Healthy correction but wise to stay alert

Change of direction: A man watches trading boards at a private stock market gallery in Kuala Lumpur. Bursa Malaysia was poised to test new highs last week when markets started to turn south.

Change of direction: A man watches trading boards at a private stock market gallery in Kuala Lumpur. Bursa Malaysia was poised to test new highs last week when markets started to turn south.

THE typical stock market mantra is to buy when others are fearful of stocks and sell when most are greedy. Buy when there is a sea of red on the board of the stock exchange, an indication that the market is down.

Investors make the most money when the market is bleeding. When there is panic and investors are selling irrationally, it offers an opportunity to pick up cheap stocks.

The recent sell-down on global stock markets saw a general decline in the prices of stocks. Many saw the sell-down on Wall Street as a healthy correction of a roaring stock market that has had a good run for more than eight years. The euphoria extended to the rest of the world, where stock markets have had an unprecedented good start.

The “melt up” of Wall Street that came in despite the likelihood of further interest rate hikes in March was because of two things – President Donald Trump’s tax effect that effectively would pave the way for US companies to chalk up higher profits. The other factor is the improving US economy.

The Trump administration has reduced the tax rate from 35% to 21%, hence increasing the potential profits of American companies. He has also announced measures for US-based companies holding their cash outside the country to repatriate the money.

Locally, Bursa Malaysia was poised to test new highs. It closed as high as 1,870 points on Feb 2, the highest since 2014. It was going to test the all-time high of 1,892 which was recorded on July 8, 2014, when markets started to turn south.

The market is still soft from the sell-off. Investors are still grappling with how much money was lost.

This brings about the question of whether it is time to jump in and scoop up cheap stocks. Or is it time to take stock of the portfolio of existing stocks in hand and start reducing exposure to the stock market?

In order to answer the question, we need to go back and look at what caused the stock markets to correct. Whether there was something which was out of the ordinary that had surprised the market.

The stock market rout started with the rise in US dollar 10-year Treasury bills, which is the benchmark for the global cost of money.

Just some six weeks ago, the bond market offered US debt papers with a maturity of 10 years at a cost of 2.4%. Today, it is already up to more than 2.8% and poised to touch the 3% mark.

When bond yields rise, it makes it more expensive for companies to borrow. The companies themselves become less attractive as an investment proposition unless the businesses are showing strong growth.

The other factor that affected the stock market is the fear of inflation going higher than expected, hence forcing central banks to raise interest rates aggressively. The fear of inflation came about because of the rise in US wage rates.

Then came the collapse of two capital market products that were related to the VIX Index, which is a benchmark that measures volatility of the stock market. The VIX Index is based on the options tied to the S&P 500 stock index. It is also known as the “fear” index.

The higher the index, the higher the volatility and indications that investors are more fearful of the markets.

The Chicago Board Options Exchange (CBOE) started the VIX Index in 1993 and it has become the reference point for stock brokerages to create capital market products. The spike in the VIX to as high as 50 this week prompted two of the exchange-traded products (ETPs) to collapse. It is said to have exacerbated the sell-down in stock markets.

Closer scrutiny suggests that all the events that have triggered the sell-down are not unexpected developments. It should not have caused excessive turmoil in stock markets.

The Federal Reserve has long signalled that interest rates would go up because the economy was improving. The effect of the tax cuts in the US and the impact on the earnings of companies and wages have long been talked about.

Hence, the steady rise in bond yields (which means lower bond prices) is something that is bound to happen sooner than later.

Inflation is something that is creeping up, but then, there is also technology which brings down the cost of doing business.

Both interest rate hikes and inflation are events that should not have surprised markets.

As for the damage caused by the VIX Index products, it is puzzling why the issue came about in the first place, as the value is small in comparison to the value of stock markets or even the alternative cryptocurrency. It has been reported that the VIX Index-related instruments that collapsed were never worth more than US$5bil.

If instruments so small can cause so much turmoil in the market, it only points to a few things.

Markets are over-valued and fragile. The smart money is looking for reasons to take their gains off the table.

Going forward, reports have said that the 10-year US bond yields should creep towards 3%. Only any sharp rise above that would be a cause for concern, as 12% of US companies could have problems servicing their debts, according to a report.

However, the earnings of growth stocks such as Amazon and Facebook are strong and would continue to drive the markets. Technology would drive down cost, meaning inflation may not be on a runaway track.

So, while central banks would raise interest rates, there is little reason to believe that it would be in an aggressive manner.

Secondly, the global economy is on track for a recovery. Fundamentally, all the major economic power houses are enjoying synchronised growth, something that is rare. There is no reason to believe that any of the major economies would undergo a slowdown.

Conventional belief is that selling stocks when everybody else is selling is not wise.

However, a study by finance experts Alan Moreira and Tyler Muir in 2015 based on historical data, showed that funds that view volatility as the beginning of a “sell” signal made better returns than passive fund managers who stay the course.

The current stock market correction is healthy, but it is also wise to view it as an indicator to gradually take some money off the table.

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