bumpy Months Ahead

I’d like to share the following Chinese joke:

When my mom walked me to kindergarten, the Shanghai Composite was at just over 2000; when my mom sent me off to high school, the Shanghai Composite was at just over 2000; when my mom attended my graduation, the Shanghai Composite was at just over 2000. I wish my mom eternal youth and never to age, just like the Shanghai Composite.

Where does the Composite sit today? Just below 3,000.

There have been highs and lows along the way. But over a nine year period, the Composite is up just over 35%.

It pales in comparison to the S&P 500’s 239% return, or the ASX 200’s 100% return over the same time.

As a result, many investors have thrown in the towel.

A freelance film screen writer, Li Wei, sold everything in January this year. Lan Qichang, a tech professional says he avoids Chinese listed stocks completely. Retiree Liu Junmin has not jumped back in since 2015, when the Composite fell as much as 40%.

And it might not just be Chinese investors jumping out of a falling market in the next few months.

Who controls prices short-term?

China’s market is full of individuals like you and me. According to The Australian Financial Review (AFR), individuals drive 85% of trades in China.

Most approach the market as if it were a lottery. Little thought is given to the underlying business. They buy and sell shares based on names, feelings, or whether it’s rising or falling.

When you have a market full of individuals, shares will swing wildly from high to low. Over the last 10 years, the Shanghai Composite has dropped more than 20% multiple times.

I’ve highlighted my favourites below.

MoneyMorning 25-07-18

Source: Bloomberg
[Click to open new window]

As you can imagine, it’s frustrating for those picking stocks by chance and hoping to find a winner. Each time they think they’re onto something, a market decline pulls their position down.

It’s a terrible market for speculators, but wonderful for rational investors. Even though the Shanghai Composite has gone nowhere in 10 years, the index is littered with winners.

One such winner is Dawning Information Industry. The company has improved earnings per share (EPS) by almost 10% annually for the last seven years. Another is China International Travel, who’ve grown EPS 25% annually since 2008.

Today, both of these stocks are 10-baggers. Dawning Info is approaching 20-bagger status as you read this.

But of course, picking winners like the above is easier said than done. Not only do you have to hold losing positions for months, sometimes longer…

You’ve also got to pass on most investments that come your way.

In Australia and the US, the market make up is a different story. 

The biggest players in our market are institutions. And while they’re not always rational, over time they usually get it right.

It’s why you might say the ASX 200 and S&P 500 is efficient most of the time.

Clearly China’s share market is not efficient, judging by the graph above. But as I mentioned, Chinese investors might not be the only ones selling soon.

And it’s when everyone’s selling that I want you to clean up big time.

The battle between risk and riskless

The US Federal Reserve sprang into action during 2008. They became the lending of last resort. They created liquidity for the banking system. They also cut interest rates to all-time lows.

Such action would pump as much money into the system. And hopefully, it would increase demand and investment.

In 2018, the US no longer needs cheap money. Inflation is chugging along. Demand is high, businesses are investing.

The job is done…almost.

The Fed now has the task of winding back the supply of money. To do so they’ll increase interest rates and sell government bonds. They’ll effectively suck money out of the system.

Professor at UTS Business School, Warren Hogan calls it the great unwind.

Over the past few years the FOMC has been able to get US monetary policy from super easy to just plain old accommodative without too many hiccups. The economy remains on a strong trajectory and, despite a modest pick-up in financial market volatility, asset values have held up well.

Key to the ability of the FOMC to get the funds rate well off the zero floor without too much disruption has been the orderly adjustment in bond markets. Not only have the government bond markets avoided any major sell-offs, but credit markets have been well behaved.

But if inflation kicks up, the Fed might be forced to sell bonds aggressively.

I can’t say for sure what the likelihood of such a scenario is. But it’s surely the worst case scenario for short-term investors.

A sell off in government bonds will drive up bond yields. Because these payments are considered risk free, the higher these yields rise, the more attractive they become.

We could see large institutions try to move billions over from stocks to bonds. And as Hogan points out, such moves would set us up for ‘a bumpy 2018/19 in global markets.

And this is exactly when I want you to act.

A US$6.8 billion fine can’t keep this stock down

In Monday’s Money Morning, I mentioned how you could have potentially made easy returns from short-term pessimism.

I used the example of Facebook, Inc. [NASDAQ:FB]. Earlier this year, the social network got into a bit of trouble.  Their privacy procedures weren’t quite up to scratch.

Analyst’s worried Facebook users would delete their accounts, which would mean lower ad revenues for the social giant. Many sold their stock for fear of further drops.

Facebook dropped 17% in short order, but rose just as quickly.

Even a US$6.8 billion fine wasn’t enough to stop Alphabet, Inc. [NASDAQ:GOOG] from rising. As reported by The Australian:

Earlier this month, the European Union hit Google with a record antitrust fine, accusing it of abusing the dominance of the Android mobile operating system, which is used by more than 80 per cent of the world’s smartphones. Google said it is appealing the charges.

Google is up more than 7% this month, thanks to higher earnings.

I’m not saying all stocks are winners over time. But there are a few that are. I called these the ‘certain bets’ in Monday’s article.

A company like Google has influence and control over their industry. Unless you see people stop googling things, then it’s likely they’ll continue to hold their number one spot for years to come.

And because of this certainty, investors are more willing to buy Google vs some other risky investment.

And if the market drops significantly, these are the types of businesses to run to first. So let’s all hope for a rocky 2018. You could potentially pick up some of the world’s best stocks for cheap.

Your friend,

Harje Ronngard,
Editor, Money Morning

Money Morning is Australia’s most outspoken financial news service. Your Money Morning editorial team are not afraid to tell it like it is. From calling out politicians to taking on the housing industry, our aim is to cut through the hype and BS to help you make sense of the stories that make a difference to your wealth. Whether you agree with us or not, you’ll find our common-sense, thought provoking arguments well worth a read.

Money Morning Australia is published by Fat Tail Investment Research, an independent financial publisher based in Melbourne, Australia. As an Australian financial services license holder we are subject to the regulations and laws of Corporations Act and Financial Services Act.

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