Recently, the stock market has experienced a series of declines, reaching new lows almost daily. As an experienced investor, I feel somewhat qualified to share insights that may uplift spirits. However, this is not just a motivational post; I intend to offer practical advice based on my personal investment experiences and how to navigate these turbulent waters.
Many individuals are feeling a sense of helplessness, questioning whether the market has hit rock bottom and if declines will continue. The truth is, no one has a crystal ball that can predict the future of the market. Some argue that valuations are so low that stocks can't possibly fall further and advocate for aggressive buying. However, many who suggest this are merely talking rather than acting; in reality, most investors lack the patience to hold onto their positions during downturns and instead find themselves stuck in losing positions. A significant number are now contemplating whether to cut their losses.
It’s essential to underline that valuation is never a reliable indicator of market bottoms in the short term. In fact, declining valuations can further accelerate market downturns. Currently, the A-share market is not particularly cheap; my experience with B-shares reveals that almost all of them trade at prices more than 50% lower than their A-share counterparts. If valuation alone determined the bottom, then B-shares should have skyrocketed by now, but they haven’t and often decline even more dramatically than A-shares. B-shares represent an abnormal market that lacks representativeness and solid backing. If we examine the more balanced H-share market, where the Hang Seng AH Share premium index clearly indicates that H-shares offer a substantial discount compared to A-shares, the findings are concerning; at a index level of 150, H-shares are 33% cheaper than A-shares. Even allowing for the impact of dividend taxes, a level of 120 is considered normal, indicating that A-shares are at least 30% more expensive. Nobody can guarantee that the currently undervalued Hong Kong stocks won't decline further, let alone A-shares.
Having started my professional investment journey in 2015, I have accumulated a wealth of experience and lessons when facing turbulent markets like the present one. Here, I will share how to effectively navigate a market that seems trapped in a downward spiral.
First and foremost, rather than trying to time the bottom, prepare for the possibility of further significant declines. Why? In this environment, institutional investors feel heightened pressure compared to individual investors. Funds inevitably face increasing redemption pressures, amplifying sell-off forces that can drive the market down even more. The market is powerful and cannot be swayed by mere sentiment. Accordingly, as long as individual investors do not use leverage, they hold an advantage over institutions. Even without further declines, adopting a pessimistic outlook helps mitigate potential losses.
Furthermore, on the basis of this caution, continuously stress-test your holdings. For a momentum investor, going with the flow is the right decision, so this concern may not arise. However, for those adhering to fundamental analysis, there's a duality at play. On one hand, a market decline makes stocks cheaper, presumably increasing their investment value. On the other hand, market downturns significantly impact a company's fundamentals. The theory of reflexivity suggests that the market often fulfills its own prophecies. This dynamic resembles a balancing act: is it a time to create value or destroy it? Hence, a thorough analysis is imperative.
While retrospective analyses of the market may not provide significant insights for future decision-making, understanding the logic behind the current market declines can be beneficial. The ongoing macroeconomic challenges, coupled with the negative wealth effect stemming from downturns in both real estate and stock markets, are remarkably pronounced. It's worth noting that the wealth effect of real estate is asymmetric; the positive effect during price surges isn't as strong as the downturn's negative wealth effect. Moreover, real estate ties closely with related upstream and downstream industries. The factors influencing the current market downturn are multifaceted; macroeconomics is just one piece of this complex puzzle. As fundamental investors, we should adopt a bottom-up approach that focuses primarily on individual companies and micro-level factors.
In summary, a declining market can amplify the risks posed by unhealthy firms, necessitating a thorough review of specific areas:
First, leverage. Leverage can be a double-edged sword, especially in a declining market where high leverage can devastate firms. There are two types of leverage: financial and operational. In the realm of financial leverage, current circumstances in the real estate sector provide valuable lessons; some firms may never recover, while others are scrambling to survive, often resorting to desperately selling assets to stay afloat. We recognize that a company's bankruptcy is usually due to financial crises rather than operational losses.
