Financial markets do not always react in the same way to news. There are times when the stock market seems immune to both bad news and good news. Investors keep calm and make investment decisions based on fundamentals. The market works. At such times, it is relatively easy for analysts. They analyse the fundamentals, the market reacts.
But there are also phases when the market reacts violently to every new rumour. Suddenly no one pays attention to the underlying fundamentals. Volatility seems to feed on itself. In this phase, the stock market is unpredictable. Only with the help of chaos theory can movements be explained, and then only in retrospect.
Long-term predictions within a chaotic system are meaningless. What we do know from chaos theory is that a phase of stability leads to a phase of instability after which another period of stability follows. Look at the research into fractals by Benoit Mandelbrot. The question now is whether it is possible to determine what phase we are in.
This can be done by looking at the implied volatility, for example the VIX. The VIX sounds like something mathematical, but it is just the residual number to get the Black & Scholes option model right. It is the collective human emotion expressed in a number, which is why it is also called the fear index.
When people are anxious, they can react very irrationally. When the VIX is high, as it is now, financial markets often react irrationally, while when the VIX normalises at lower levels the ratio returns. It is like a bipolar disorder, like manic depression.
The irrational phase
In recent days, the Hong Kong stock market was a good example of such a manic phase. After the harsh Western sanctions against Russia, including the freezing of the reserves of the Russian central bank, the Chinese themselves must be wondering what to do with 3 trillion dollars in reserves that could suddenly become worthless.
Following a report that China might be supplying arms to the Russians for the war in Ukraine, the market fears that China could face these Western sanctions. Strangely enough, they do not extend the line to other financial markets, because the current sanctions against Russia will probably cause a recession in Europe, the same sanctions against China will soon cause a global depression.
That is exactly the reason why they will not come. But fortunately, of course, there is always the excuse of a Covid-19 outbreak that will send major cities like Shenzen and Shanghai into lockdown. You would expect markets to be immune to Covid news for a change. Perhaps it is because market participants were already somewhat disappointed by the Chinese central bank’s modest stimulus measures.
Instead, the central bank launched an investigation into Tencent for money laundering. Investors are no longer frightened by such news. It does not surprise.
The turmoil on the Hong Kong stock exchange is probably also the result of the fact that the SEC is going to implement Trump’s anti-China policy, with the result that in a few years’ time there will no longer be any Chinese companies listed in the United States. Those companies will then have to move to Hong Kong and many private investors in the US do not invest that far from home. Especially now that investing in Russian stocks is prohibited, any stock outside the US is suspect. Finally, a Chinese company turned out to be short in nickel, while on the London Metal Exchange the price rose sharply, probably partly because of that.
However, the sharp fall in stock prices in Hong Kong was quickly followed by a sharp rise in prices after the Chinese financial regulator indicated that it wanted to stabilise capital markets, expressed support for listings outside China, would resolve the risks surrounding property developers and announced that the regulatory frenzy towards Chinese Big Tech would soon end.
The Hong Kong stock market then enjoyed its best session since 2008, proving once again that the best and worst days on the stock market occur in clusters.
The rational phase
Instead of speculating on which rumour or story could set the Chinese markets in motion again, it might be time to look at the fundamentals. First, the valuation. Chinese equities are now at levels last seen during the Great Financial Crisis of 2008. The Hang Seng index has fallen 40 percent in the last 12 months. Chinese stocks listed in the United States are down 75 percent and the yield on Chinese junk bonds is above 27 percent for the first time.
Chinese shares are therefore dirt cheap. Alibaba, once listed at 20 times its turnover, is now listed at only two times its turnover. Chinese tech companies combined are valued at less than half of US tech companies.
Another fundamental development is economic growth. That growth has been depressed in recent quarters by corona policies, energy shortages and the problems of property developers. But property sales are recovering, generating cash again, which is a scarce commodity for a Chinese developer these days.
The shortage of energy is also finite, soon only the Chinese will buy Russian energy, but at half the market price. And it is precisely China that has shown that it can grow even during the pandemic. The measures taken by the Chinese government last year to pursue an olive-shaped income distribution - with few poor, few rich and a large broad middle class - will ensure much more stable economic growth in the future.
Furthermore, since the end of last year, the Chinese government has turned a corner and is again pro-growth. Remember that Chinese exports are currently at record levels, despite the fact that the renminbi has risen more strongly than the dollar.
The third fundamental factor is liquidity. The PBoC’s moves so far may be modest, but they are a clear contrast to the tightening Federal Reserve. Modest inflation also gives the Chinese central bank much more room to stimulate. Valuation, economic growth and liquidity are factors that determine long-term equity returns. Now we just have to wait until we are in a calmer phase.
Han Dieperink is chief investment strategist at Auréus Asset Management. Earlier in his career, he was chief investment officer at Rabobank and Schretlen & Co. Dieperink provides his analysis and commentary on the economy and markets.