Afraid of their own shad­ows

Bulls don’t al­low the Chi­nese tail to wag the dog

Finweek English Edition - - Companies & markets - VIC DE KLERK

THE WORLD ECON­OMY is in good shape. That was the it­er­a­tion of com­men­ta­tors on CNBC’s fi­nan­cial news chan­nel over the past week. A freak event, as The Econ­o­mist de­scribed the sud­den 8,8% fall in share prices on the Chi­nese mar­ket in a sin­gle day, is cer­tainly not enough to cause a world re­ces­sion, as some graph ex­perts and fore­cast­ers on that fi­nan­cial chan­nel would like us be­lieve.

The Econ­o­mist is even start­ing to spec­u­late whether the past week’s in­sta­bil­ity on world stock mar­kets isn’t per­haps a sev­en­day won­der.

But what­ever the fu­ture holds, one thing is cer­tain: in­vestors and spec­u­la­tors take fright eas­ier and be­come more wor­ried th­ese days. On Wall Street there was so much fear at times last Tues­day and the sell­ing or­ders were so large that this huge mar­ket’s enor­mous com­put­ers couldn’t cope.

In­vestors in SA also took fright. Long- term in­vestors, who should ac­tu­ally be on hol­i­day at the sea­side, sud­denly started look­ing at the state of their port­fo­lios ev­ery few min­utes. Short-term spec­u­la­tors, usu­ally those who thrive on falls in the mar­ket, also called bears, had a lot to say for them­selves, as usual, which made it dif­fi­cult to dis­tin­guish be­tween de­pres­sion, re­ces­sion or cor­rec­tion in the midst of all the noise last week.

That’s when in­vestors, whether short- or longterm ones and whether they’ve got strong nerves or not, should again look at the fun­da­men­tals of shares and the tra­di­tional prin­ci­ples of value.

The com­bined graph shows that the price:earn­ings (p:e) ra­tio of the all­share in­dex over the past two weeks has been adapted from a some­what over­val­ued al­most 18 to nearly 15 last Tues­day. That’s a dra­matic fall and com­pares with the ad­just­ments that will usu­ally oc­cur dur­ing a small bear mar­ket or de­clin­ing phase in share prices over a pe­riod of six to 12 months.

The p:e sim­ply mea­sures the rel­a­tive value of shares. The share price is di­vided by the com­pany’s profit per share. This ra­tio, which was still at 18 a few weeks ago, sim­ply says that lo­cal in­vestors were pre­pared at that time to buy shares at an av­er­age of 18 times the cur­rent profit. When in­vestors start be­com­ing jit­tery, they buy fewer years’ profit, and that’s why the p:e falls to for ex­am­ple the present 15.

How­ever, this fall wasn’t only as a re­sult of the fall in share prices. The largest com­po­nents in the in­dex, such as Bil­li­ton, An­glo, An­glo­plat and Im­pala, all de­clared huge prof­its, and the di­vi­sor in the p:e sud­denly be­came much larger, which caused a fall in the p:e. This makes a bit of fun of all the prophets of doom who were still want­ing to warn us a few weeks ago that our shares are too ex­pen­sive be­cause the p:e of 18 was much higher than our av­er­age. It was even higher than that of more de­vel­oped re­gions (see ta­ble). Re­mem­ber in such cases to use the 12-month for­ward p:e.

On the graph, the three pe­ri­ods are in­di­cated where the p:e of the all-share in­dex fell sharply, so much so that it can be de­scribed as a sig­nif­i­cant cor­rec­tion.

On the top graph, which shows the course of the all-share in­dex, which has dou­bled over the past two years, th­ese three cor­rec­tions are just blips, and The Econ­o­mist’s re­port of a seven-day won­der starts look­ing ac­cu­rate.

The first ma­jor cor­rec­tion or fall in the p:e be­tween Fe­bru­ary and April 2005 was caused when new Fed­eral Re­serve chair­man Ben Ber­nanke, the suc­ces­sor to the di­vin­ity of Alan Greenspan, opened his mouth too

widely and pre­dicted that US in­ter­est rates could rise fur­ther. Stock mar­kets didn’t like that and the Dow Jones dropped by nearly 1 000. We also took fright and sold shares. Pity. It wasn’t long be­fore our all-share in­dex climbed by about 75% – be­tween May 2005 and May 2006.

The sec­ond event that caused the stock mar­kets to take fright re­cently was the sud­den fall in the prices of com­modi­ties – led by cop­per – af­ter ru­mours of a ma­jor lev­el­ling off in China’s de­mand for re­sources. This cor­rec­tion was pretty sharp. The Dow Jones again dropped by nearly 1 000 points, but lo­cally there was may­hem among the share prices of our fi­nan­cial shares and of the re­tail­ers who sell on credit.

Only two months later – that’s just slightly longer than The Econ­o­mist’s seven-day won-

A sud­den fall in share prices on the ex­tremely

spec­u­la­tive and un­reg­u­lated Chi­nese stock

ex­change is re­ally just a tail try­ing to wag the dog.

der – our share prices started climb­ing again, and be­fore the 2006 New Year’s Eve par­ties there was a 50% profit to be made.

Now we have an­other such event. The p:e has al­ready fallen sharply, but not yet as low as in 2005 and 2006. Sus­tained profit growth over the next six months – which has al­ready been earned by the com­pa­nies and only has to be de­clared – is enough to push the p:e down to near to 14 by Au­gust if share prices don’t rise.

How­ever, if our share prices were to rise by about 5%-10%, the p:e of the all-share in­dex will be a good deal lower than 14 by Au­gust. That’s cheap, and it looks as if the op­por­tu­ni­ties of 2005 and 2006 could soon be re­peated.

The les­son: look at val­ues like fu­ture profit growth and for­ward p:e. And re­mem­ber, the world econ­omy is in good shape, and so is ours. A sud­den fall in share prices on the ex­tremely spec­u­la­tive and un­reg­u­lated Chi­nese stock ex­change is re­ally just a tail try­ing to wag the dog.

MAR­KETS... THE THREE COR­REC­TIONS

Source: I-Net Bridge

Spooked the mar­kets.

Ben Ber­nanke

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