Regarding operational leverage, firms with high operational leverage correlate with cyclical businesses. In adverse economic climates, extended cyclical downturns may cause a segment of these businesses to fail to recover from the cycle.
We can monitor leverage through metrics such as debt-to-asset ratios, current ratios, and working capital (current assets minus current liabilities) to assess the leverage position and make informed judgments based on market conditions.
Secondly, cash flow is critical. Companies with robust cash flow possess better resilience; as long as market declines do not disrupt their business logic, these firms are relatively safe.
Third, dividends are closely associated with cash flow levels. In value stock investing, dividends become even more crucial. The capability to pay high dividends attests to a company's genuine cash flow, acting as a safety net. With dividends as a foundation, falling stock prices become less concerning as the lower the price may amplify returns in the long run.
Fourth, industry positioning matters. So long as the sector a company operates in isn't obsolete, the security of industry leaders remains assured. The best enterprises within their sectors tend to withstand cyclical challenges better and are often positioned for growth opportunities following downturns.
Moreover, declining markets can present excellent reallocation opportunities. Every industry is influenced by economic cycles, albeit to different extents. For example, consumer stocks, despite being typically resistant to downturns, have recently faced sharp declines due to the spending apprehensions fostered by the residual effects of falling real estate and stock assets. The impressive Kweichow Moutai has seen its stock price almost cut in half from its peak. However, it’s worth noting that the business model of many of these firms hasn't fundamentally changed; their primary issue may simply have been inflated valuations. Such companies tend to have low leverage and strong cash flows, meaning their price drops can represent opportunities rather than threats. Furthermore, these companies often have robust institutional holdings and liquidity. Consequently, when facing market downturns and redemption pressures, they may experience abnormal declines, providing savvy investors a chance to capitalize on these dislocations.
Finally, and perhaps most importantly, understanding market cycles is paramount in stock investing. In "Cycles" by Mark McClleand, three pivotal laws are introduced: 1) movement won’t be linear, but rather cyclical; 2) cycles won't be identical, but rather similar; and 3) it’s crucial to avoid the middle and pursue extremes. To effectively approach cycles, three principles emerge: discern where the market is currently positioned within its cycle, maintain resolve to act contrarily during periods of excessive greed and fear, and prepare for possible errors both personally and in the market at large.
By comprehending economic cycles and recognizing the roles leveraged play, we can better understand corporate profit cycles. Similarly, understanding psychological and credit cycles can inform us about market cycles that are most pertinent to investors. Market cycles remind us that neither bull nor bear markets last indefinitely; every bear market experience strengthens our immunity against the next downturn. Yet, we must prepare for the worst; as the saying goes, markets can remain irrational longer than we can remain solvent.
In practice, the most significant threat amidst a persistent downturn is our emotional management capacity. Everyone is susceptible to bouts of overconfidence, and such tendencies can lead us astray in market strategies. Thus, it's vital to prepare beforehand; avoid making snap investment decisions during turbulent times. Instead, establish your investment strategy on stable ground, articulate clear investment principles, and strive to assess your investments in a calm and objective manner.
Even professional investors cannot predict short-term market movements, let alone individuals. Understanding our position as retail investors gives rise to certain limitations that might not grant us a competitive advantage in reacting to market changes. Our strengths lie in patience, investment discipline, and long-term perspectives. Consequently, a critical task becomes assessing our cash positions—ensuring sufficient funds are reserved to weather potential challenges, so we avoid becoming forced sellers. After establishing this groundwork, stepping back from the market sometimes proves beneficial. Setting necessary reminders can help minimize daily trading distractions, potentially leading to deeper insights into the fundamentals of our investments away from market noise. True long-term perspectives are reflected in actions that disregard short-term fluctuations.
Reflecting on my investment journey over the past decade, I've encountered numerous prolonged downturns. Each experience has deepened my investment acumen, allowing me to approach today's market more calmly. I’ve learned that amidst such turbulence, the crucial aspect is to adhere to my investment principles—emotional intelligence often outweighs mere intellect in the art of investing.