Why I Love A Sharemarket Sell-Off

The correction we had to have

September lived up the bear’s warnings and the ASX200 fell 2.69%. But with dividends included the total return came in at negative 1.85% using Standard & Poor’s data.

The US markets fared worse with the S&P500 down 4.76% and 4.65% including dividends.

Technology stocks were the weakest though as bonds yields climbed over the month on inflation concerns. The NASDAQ index fell 5.3% (total return, source Nasdaq).

No shares go up indefinitely, so a correction in markets is all part of the process, as investors take profits and reset portfolios. The indices belie the fact that some stocks fell substantially more than others. In Australia, material stocks (BHP, RIO and FMG) fell heavily on the hefty retracement in the iron price, down over 50% from the recent record around US$230 per tonne.

Macro maelstrom

The months of September and October are synonymous with stock market weakness.

In fact, commentators can find plenty of reasons for investors to run for the hills:

  • ongoing high inflation readings and bond yields from high energy prices
  • ongoing pandemic-induced supply chains disruptions
  • a looming collapse in China’s second largest property developer, Evergrande
  • the spectre of slowing US economic growth next year
  • political shenanigans around raising the US debt ceiling and the re-appointment of Chairman Powell as the head of the Federal Reserve in February 2022
  • the possible Chinese incursion into Taiwan lurking on the horizon.

These factors, and a more hawkish tone from the Federal Reserve Chairman, has helped lift the global risk-free rate, the US 10-year bond from 1.3–1.35% to 1.55%.  The hawkish tone  is a result of the announcement that the Fed will unwind the US$120bn monthly bond buying programme, even as soon as November and prepare to finish the taper (as it is referred to) by mid-2022. Tapering doesn’t mean raising interest rates, but that doesn’t stop the bond market anticipating the eventual rise in interest rates in the second half of 2022, or 2023.

If an investor were looking for a glass half empty macro-economic picture, then the confluence of events that is creating the dark clouds is one that was not anticipated a couple of months ago as the reality of the pandemic continues to figure prominently across the globe.

The Australian story is a bit different

Australia’s economic recovery is more than a few months behind that of other major economies, thanks to the Delta variant outbreaks. This means investors can hopefully look ahead to the re-opening trade for Australia’s two largest cities Sydney and Melbourne in October and November, respectively. Our international borders will also re-open in November, meaning we are more likely to travel overseas than visit Queensland or WA at this stage. Oh, the irony!

Despite the growing excitement for those of us who are well over lockdown and crave the freedoms to see friends, family and grab a drink at the local pub or bar; the Australian market is decidedly more in favour of dancing to the tune of the US markets, as well as the fallout of energy shortages, carbon reduction policies and Evergrande in China. The China travails have weighed heavily on iron ore prices and with that the share prices of our major miners. More pain maybe in store as the Chinese authorities start the long process of deleveraging an overheated property market, and move to more high-tech manufacturing and the deployment of green technologies.

Slowing over exuberant property markets is not limited to China. Australian authorities are also looking at ways to offset the demand for property which has pushed prices across Australia to major highs in the low-interest-rate environment.

Weighing up all these factors, I don’t think anyone could be surprised to see some profit taking moving into the markets and, whilst we can try to point the finger at any or all these above-mentioned factors, the point is rates are moving higher and when that happens, valuations adjust downwards.

This doesn’t mean we are looking at a Chicken Little situation, more a reset and reminder that markets go up and they come down. How you respond to the sell-off is what counts.

Why I love a good sell-off

It took some time for my thoughts to clear over the past few weeks, since the last newsletter. Out of the space, I have been reminded about how important it is for investors to understand the companies they invest in.

The fear of falling share prices has a habit of blinding us to the good reasons why we invested in the company in the first place.

It is also a time to reflect on how you can invest in great companies that will not be exposed to the vagaries of changing commodity prices and adverse regulations or sovereign risk in the case of China.

Of course, the sell-off will be different for everyone, some of you will have more cash than others. If you are in the fortunate position to have cash to spend, then when those are panicking, is a good time to buy into those companies you wanted to own but were just too expensive or had run too far in the short term.

Over the past few weeks I have been researching companies in sectors or themes that I know have the capacity to cope with higher interest rates. They are ideally market leaders with some pricing power and operate in non-cyclical sectors or markets which align with some major secular trends.

An example is MSCI. Bizarre as it may seem, it had never occurred to me that MSCI, the index provider, was a listed company. As chance had it, I was listening to CNBC about the top performing US stocks in the S&P500 over the last 10 years and the number two stock was MSCI.

As usual, when a company is flagged, I start the process of researching it. I look at the financial metrics, the size of the company, the performance and what the business does. In short, the company threw up several interesting sectors that the MSCI businesses operate in, namely ESG, climate change, DATA analytics and fund management including the high growth ETF market.

The appeal of the company stems from the fact the company should be resilient to interest rate rises and inflationary pressures, from the perspective of demand for their services.

The valuation which is not cheap (great companies rarely trade on low valuation metrics) can be impacted if sustained inflation fears and the spectre of soon-than-expected rising rates looms large.

Rising interest rates basically depress valuations on stocks, because the relative increase in the cost of capital makes shares less attractive to bonds. Shareplicity 2 explains valuations and the impact of interest rates on shares in more detail.

In the MSCI example, the more defensive nature of the earnings will help the company through the economic cycle, as most of the business is based on subscription models or as MSCI management refer to it as iSaaS or ‘information software-as-a-service’.

Therefore, I would use any price weakness to buy into the company.

With economists, experts and the FinTwit community divided on transitory versus more permanent inflation, retail investors should continue to expect share price volatility.

No one knows what will happen in a month, let alone six, so short-circuiting the macroeconomic noise is probably prudent. You have already probably noticed that the shares you own are dancing more to the tune of bond yields now, meaning certain value cyclical stocks such as banks and energy are popular and then the great switch back into technology and growth stocks happen when bond yields move down and vice versa when they go up.

Know your companies

 The volatility will pass at some stage but be prepared for the wild ride to continue for a few months. This means, now more than ever, you should understand what companies you own and why you own them, so you don’t panic and throw out a great company because of an extreme price movement.

Note: at the time of writing this piece I had started a small position in MSCI.

Disclaimer: Shareplicity offers information that is only general in nature. It does not take into account your personal financial situation, needs or objectives. Nor does it take into account the financial needs of any specific person. You should consider your own personal financial situation and needs or seek financial advice before making any decisions based on this information.

 

The material does not constitute or undertake to give advice of any nature, including fiduciary investment advice, nor is it intended to serve as the primary basis for an investment decision. Prospective investors are recommended to seek independent legal, financial and tax advice before making any investment decision. Past performance is not a reliable indicator of future performance. Investment involves risks. The value of an investment and any income from it can go down as well as up.

Information and opinions presented have been obtained or derived from sources believed to be reliable and current; however, we cannot guarantee the sources’ accuracy or completeness. There is no guarantee that any forecasts made will come to pass.

A simple approach isn’t simplistic