Are We There Yet?

Anyone who has driven on a long road trip with children will be familiar with the cry of “Are We There Yet”. After 13 months of the credit crisis we are also hearing the same cry from investors wondering if we have arrived in Bull Market territory once again.

The children usually start this refrain when they have become bored and tired, regardless of the distance still to be covered to reach the destination. Investors also become bored and tired by bear markets and are impatient to see their portfolio’s resume growth once again. Unfortunately for investors the answer will depend more on where you have put your money rather than the distance you have covered.

Many market commentators have talked about how world markets seem to be operating in tandem with no real decoupling evident. This is true if you are watching falls in the US markets rippling through Asia and Europe the next day. But if you step back and look at things over a larger time frame you can see that the markets are acting more like dominoes rather than operating in tandem.

The credit crisis has its roots in the falling values of US property. Due to financial engineering and credit derivatives most of this risk had been sliced and diced and scattered in various toxic packages around the globe. As the mechanism that allowed this financial engineering seized up, so did other mortgage markets that had used the same models. The best example of this is the UK which had also adopted most of the same irresponsible lending practices.

First the US property market fell and this quickly caused the market for CDO’s to dry up. Without this way of offloading risk the UK banks had to curtail their imprudent lending practices. With no one able to lend to prop up the rotten edifice, the UK property market also began to fall. Banks around the Globe stopped lending to each other because they all knew that their bookkeeping was suspect, with many being slow to mark to market the toxic CDO’s that where now, at least in the short term, worthless. This caused them to go running into the arms of sovereign wealth funds to shore up their capital.

All this financial turmoil has significantly impacted Global growth to the extent that it was even able to slow the Emerging Market juggernauts of China and India and throw a spanner into the Commodities Supercycle.

Which brings us to where we are now with US government ostensibly nationalizing the two GSE’s that back the US housing market.

You can reasonably expect that since things fell like domino’s that the recovery will be quite similar. The US property market has shown signs that its decline is slowing. Commodity prices and the inflation that they stoked have stalled, which will allow the central banks to change focus from inflation to pump priming.

Expect that the US markets will recover first followed by Europe then Asia and the emerging markets. This will allow the Commodity Supercycle to gain traction again.

So in answer to the question, “Are we there yet “. The answer will very much depend on how you have positioned your portfolio. If you have over weighted the US market you should already be starting to see your portfolio recover. If you still have most of your assets in Europe it will be a long winter. If the bulk of your assets are invested in China, well, see you next year.

Surviving Volatility

Markets in the past month have been whipsawing back and forth, this volatility has caused a lot of investors to retreat to cash until the markets show some direction. While this may be a prudent play if you are a day trader, it is not if you are a long term investor. Here are 5 things you should know to understand how to survive a volatile market.

1. Watching From The Sidelines May Cost You.

When markets become volatile, a lot of people try to guess when stocks will bottom out. In the meantime, they often park their investments in cash. But just as many investors are slow to recognize a retreating stock market, many also fail to see an upward trend in the market until after they have missed opportunities for gains. Missing out on these opportunities can take a big bite out of your returns. Consider that in the 12 months following the end of a bear market, a fully invested stock portfolio had an average total return of 36.8%. However, if an investor missed the first six months of the recovery by holding cash, their return would have been only 7.6%.

2. Dollar Cost Averaging Will Help You.

Most people are quick to agree that volatile markets present buying opportunities for investors with a long-term horizon. But mustering the discipline to make purchases during a volatile market can be difficult. You can’t help wondering, “Is this really the right time to buy?” Dollar-cost averaging can help reduce anxiety about the investment process. Simply put, dollar-cost averaging is committing a fixed amount of money at regular intervals to an investment. You buy more shares when prices are low and fewer shares when prices are high, and over time, your average cost per share may be less than the average price per share. Dollar-cost averaging involves a continuous, disciplined investment in fund shares, regardless of fluctuating price levels.

3. This Is a Great Time For a Portfolio Checkup.

Is your portfolio as diversified as you think it is? Meet with us to find out. Your portfolio’s weightings in different asset classes may shift over time as one investment performs better or worse than another. Together with your advisor, you can re-examine your portfolio to see if you are properly diversified. You can also determine whether your current portfolio mix is still a suitable match with your goals and risk tolerance.

4. Tune Out The Noise.

Numerous television stations and websites are dedicated to reporting investment news 24 hours a day, seven days a week. What’s more, there are almost too many financial publications and websites to count. While the media provide a valuable service, they typically offer a very short-term outlook. To put your own investment plan in a longer-term perspective and bolster your confidence, you may want to look at how different types of Asset Allocation models have performed over time. As you will see, while equities may be more volatile, they’ve still outperformed bonds and cash over longer time periods.

5. Believe Your Beliefs And Doubt Your Doubts.

There are no real secrets to managing volatility. Most investors already know that the best way to navigate a choppy market is to have a good long-term plan and a well-diversified portfolio. But sticking to these fundamental beliefs is sometimes easier said than done. When put to the test, you sometimes begin doubting your beliefs and believing your doubts, which can lead to short-term moves that divert you from your long-term goals. To keep from falling into this trap, give us a call before making any changes to your portfolio.

Shanghai Rules

When I first moved to Shanghai in 2004 I was told by a lot of old china hands that “Shanghai is not China”. That saying has been true for most of the 150 years that Shanghai has existed. She has always been China’s gateway to the rest of the World and was usually allowed to play by her own rules. The same can also be said about the Shanghai Stock Market, it too seems to play by its own set of rules, though these rules seem to be more about second guessing the intentions of the mandarins in Beijing.

