To buy or not to buy

Will be going overseas tomorrow.  There may be a lull in blogging activity.

 

The stock market has become hot again, and many people are starting to make easy money from the share market again. Those who were burnt previously, are coming in again as the indices have been going up for the last few weeks. It looks like the good time is coming again. I know of friends who are investing again with gusto. They do think that the bull will not last long, but are willing to take the risk. They are betting that it will last until end of September, in this window period stocks will trade like hot cakes –  It’s good buying opportunities.

 

As for me, I’m just cautious as usual. It’s time to sell in 2 weeks time.  

 

On subject of the bubbles and bears in the stock market, Andrew Sheng, who was the Financial Secretary for HK, wrote the following article which was supposed to appear in Caijing magazine:

 

 

Bubbles in Bear Markets

 

I have to apologize to my readers who comment that I have been ignoring my investment education column and have been diverted to talk about monkeys and global imbalances.   Indeed I may have missed talking about the greatest recovery in the A share market since the great bubble of 2005/2007.  The Shanghai A share index has risen by over      percent from 1500 in          to the current levels of 2700.   Turnover volume has increased to levels last seen in 2007. 

 

The China stock market recovery has given lots of hope to the US and other markets.  Since the announcement of the stress test on US banks in April, the Dow Jones Industrial Index has risen by     percent and even the Japanese market has recovered back to just under 10,000, despite the fact that Japanese exports are still 30-40 percent down year on year basis.  

 

Some stock market analysts are claiming that stock markets are leading indicators and they signal the bottom of a market or recovery in the real sector roughly six months ahead.  If this analysis is true, then the US economy should be turning around fourth quarter of 2009, and perhaps Europe and Japan may recover in 2010.   But stock markets can also be wrong as indicators of the future, in the same way that CDS market also underestimated the risks in the debt market.

 

Let me repeat up front that I never make forecasts of which way the market is going..  I write this column because I feel investor education is the most important thing lacking in capital markets in Asia and it is important that retail investors understand how one should look at markets.

 

What I want to do is to repeat something I learnt from hard experience in the 1980s.  The most dangerous market crash is not the first, but the second.   There are several good reasons for this. 

 

The first is that market booms or bubbles are basically due to momentum trading.  If everyone thinks the market will go up, the market will go up.  Professional investors, such as institutional fund managers, should strictly be value traders, looking at market fundamentals.  But if they think that the retail market is getting hot, then their buying will also push the market higher.  Indeed, many analysts will start appearing on TV and show you charts on how the market is moving in what direction.  The retail investor will be tempted, go in and then make a little money.  He gets confident and put more money in, making a bit more.  He hears his friends making money and he plunges in more.  Then one day, the market turns, he hangs on thinking that the market will go back up and he loses more and more.  He panics and sell at a loss, eventually regretting he ever bought shares.  A short-term speculator has become a long-term holder.  Familiar story?

 

But now that the market has recovered, the retail investor is kicking himself that he sold out too early.  So he is plunging back in again and lo and behold, he is making money again or at least recovering some of his past losses.  Your friends are telling you how much they made.  Greed once again overcomes fear.

 

Let me analyse why the bubble in a bear market is dangerous.  When the market is in its first bull run, there is confidence that the economy is doing well.  The listed companies are making good profits.  If a listed company is earning $1 per share, 8 times Price earnings Ratio means that the stock should trade at $8.  If the average market PE ratio is 15, then the price can nearly double to $15.   If the economy is good and analysts think that the company may double its profits next year to $2 per share, at PE ratio of 15, the price can again double to $30.  With rising expectations, a forward PE ratio of 30 would give a price of $60!  So, in a bull market with rising profits and rising optimism, the price can increase from $8 to $60.   But suppose the market turns, the reverse situation of fear and pessimism occurs, the price can drop back to $8, but even lower.  This is because when the economy goes into recession, the company earnings decline.   If earnings drop 50% back to 50 cents, then at a PE ratio of 8, the price is $4, a drop from $60 to $4 is over 90 percent if you buy at the top.

 

Let us now assume that the government stimulates the economy and the central bank injects liquidity and the market price recovers from $4 to $8.  You get a situation where the market looks as if you doubled your money, but actually, you still lost 86 percent if you bought at $60 per share.  Suppose the real sector is still in bad shape and the company earning falls to 20 cents per share.  The true PE ratio at 8 times is actually 40, which is higher than the 30 PE at the height of the bull market.   In other words, if earnings do not recover, a bear market bubble is more severe than the bull market bubble.

 

In the first bubble crash, at least most people had lots of profits accumulated in the boom time.  But in the second bubble crash, the corporations and investors are usually in a weaker financial state.  In other words, you would take much longer to recover if you had two illnesses in a row.

 

I am not stopping retail traders hoping to get rich.  All I am saying is please don’t be greedy.  If you make money from this recent rally, cash in some and don’t bet your pension money.  Paper profits are still dreams.  Having cash in the bank still allows you to buy stocks at good value.    

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About kchew

an occasional culturalist
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