8 January 2016

What Circuit Breakers?

Executive Summary

The Chinese market has had a turbulent start to the new year and has resulted in some selling across the various equity markets as investors fled to safety. We do not see further selling in Chinese A-shares surprising, given that they still trade at a 40% premium to their Hong Kong counterparts. Our exposure to A-shares is NIL, whilst we have very small exposures to the H-share market which limits our risk. Our risk matrix did not flag a risky environment and gauging market news and investor sentiment; we view this correction as an excellent buying opportunity.

Article

The Chinese Market

Circuit breakers appear to be the new buzzword. The media has been in a kerfuffle over how Chinese regulators put these trading curbs in place to reduce volatility, only for it to cause more volatility and anxiety, and then for them to reverse the decision after only four trading days.

Logically, to halt the market for the entire day after a 7% loss is quite extreme. Take the US market for example. The New York Stock Exchange implements three level of breaks; a 7% loss results in a 15-minute trading halt, if it reaches a 13% loss another 15-minute trading halt is implemented, and the market is closed only if the intraday loss reaches 20%. Average market volatility of the S&P 500 over the long term is approximately 17%. Now compare this to the Shanghai Composite where the average volatility is nearly 30%. For such a volatile trading environment, it makes sense for the Chinese to have a much higher threshold before halting markets for the day.

Why the sell-off in Chinese markets then? We are not surprised that it happened as Chinese A shares ended 2015 with a nearly 7% gain despite having a severe 45% downside in the middle of the year. The chart below (Fig 1) shows that despite what is happening in the A-share market, it still remains expensive when compared to its exact counterpart listed in Hong Kong. It is a sign of a “bubble”, something which could continue to deflate over the next few months or year.

Fig 1: The Chart Shows the A-Share Premium Over H-Shares. A Shares Are Still Overpriced Despite the Sell-off.

Portfolio Exposure

Whilst we have no direct exposure in Chinese A-shares, we do have some small exposure in Asian equities and we are worried that the negative sentiment will continue to drag our Asian exposures down. Our largest exposure is in our Aggressive Alpha portfolios where the exposure to Hong Kong listed Chinese companies is around 10% of the portfolio. Our more strategic portfolios like the gManaged series has a maximum exposure of 5.9% to Hong Kong listed entities. As such, we are not too worried about the localised share rout in Shanghai as long as our risk matrix does not turn red and the world does not slip into a recession.

Economy and Stock Returns

Some commentators may say that a slowing Chinese economy will hurt its own stock market and the stock market of the Asian region quite significantly. It may happen only if the animal spirits of investors are broken. In terms of historical performance and theory, the chart below shows that there is very little relation to equity market returns and the growth rates of countries (Fig 2).

Fig 2: GDP Growth Rates Are The Purple Diamond and Equity Returns Are Shown In Gold Bars. High Growth Does Not Equate High Stock Returns.

Taking Advantage Of Volatility

We have written before that the sell-off in 2015 most closely resembled that of 2011 (Fig 3). Whilst the circumstances and causes are different, market psychology and how investors react to certain events do not change. We noted that we are likely still in a basing process – where the market attempts to find its feet. As a result, we could be in a sideways choppy market over the next quarter or so. As long as our risk matrix does not signal a high risk event, and there is no global recession on the cards, then we are assured that a large global bear market is not imminent. A check on investor sentiment shows that we are back in the pessimistic zone and further large falls grow less likely (Fig 4). As such, our thinking is quite contrarian compared to the rest of the market in that we see the current fear in markets as an excellent opportunity to get invested.

Fig 3: Market Reaction Most Closely Resembles 2011.

Fig 4: Investors Feeling Fearful and Pessimistic Is a Good Sign

Risk Reading

You may be surprised to know that our risk matrix had not turned to red compared to the Aug 2015 sell-off. A measure of deeper market data shows that internal market metrics have quietly improved despite what is happening in the markets (Fig 5). We are watching larger bear market signals which would indicate that the current correction is turning into a full blown bear market of more than a 20% downside. At the moment, it is not happening and we want to tell all our investors that we are on top of things and NOT TO WORRY.

Fig 5: Internal Market Metrics Are Better Than Aug/Sep 2015

Conclusion

We looked at what was happening in the markets and quickly analysed our risk signals as well as the output from our risk matrix. No risk-off signal has been set and we view this as part of a correction. The market action for now is localised to Asia and EM but we are watching for contagion. However, the chance of a full blown bear market in equities is less likely if the US does not tip into a recession. As such, we advise all our investors not to panic and to view this period as an excellent buying opportunity.

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