Markets for Strong Hands!

Globally, investors were frightened by China’s market (Shanghai Composite Index) falling this week. Chinese government intervention halted stock market trade with reports of a possible further devaluation of China’s currency (the Yuan) on Thursday.

Though China is a police state, it utilises some democratic elements including its ‘managed’ stock market. Unlike our Australian Stock Exchange, the Chinese Stock Exchange can implement a “circuit breaker” by applying a trading halt if the local index falls by 7% on any given day. It is the second time this week that China’s newly implemented circuit breakers have crossed over and infected the broader US market.

The Chinese share market downturn reacted to a poorer manufacturing outlook than expected; worries about new share sales when a scheduled six month ban on insider selling ends and; continued decline in the value of China’s Renminbi. (Renminbi is the official currency with the Yuan being the unit of account – expressed as 20, 30 100 yuan, etc, but essentially they refer to the same currency).

China’s market sell-off was probably exaggerated, as the anticipation surrounding the ‘circuit breaker’ market shut down seems to have boosted selling with investors thinking they better sell early to beat the circuit breaker.

Monday’s manufacturing survey was weaker than expected, but other economic data over the last few weeks like manufacturing and services data released last weekend was more mixed, perhaps suggesting stable growth. But China’s decline in manufacturing is not really a surprise as markets have been expecting weakening property and manufacturing there. Over time it will be offset by rising consumption, services spending and ongoing infrastructure investment.

China’s share market may not be a good reflection of its overall economy as it is relatively small and poorly managed. Most market participants in its A-shares that are generally only available to mainland citizens, are retail investors and turnover is very high. B-shares are quoted in foreign currencies and are open to domestic and foreign investment.

Apart from China, tensions between Sunni dominated Saudi Arabia and Shia Iran have been also worrying markets. As has softer than expected US manufacturing data – its Supply Management (ISM) Manufacturing Conditions Index fell further in December.

Right now there is considerable global uncertainty on the minds of investors, so we expect higher than usual volatility this year. As we’ve been saying, it will take many more years to work through this period of high and rising debt, high European unemployment and US under-employment. With aging populations and new technologies reducing the need for some worker skills, this is all dragging on growth and inflation. But it can all potentially cause short term market over-reaction, providing opportunities to buy high-quality assets more cheaply.

We consider it best to keep focused on high quality, durable companies that can grow their revenues and manage market volatility better than other seemingly ‘cheap’ companies. Periods of volatility like this can be useful times to buy high quality assets at cheap prices, while taking a longer term view. In tough markets, wealth passes from weak hands to strong.

Market behaviour after the GFC shows the market can fall significantly but then recover and we can never rule out a large market fall, though we do not consider this the most likely.

Price to Earnings ratios (PEs) are high but compared with interest rates, we do not think shares are over-valued. The key for the coming year will be company earnings. Companies that can keep growing earnings despite the tough economic conditions will justify their valuations and their PEs will reduce as those earnings rise. Companies that can’t increase earnings may be found out, as the tailwind effect of expanding PE’s as the market revalues against falling interest rates drops off.

Higher quality companies with a competitive advantage operating in industries with positive fundamentals, should endure best. Stock markets often work through phases where emotion takes over from fundamentals and we seem to be in this situation now. But given the poor earnings environment in Australia, valuations are fair rather than high. Rather than panic, long-term investors might better view the markets as being on sale!