Saturday, 18 October 2014

Stock Market Capitulation - Why and How to Profit from it ?

Last 2 weeks has been quite tough on investors with stock market capitulating; whipping out this year gains, in fact S&P 500 was briefly negative for the year. I was expecting this kind of correction all this year but it never happened until start of October. It was interesting to note this time the reason for the decline was not due to one factor but multiple factors that interestingly happened at same time. Let's take a look at the all the factors that contributed to market decline, put them in perspective, and discuss how investor can take advantage of decline.

Reason for Market Decline

1) Strong US dollar - The market correction started with strong US dollar on a back of rate increase over next year. This has caused disturbance in global markets because with ultra low interest rates in US; institutions are borrowing in USD and investing overseas for higher yield. With stronger USD, they have to reverse their positions causing decline in overseas markets and currencies - AUD under $0.90c, ASX down 10%, EUR under $1.30, Emerging market currencies down as well. Not to mention, commodities which are down significantly as well - oil below $85, copper under $3!

2) Market was slowly adjusting to stronger USD when bad economic news from Europe started reflecting that deflation and recession in Europe is a real possibility. This got exasperated with news of economic contraction in Germany - exports down 5% - Russian teeth biting them ouch! 25% of Germany natural gas consumption comes from Russia.

3) Domino effect of recession in Europe, Slowness in Global economy esp China could slow US economy therefore market got concerned. This got exasperated with poor retail numbers. Hence, we saw 10 yr treasury down from 2.5% to under 2%

4) Oil below $85 is major concern, This reflects slow global growth. However, I think Oil is also down due to stronger USD and over-supply as we enter into price war with Saudi pumping more oil in the market and wants lower oil price so that it can whip out high cost producer. Saudi is a low-cost producer with average crude cost price of $16.5 a barrel whereas US Baken shale producer has average crude cost about $60-70 a barrel. So keep an eye on that as well!! Also S&P500 has about 12% weightage to energy sector so it can have domino effect on index return with change in oil price. Energy sector is down about 10-12% in this correction

5) Concern over Corporate Earnings - Mainly due to global economic growth concerns, decline in earning due to stronger USD as most of the large caps company has earning from overseas. This is a good example why market trade on sentiments but not on logic  - Market tend to forget that most of large multi-national companies tend to hedge their currency exposure; however this is not reflected in income statement or EPS.

6) Rise in 10 yr bond yields of Greece, Italy and Spain (GIS). Greece bond yield are about 9% again (last saw them at these level in 2011). This reflects that investor are quite concern about Europe. I'm keeping track of these since 2011, a good gauge of potential financial crisis in Europe. I get quite concerned when bond yield in GIS goes up because this effect US banks stocks and I've major exposure to them. Note: JPM down almost 9%, BAC down 10-12% even after good earnings report

7) Fed taper officially ends this month. Though market were aware of this but exasperated with other concerns
   
In addition to these concerns were geo-political concern such as protest in Hong Kong and fighting in Ukraine. It's an old saying - "Wall St doesn't like uncertainty" and we had all these event happening simultaneously within 2 weeks; therefore violent move to downside was quite expected. 

I thought S&P500 will end at 1800 by friday (17th Oct) but we had a strong reversal at 1820 mainly due to good economic numbers from US - industrial prod up 1% and jobless claims down 20k to 260k followed by strong corporate earning; in fact earnings are been revised upwards. This is a cliche where stock market correction due to global macro concerns is supported by strong corporate earning. Also on Friday, Central bankers in Europe has announced major bond buying program starting immediately, and China central bank has announced 200B yuan ($33B) stimulus package to shore up banking system. This has helped to taper concern over Europe and China as printing money potentially abate deflation concern in Europe and stimulus package will be help stimulate Chinese economy. It will also support market going forward as well.

As a long-term value investor, I cherish these corrections because stocks gets cheaper; providing an opportunity to buy more as they go down. Though I keep track of macro events, I don't make decision based on macro events and data. I continue to focus on researching and valuing good businesses, buying them at reasonable and cheap price. This is nice opportunity for long-term investor to buy companies that they like or add to existing positions. I think volatility in the market will continue for a while; giving long-term investor an opportunity to put cash to work. This is exactly what i'm doing!! You could be assured of nice long-term gains.

I would also highlight buying in the declining market is less risk for long-term investor as opposed to common belief that buying in declining market is more risky. Let me explain why: 
  • Firstly, market declines because of some macro concerns or bad news. After certain point these concerns and bad news are built and reflected in the market so even if there are more bad news, market would not decline exponentially; whereas any good news would cause reversal in market direction
  • Secondly, investor get better return on money when share price goes down For eg: QBE at $12 has a potential earning yield of 16%, at $10.6 it has potential earning yield of 18%.
Buying share when market in turmoil is a difficult process, therefore I would highlight two points. Firstly, with all these macro concerns and headwinds, investors should have long-term horizon to investing with focus on business performance of individual companies because in long run it's the earning growth that will drive the share price of a company higher. Secondly, have a strong belief in old saying: "Wall St will eventually climb the wall of worries"