With the recent volatility on the world financial markets we’ve been busy talking to our clients to keep them abreast of the situation but I thought a post on LinkedIn would be a good idea as well because sometimes a fresh perspective is needed to see the opportunity amongst the headline grabbing articles that today’s press loves to pump out.

The recent selloff is unique in that a normal correction in stocks is usually driven by negative sentiment towards a particular stock or sector or country however what we are seeing at the moment is indiscriminate selling across the board regardless of company, industry or country. I believe this is primarily being driven by three things. The first is that in recent times investment managers and investors prefer to gain market exposure using either ETF’s or future contracts across an index.

Whilst this makes it quick and easy to get money into the market when a selloff in the market occurs and you are holding an S&P500 ETF you can’t exactly sell your exposure to a particular company or sector and keep the remaining stocks. It’s an all or nothing weighting. According to this Bloomberg article in the past 12 months investors traded US$18.2 trillion worth of ETF shares on the US markets. That’s 17 percent higher than 12 months prior and more than triple what it was 10 years ago and in dollar terms is larger than the GDP for the US economy. Simply staggering.

Secondly when it comes to managing money for investors fund managers don’t keep a large amount of cash on hand to fund redemption’s so when they see a downturn their focus turns from generating returns to building up their cash reserves to fund the redemption’s that they anticipate will come through given the fall in the markets. This means that there is selling across their whole portfolio to fund the inevitable.

We believe the third catalyst for the selloff is being driven by a lack of understanding of the Chinese stock market. Too much emphasis is being placed on a market that not only is a poor indicator of the Chinese economy  but also operates differently compared to the majority of world markets.

For example Beijing has only just allowed the Chinese pension funds to invest in the Chinese stock market. Up until this policy change it is believed that between 60-80% of turnover in the Chinese market was driven by mum and dad investors. I cannot think of any other market in the world where retail investors make up such a large percentage of the daily turnover.

Their investment decisions weren’t based on fundamentals, more so what they read in newsletters and online forums. Also if you look at the performance of the Chinese stock market versus the growth of the Chinese economy there are very little parallels to be drawn on. For example during the period 2003 to 2006 when China’s economy grew at a rate of greater than 10% the Chinese stock market actually went sideways.

But for arguments sake lets say that there has been a change in the way that the Chinese market has been viewed and it is now a more reliable indicator (which I still don’t think so but its always good to look at both sides of the coin). Lets put the recent sell off in China into perspective. Try and guess what the Shanghai Composite Index has returned since the 1st of January 2015. I bet you’re thinking down 20, 30%. Try down 5.95%. Next test, try and guess what the 1 year return on the Shanghai Composite Index has been. Give up? How does a 41.95% gain sound. Comparing that to the S&P500 (down 4.01%) and the Dow Jones Industrial Index (down 7.05%) you’d have shot the lights out if you were long the Chinese market and short the US markets over the past 12 months.

So whats the point of this post? We need to get back to fundamentals and stop reading the headlines. I’ve been in the markets long enough to know that no one rings a bell when the market reaches it peak or its trough. So what do you do in these times? Well I could provide 20 Warren Buffett quotes to provide an explanation of what do do but all I’ll say is look for companies that display fundamentals that are at odds to their financials. There is a very good reason why the financial markets have been using Earnings per Share (EPS), P/E ratios and Return of Capital/Equity for many years as a way to value and evaluate companies and that is because they are a unemotional barometer of whether a company is cheap or expensive. Draw that line in the sand on the company that you are happy with combined with the price you are comfortable at. You may not pick the bottom and may have to wait a little time before you see some green on your screen but history has shown us that buying world class companies during market sell downs at prices 20-30% below their recent peaks has proved one of the most effective forms of wealth creation.

Update – 26/08/2015

This morning I was interviewed live on air by Sandy Aloisi from ABC News Radio as part of their breakfast segment after publishing this post about world financial markets. If you would like to listen to this interview click here or on the link below and then press the play button at the top left hand corner of the article. https://www.abc.net.au/newsradio/content/s4300209.htm

The above article was written by our Managing Director, Brett Evans, and was published on LinkedIn. To read this and other posts please click here or go to https://www.linkedin.com/today/post/author/posts#published?trk=mp-reader-h.

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