Stock Market Musings

I decide to take the events of the past two weeks to reflect about the mis-priced events and expectations. This year has seen two such situations present themselves – namely Brexit in the UK and the Presidential Election in the United States.

Both situations had binary outcomes. Markets mis-priced the outcome wrongly in both instances, and reacted violently initially when it became apparent they had misjudged the situation.

There are a couple of points I like to draw from these two events.

Firstly, predicting the outcome of major events and taking huge directional bets on it is a very tough to get right consistently. One not only has to be right on the outcome, but also the reaction of the markets. 

I remember the night when it became apparent Trump was clearly winning. Futures in the US plunged precipitously and fell 5%. In Asia, markets were open and sold off hard. 

By the time of opening bell however, investors had recovered from their shock and narrowed their losses dramatically, and markets actually rallied!

So much for the end of days that Trump was supposedly about to bring about. 

Investors who were right, but were not quick footed enough may have initially racked up huge gains, only to find themselves taking huge losses days later. 

Not a pretty situation in any case.

So far we’ve established that investors so far have to:

  1. Get the outcome correct
  2. Get the timing of their trades right in response to the outcome

But I think the most under looked point is actually:

The payout if an investor is right, or the potential loss if an investor is wrong

I’ve seen the above point articulated in many different ways but my preferred interpretation is quite simple.

We want a situation whereby any investment we make as an asymmetrical risk/reward payout.

This really feeds into the idea of risking 20-30 cents to make $1. 

The idea is not very far off from buying travel or medical insurance. None of us would like to make a claim, but in the case we need to, our payout is normally in multiples of our paid premiums.

The whole idea of a trade with an asymmetrical risk/reward payout was articulated excellently in The Greatest Trade Ever and in Michael Lewis’s excellent book, the Big Short. It’s since been made into a movie which I highly recommend.

On the reverse end, my own general observation is that many investors tend to act quite differently by risking $1 to make 5 to 10 cents. 

My observation on trades placed on events with binary type outcomes is that you are either right or wrong. And if you’re wrong, and you’ve used leverage on the trade, things can get very dicey as investors head to exit at exactly the same time.

How we position ourselves:

My personal preference simply has to hold higher levels of cash going into such events to take advantage of any market dislocations that may occur purely out of emotional sentiment.

As value investors, I’ve never been too keen on the idea of macro-economic forecasting.  If “experts” who had every vested interest of getting it right were this wrong on an event with a simple binary outcome – I cant imagine economic forecasting to be any easier given the wide myriad of outcomes.

Still, let me draw a distinction between marco-forecasting and knowing where we are in the cycle which I think is a much more achievable goal. 

I always like to liken the market to a pendulum – swinging from greed to fear and back again. The most extreme the swing to one end, the quicker the pendulum swing backs.

Although we do not know exactly know when the pendulum will change course, I still think its extremely important to know where we are in the cycle. 

When others are overly optimistic, we are far more cautious. Conversely, when fear permeates the news, we get more aggressive.

Buysell Ratio
Source: Asia Insider Limited

So the ratio of insider buying to insider selling has hit an all time high of 4.7x.

One other point which I find really interesting is that the greatest cumulative value of buying and selling was done in 2007.

It seems half the people in the room drank their own cool-aid.

Thoughts on Insider Buying/Selling

I don’t think we have enough data here to form a clear conclusion from the Singapore markets. But there’s been quite a bit of academic research showing that heavy insider buying does lead to out-performance.

For me, its a matter of common sense.

If I think the company is cheap, but the Board of Directors are engaged in heavy selling, I would re-examine my thesis very slowly and carefully again.

Likewise, if the directors are buying heavily, that’s a net positive to me.

In continuing with the series, I like to draw attention to the valuations of the STI Index, which notoriously received the dubious distinction of having as bad a year as Greece.

ScreenClip

It’s probably worthwhile to note that the last 5 years have not been by any measure a particularly exuberant time in the stock market (especially in comparison to 2005 – 2007).

This lower valuations have also resulted in a corresponding surge in the dividend yield of the STI to close to 4%, a near record high.

Some large capitalization stocks are extremely cheap, trading at close to 2008 levels.

Can stocks go lower?

Sure.

But I would argue that hoping for the bottom in 2008 valuations is a case of being penny wise pound foolish. Risk reward ratios are skewed towards risking 10 cents on the dollar to make 50 cents to a $1.

We should probably bear in mind that the 2008-2009 crisis was a crisis that it rivalled the Great Depression, so whether one should expect that kind of valuation levels to materialize is up to debate.

Personally, we haven’t seen the mad excesses of the 2005 – 2007 period, and certainly none of those seen in the run up to the 1997 crisis.

Source : Emerging Perspectives

And how about the rise of interest rates in the US which is widely believed to bring about the ruin for corporates? Well… the available data we have on instances where interest rates have risen do not actually support that conclusion.

1
Source : Emerging Perspectives
2
Source : Emerging Perspectives

In the end valuations are what drives the long run stock market returns. And by this measure, emerging markets are cheap (Singapore stocks are priced similarly).

ScreenClip
JP Morgan Market Insights

Final Thoughts:

All that is required now is patience and fortitude of character. Markets have always been volatile – something that investors in stocks must come to terms with one way or the other.

Cheap valuations do not mean stock prices go up straight away.

However, in my view, investors have the odds stacked heavily in their favour. If investors can be calm and cool-headed as others panic in the next few months, than they can look forward to satisfactory returns in the coming years.

There’s plenty of noise in the markets at the moment. Plenty of market manipulation (whether true or perceived!).

It reminds me of the time that Asia went through its own “learning lessons” in the 1990s. That’s just part and parcel of the capital markets.

But ultimately, valuations are what really drives stock market returns in the long run.

The below charts serve as a signpost to know where we are in terms of market valuations.
1 PetroChina

2 Industrial and Commercial Bank of China Ltd

3 Agricultural Bank of China Co Ltd

4 Bank of China

5 China Life Insurance

6 China Petroleum & Chemical Corporation

7 Ping An Insurance

8 China Merchant Ban

9 China Shenhua Energy

10 Citic

** Data from Thomson Reuters