When I first came to Shanghai the equity markets were in the doldrums after one of its typical boom bust cycles, the market had sat in a narrow trading range for many months, no economic news no matter how positive could seem to make the market move. The market had become weighed down by the overhang of millions of state owned shares. All most all the listed companies had at one time been a state owned entity. When they had gotten their initial listings they had issued freely tradable shares but had kept back the majority of shares in the government’s hands. These shares were not tradable, but the government had started to make noises about freeing these shares to trade.



This made investors very reluctant to buy shares even in companies that were showing very good revenue and earnings growth. The thought of having a wall of previously state owned share hit the market kept investors away. It took a couple of years of effort by the government such as cancelling some state owned shares as well as giving additional shares to private investors to sort this out. This exercise just reinforced in the minds of investors that the performance of their investment portfolio rested on the whims of the mandarins in Beijing.

The Shanghai Stock Market is once again waiting for the mandarins. This time investors are waiting for the government to intervene to prop up a falling market. Since it began its long decline in November last year, the rumor had gone around that the government would ride to the markets rescue because this was the year of the Olympics and the government would want to avoid any unrest. Many grimly hung on to their stock position as the market began its long decent, believing that the government would intervene. The Olympics are almost over and they are still waiting. Very soon, perhaps during the closing ceremonies, it will dawn on them that there will be no rescue this time. This will be when the market finally accepts reality and will reach its bottom.



At current valuations the Shanghai Composite index has an average P/E ratio of 19. Now this may not sound particularly high for an economy that is expected to grow at 8.6% this year. But you should bear in mind that between 2004 and 2006 when the Chinese economy was growing at 11% + the Shanghai Composites average P/E ration never exceeded 13 times earnings. It’s reasonable to assume that when this market does finally bottom it may well be trading at a low double or high single digit P/E. In the developed economies having growth rates of 8% would mean a stock market boom, but having growth slow this much in China is going to have a significant impact on many companies. Many firms operate their businesses on razor thin profit margins; they rely on constantly growing their top line to support their business model, with growth slowing from double digits many of these companies will no longer be able to maintain profitability and some will simply go out of business.

A period of consolidation is want this market requires. As a number of competitors fall by the way side the survivors will be rewarded with greater pricing power in a less cut throat competitive environment. This process will not happen overnight, in fact it may take a couple of years. So don’t expect the post Olympic capitulation to usher in a new bull market.

In Shanghai they play by their own rules, in all likelihood this market will sit range bound for sometime ignoring good economic news as it did in the past until the government changes the rules and sends it soaring again to unrealistic levels. Though this is the main market of the world’s second largest economy, it is still very unsophisticated. It is driven more by rumors of government interventions than it is by any economic fundamentals.

Is this the Bottom?

The well worn saying that it is always darkest before the dawn also holds true for the stock market. Stock markets, by their very nature, are often driven more by sentiment than pure logic. When the majority of investors have thrown up their hands in frustration, it is usually an indication that a bottom is being reached. Investment market prices are based on forward looking sentiment. Investors make buying or selling decisions based on where they think the market will be in 6 months to a year in the future. In this way they are leading indicators.

So what signs do you look for to try and differentiate between a dead cat bounce and a real change in direction? In a word, capitulation.

You want to see that things have become so negative that the majority of the investors are just giving up and putting their money somewhere safe, like cash.

We saw signs of that kind of capitulation last week by Merrill Lynch. Merrill Lynch cleared all of their CDO’s off their books for 5 cents on the dollar. They agreed to unload their entire tranche to the fund Lone Star for 5 cents on the dollar in cash, with the chance to get up to a total of 22 cents on the dollar if the CDO’s recover. Anything beyond the 22 cents goes to Lone Star. This will allow John Thain, their CEO, to draw a line under the Credit Derivative debacle that cost Thain’s predecessor his job back in December.

Another sign that markets are reaching their bottom is when investors throw in the towel and sell stocks regardless of their value. You want to see a sharp rise in the number of shares hitting new lows. We saw this last month with 1304 new lows on the NYSE. This was coincident to the Dow hitting a closing low not equaled since July 2006

Market bottoms are periods of great volatility, you want to see the Volatility Index (VIX) going over 30, which it did on July 15th.

Another index which has been a very good indicator of when to buy is the American Association of Individual Investors (AAII) Sentiment Index. It is based on a survey of investors as to whether they are Bullish, Bearish or Neutral on the Stock Market. Historically, when it goes below 25% Bullish, that has indicated a market bottom. It hit 25% in the 2nd week of June and has since risen to where Bulls and Bears are just about even.

The professionals are also showing a great deal of pessimism, the Merrill Lynch Global Fund Manager Survey which measures the positions and sentiment of Fund Managers, shows that only a net 4% of managers where optimistic. It also indicated that 40% of managers said they were underweight in equities and 53% said they were overweight in cash.

Finally you want the last shoe to drop. Shares of companies in natural resources have traditionally been that last shoe. We have seen a sharp decline in Brazil, Russia, Canada and Australia, markets that have up to now weathered the crisis fairly well because of their exposure to resource extraction and basic materials.

Whether this is a rally within a bear market, or if market direction has already changed, will be decided over the next two weeks. It could be just an uptick caused by changes to the rules on shorting financial stocks in the US gaining some additional leverage on a drop in Oil Prices. Only time will tell. Either way, if this is a dead cat bounce, it is the bounce that foretold the final plunge that brought the market to its bottom.