Drawdowns in Markets

Investors are obviously worried about the outcome of the Trump Trade War. Asian markets have entered into a technical bear market but the US markets have hit an all time high. Just last week, the US markets officially recorded the longest bull market in its history.

Usually markets have cycles. Some say there is a 7 year Joseph cycle in Asia. 7 fat years followed by 7 lean years. An entire book has been written about it and I shall not repeat its observations here. So why hasn’t it applied to the US markets today? I believe one of the reasons might be this unusual period of market interventions called the QE since 2008. Excessive liquidity pumped into the markets has certainly made its way into equity markets and real estate in general, and even the bond markets. The markets have been pumped up when on its own natural rhythm should have have started gong down from 2015. (7 years from 2009). In fact, the decline has been observed in Asian markets, especially in HK/China which saw a low in many stocks. Consequently by that same theory, we should have seen 7 years of up markets from then up to 2022.

So the current correction is probably just a typical market correction in a bull market. The underlying fundamentals of the companies seem to confirm that view. In China for instance, unlike in 2015, many companies are reporting strong results and not declining profits as was the case in 2015. Just looking at the China auto sector where representative stocks such as Brilliance China and BAIC Auto (Mercedes Benz) JV, stock prices have halved from their recent peaks less than 6 months ago, when the companies are reporting profit growth of 30% or more. The outlook also remains bright as their foreign JV partners such as BMW are expected to introduce more models into China. The structural trends are still intact, as Chinese consumers are still enamored with these foreign luxury brands. The decline in share prices is caused by the recent news that the auto sector would be slowly liberalized and foreigners are allowed to own majority stakes in foreign JVs. Some worry that this means that foreign brands no longer need to work with Chinese companies and can sell cars on their own. However, the current JV agreements are still in place at least until 2023. There is still plenty of time to negotiate the new arrangements. But markets of course hate uncertainty. But to half the share price because of that?

Brilliance China

brilliance china 27082018

[Ed (27 Aug 18):  Brilliance China incidentally announced interim profit growth up 54% and the stock popped 14.7% today.]

BAIC 

baic 27082018

 

I have observed that share price decline fall into several categories. Declines of up to 20% should not be treated with concern. This is still within the normal deviation of stock prices in general. In more volatile markets or stocks, fluctuations in stock prices up to 30% can happen as a normal course of action without any news or change in fundamentals. I have learnt that this can be heart wrenching if we look at our P&Ls on a daily basis. However the best thing to do in this case would be to do nothing or we risk being shaken out by short term market fluctuations. The only exception to this rule is if the stock price were to break its 200 day ma. We should then sell the stock immediately as this usually isn’t a good sign. It shows that investor sentiments have changed and we do not know how much further it would go. The caveat to this rule of course is if you are a truly long term holder in the stock like Warren Buffett and you need to have unshakable conviction in your investment and analysis. Make sure you are also sufficiently diversified. In life many things can go wrong even when you have done all you can to consider all things in your analysis.

The second type of correction is the 40% correction from the last peak. A stock that recently fits this criteria is HM Sampoerna in Indonesia, majority own by British American Tobacco. The stock has compounded total returns of more than 25% in USD since its listing. A very impressive achievement in Indonesian markets given its volatile history and unpredictable FX movements. (A feat achieved by the equally impressive Unilever Indonesia, it has it be mentioned.) Tobacco stocks, it has to be said, normally do very well over the long term. Once I did a study and dug out the share price performance of the longest listed tobacco stock I could find – BAT London and was amazed to find that the stock has also compounded close to 20% p.a. since the 1960s which was as far back as my data source went. If anyone out there has a longer listed history of a tobacco stock, I would be interested to know the compounded annual TR of the stock. This proves to me that certain consumer companies like tobacco companies are much suited to weather through all sorts of economic conditions. Well back to HMSP. It is indeed unusual to find these stable stocks correct so much in such a short period of time. To be sure, the decline from recent peak has been about 44% in USD terms and have rebounded recently. In local currency terms the correction had been less. Investors are worried that the company has been losing market share and have not taken recent excise duties very well. But if we understand the long term characteristics of the tobacco business, I would say this should at best be a temporary issue. Indeed BAT Malaysia has also more than halved from recent peaks but for a different set of reasons. It is my contention that these stocks therefore are probably pretty close to being ripe for long term investors. If only I could get it at a lower price… Haha… Patience…

HM Sampoerna

HMSP 27082018

HMSP 1991 to 2018 Returns

HM Sampoerna compounded at a compounded return of 25.44% since it was listed in 1991.  That is a total return of 43,528% over the last 27 years! And this is in USD terms (hence taking care of the weakness of the Rupiah over this period.)  Notice that the total return is a lot higher than the price return.  Which means that about 60% of the total returns are made in dividends!

BAT Malaysia

ROTH MK 27082018

The final and most severe correction are those that typically go down. 60%-90%. These normally signal a severe crisis of confidence such as the Asia Financial Crisis on 1997 or the Global Financial Crisis in 2007, or if there are some structural reasons in the stock or the industry that the stock is in. Stocks are sold because of fear and not because of the fundamentals. Indeed, fundamentals and valuations are no longer meaningful. The only question then is when the we buy the stock., This would have been more an art than science. This is where I believe that technical analysis would be useful. It would be advisable to wait until the long-term trend is confirmed to be changed. In other words, we wait for the markets to signal that the trend is changing. Currently, my preferred indicator would be to wait until the 100 day moving average line cuts across the 200-day moving average line. This will ensure that we will not be tricked by the many false starts that are typical of a downward moving bear market. The dumps out this approach of course is that we normally would not be able to pick the bottom of the market. In fact, from my own observations, we would typically miss about 20 to 30% of the price from the low. This would of course be a small price to pay in order to avoid catching a falling knife. And you would also help reduce too many sleepless nights while we all want to stop to find it only to go down further if we went in too early. Here, I’m of course speaking from my very own painful experience. This is just a guideline for myself and of course if you readers have any other alternative way of timing the bottom I will be interested to find out as well and to refine my own approach.

This has been a very long discourse but I thought this would be a good time to summarize my own views on what to do when markets are down. Of course, to minimize our risk and to maximize our outside, it would be advisable to enter a stock only when it has declined more than 40%, I find that this would be much safer in the long term. This would also mean that we might miss a lot of opportunities along the way. But I would very much prefer to keep my bullets for those few real opportunities for the stock has declined 50% or more and has a chance within the next two to three years to double in price. The compounded annual return for some of these stocks will then be more than 20% which I think is a very reasonable goal and a very lucrative one for many investors.

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