Shanghai Surprise

Since 2009 there have been 5 separate 10% plus corrections to markets, the longest it took to regain the previous highs was 91 days. Over decades one occurs on average every 18 months.

If you are an avid market watcher and active participant these last few days have been about as wild as it gets.

China is down 16% in two sessions, the U.S. market shed 1000 points in a heartbeat at the open on Monday then bounced up 500 within minutes, then down, then up, then down again.

Europe being a more mature player didn’t go all schizophrenic, it just got steadily hammered and Japan the same.

Wow!

Now what it all means and how it all plays out is anyone’s guess in the short term but that is not the focus of this blog.

Rather it is to focus on some facts and explanations which give some perspective and context to what the legendary Ron Atkinson would refer to as “squeaky bum time.”

  1. A big reason owning shares offers higher returns is that you as an investor will inevitably encounter times like these, which are distinctly unpleasant experiences. In effect the volatility is what you are getting paid for.
  2. The explanation for the huge immediate fall in the U.S. market was the effect of the ‘Quant Funds’. These are computer algorithm driven pools of money which trade automatically and at hyper speed in reaction to inflowing market data. They are fine when the data falls within the parameters of the algorithm, but they don’t account for anything that doesn’t as they have no artificial intelligence. So a sudden mass of sell orders creates a reaction of more computer generated sell orders, which flood the market: far outweighing the necessary quantity of buy orders to make a trade. This causes prices to gap down (i.e. be 20-30% lower immediately) which happened to the likes of JPMorgan, Facebook, GE etc. There are however circuit breakers which operate to halt markets if movements exceed set maximums, so it’s not something that can get totally out of control.
  3. Since 2009 there have been 5 separate 10% plus corrections to markets, the longest it took to regain the previous highs was 91 days. Over decades one occurs on average every 18 months.
  4. Such corrections are an absolutely normal phenomena and do not necessarily predict a coming economic catastrophe, most are simply pauses in upward traveling markets.
  5. 2008 still weighs on people’s minds and with good reason, it was a disaster and could have been far worse but it’s an outlier in terms of severity and the same fundamental structural defects in the financial system no longer exist (it might feel the same as then but it isn’t). The most recent economic data out of Germany (big exporter to China) is up, the correlation between a China stock market blow up and their economic situation does not appear to be strong. Tim Cook (Apple CEO) confirmed yesterday their performance in China in July and August was positive.
  6. The fact that China is only growing by 5% say (no one is sure) is obviously not the 10% pa of ten years ago, or 7% of the last few but remember the law of large numbers. If something grows at 10% pa, it doubles in size in 7 years (compounded growth). This means 5% of something double the size, is 10% of something half as large 7 years ago. This is not strictly relevant but it’s interesting. It is not possible for something to continue to grow rapidly for ever as it will consume everything else so there is in effect, a natural curb to size which is why nothing is bigger on land than an elephant. The various strains on energy required; bones, blood supply etc can’t cope beyond certain limits. This same effect relates to economies and companies; Apple is the most cited example of an entity potentially increasingly restrained by large numbers.
  7. The oil price collapse is fundamentally a supply issue (not a demand issue which would indicate slowing economic activity). Saudi Arabia last October declared a price war on the U.S. fracking industry by saying it would knowingly allow more oil supply to the market than demand required. This created an excess supply which pushed down prices. Saudi Arabia has a much lower cost of production than the frackers so they are still profitable at $ 40-50 a barrel, the frackers aren’t. The U.S. / Iran deal stops the sanctions which have prevented Iranian oil sales, so this recently added to the potential supply glut, hence renewed weakness.
  8. China has around 3.5trillion of foreign reserves, if it wants to sort out stuff it has unequalled fire power.
  9. The calming effect that QE had on the U.S. market was significant and probably far greater than any real benefit (the jury is still out on what QE actually achieves beyond giving confidence.) Think of it this way, if you put a builder’s plank on some grass and ask someone to walk along it they do so no trouble. Suspend it 30 feet in the air and most would then fall off, so it’s the fear that causes the fall, not the ability of the person to perform the task.
  10. This one’s a bit nerdy but interesting to nerds I guess (yep that’s me). Why would the € rise against the $ over the last week when everything points to its continued decline, it makes no long term sense? The answer in part (large I’m guessing) is that as the € will have the lowest yield (interest rate) for longest it is the borrowing currency for the global carry trade (you borrow in euros and buy something with a higher yield and pocket the difference between the two). In a period of fear a lot of these trades were being unwound, to do that the purchased asset was sold and €’s purchased to pay off the borrowing. So demand for €’s went up, so the price went up. Was this a reflection on the perceived safe haven status of the European currency? No it wasn’t; it was a contra intuitive short term reversal of a much longer downward trend but unless you knew why it was happening it looked unfathomable.

Conclusion

Let’s take Disney, the new Star Wars film is due in December, and a new Toy Story, they have the Marvel franchise, ESPN, a new park opening in Shanghai and the existing parks doing huge business, all known information with nothing new.

Shares traded up to $130, too high, great company, terrible price.

Nothing has changed with Disney over the last few weeks apart from the price, yesterday they were priced at $95.

I repeat nothing apart from the price changed, the market just decided to go on sale with a 35% discount!

So the point is that the schizophrenic nature of markets (and they’ve always been like this) gives opportunity for those who can stomach the hysteria and keep focused on the longer term values to buy at wonderful prices in periods (usually short and violent) when the herd has a communal panic attack.

That’s when the best investors (hopefully we have identified these in the portfolios) profit their investors (as they know the baby from the bath water) so they are actually to be welcomed as perverse as that seems.

NOTE: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.

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