The single most important question for investors is right-sizing risk. In Part One of this series I emphasized that risk was an individual matter. You cannot depend upon wise investors, no matter how good they are, to tell you what your asset allocation should be. It is fine for Warren Buffett to go "all in" on stocks versus bonds, but he can afford to be wrong!
With that background in mind, let us turn to evaluating downside risks. With China at the forefront of attention (for a moment at least until the pundits turn back to Greece or the Fed or deflation) we'll take that as the focus.
The most common discussion of risk – by far – is "headline risk." This is the result of the media reward system that attracts attention to anything that is going wrong and draws facile cause and effect relationships. No matter how hard you try to be rational, the media pounding is too powerful. Experiments in behavioral psychology invite listeners to pick a random number. Later answers are anchored to the number. Who cares whether the plane landed safely? It is powerful psychology, but you get paid if you can take a deeper look.
In my "young prof" days I took the bus home from the university and got off a block from my apartment – a nice neighborhood. It was twilight. I was dressed in a coat and tie. As I walked toward my place I noticed that the woman walking thirty yards in front of me was accelerating and looking back over her shoulder. Naturally I slowed my pace, but I have always remembered her reaction – a teed up suspicion from too many TV shows.
And so it is with today's investors. So many sources get paid to frighten you, making sure that you are scared witless (TM OldProf Euphemism).
Today's headline is China. The story line goes something like this:
- Chinese stocks were dramatically overvalued – a classic bubble.
- These stocks are crashing, reflecting either bad policy or a return to reality – take your pick.
- Since China is a big, important country, with economic implications for others, we should expect contagion.
- The 1 or 2 percent decline in US stocks validates the China concern.
- The Chinese stock decline implies significant weakening in the underlying economy.
- Crashing commodity prices validate the "weak economy" inference.
- This means pressure on Europe and US earnings.
The story is seductive and easy to write. And so many have!
Analyzing the Downside Risk --- and the Opportunity
Taking the perspective of an investor with a free choice of asset allocation, the biggest challenge is to get beyond the headlines and insist upon data.
The first two points in the mainstream narrative above are clear enough, reflected in traditional metrics like P/E ratios. Trading the Chinese market could be profitable for traders, but you needed to be agile. Felix played here, but it was not attractive for long-term investors.
When analyzing risk, we need to get beyond the headlines and focus on data. It often helps to consider the various possible investments.
Direct investment in China
This has been very dangerous. Now it is becoming more attractive. Goldman Sachs' Timothy Moe opined that a bottom was getting closer. I liked his breakdown of stocks into offshore China (cheap at 9.6x forward earnings and also good on book value, yield) Hong Kong (OK on all metrics) Shanghai (still a bit expensive) and small caps (the highest valuation). We are considering the mainstream stocks for our "high octane" accounts and we already own BABA.
An important question is whether a popping of the bubble has any implications for the Chinese economy. Because of the general lack of economic data and suspicion about the reports, the Chinese economy is a fertile ground for pundits of all stripes. Sorting out reality is challenging. My own assessment is as follows:
- The Chinese stock market, especially the "A Shares" does not reflect the economy. So many observed that the bubble in stocks was detached from economic reality. Now, as the bubble is pricked, why should we believe that the Chinese market has somehow become a great read on the economy? A little consistency is needed.
- Commodity price shifts do not reflect the Chinese economy. Chinese investors often must sell commodities to meet margin calls in stocks. Commodities have also played a role as collateral. These effects are significant, which means that commodity prices are a poor and noisy indicator.
- The earnings effects from the stock market collapse should be minimal. We'll have more evidence on this soon. Some stocks have a high exposure to Chinese consumers. If they cut back on purchases because of stock market losses, there is a direct effect. Here are the most-exposed stocks.
- False economic read. The single most important takeaway is that the Chinese headlines have little to do with the global economy or the attractiveness of US stocks.
- Opportunities are focused in material stocks and cyclical names. (I like FCX and some oil stocks). Here are some other ideas.
- Aggressive investors can start a shopping list – almost there – in some mainland Chinese stocks. (FXI? BABA?)
Analyzing risk is tricky, especially when headlines and pundits oversimplify the story. A successful investor knows how to take a deeper look. In particular….
Beware of "headline risk" -- already known and reflected in market prices.