Enter the Dragon 🐉 🐲

If you're a regular reader of this newsletter, you'll have noticed that we usually spend time focusing on US and European stock markets as well as the broader global economy. 

Even though the Chinese stock market is now very large, we don't usually focus too much on it beyond a quick glance at how the Hong Kong stock exchange is performing, and for a couple of good reasons. Firstly, we know the majority of our reader base is more interested in (and invested in) US and European stock markets. Second, the mainland Chinese stock market is absolutely bonkers. Like - really - it's sometimes just not very rational (more on this to come). So this week, we want to mix it up and take a slightly closer look at the madness to break down what is a pretty interesting market structure in Mainland China.

First, it's worth looking at major stock market barometers in Mainland China to acknowledge the gains they've recorded this past week. The Shanghai Composite, FTSE China A50 and the Dow Jones Shanghai were all up between 5% - 10% on the week, having been up by more than 10% over the course of the first 3 days of the week. 

Now, let's take a look at the "why". With the mainland China stock market, it usually comes down to looking at market structure (i.e. what kinds of people / institutions dominate the day-to-day trading flow - how they think, how they feel, how they operate) and leverage (i.e. borrowing cash to invest in the stock market, known as margin investing).

Chinese Market Structure

This is where the Chinese stock markets are very different to most (any?) other major stock markets. Individual Chinese investors make up the bulk of trading on the local stock markets - everyday people like you or me. The simple fact that these people also have day jobs working in a variety of industries means there is less time for rational financial analysis in order to find the fundamental value of companies.

So typically what ends up happening is the local stock markets there move in line with broader / general sentiment more than most other markets - whether that's fears around the US / China Trade War, COVID-19 or even just the sentiment that comes from hearing your friends and family are making great returns by investing in the stock market right now. 

Mainland Chinese stock markets therefore end up being more prone to herd mentality and extreme swings in sentiment (arguably all stock markets are, but mainland China markets especially so), and this herd mentality has been a key feature of this past week's stock market rally.

Leverage

To further complicate this roller coaster of a stock market, it's common for retail investors in China to invest on margin. That is, borrowing cash from a lender for a short period of time (often at high interest rates) in order to invest it in the stock market and hopefully make a return.

The problem is that if you're leveraged 10x for example (not an uncommon practice over there), you could lose all your money and be forced to sell out of your positions if your investment drops by just 10%.

So when stock prices turn slightly lower in a market dominated by highly leveraged individuals who likely do not have the capacity to take on so much risk, it forces increasing numbers of people to close out their positions, in turn forcing stock prices further lower at an accelerating pace. And it has happened before, 5 years ago. The same dynamic drove the market screaming higher over the course of the first half of 2015 before collapsing back down pretty much exactly to the level at which it all began.

Now, leverage isn't necessarily a bad thing on it's own - if a handful of highly risk loving individuals or institutions engage in leveraged investing, it doesn't compromise the stability of the broader market. This is because the size of their investments - even if they had to sell them all - wouldn't drive or de-stabilise the entire market. For example in the typical western economy, hedge funds and some wealthy individuals take leveraged risks, but control far less wealth than large pension funds, mutual funds and asset managers and take a long term approach to investing, keeping a firm lid on the amount of risk they take. 

The fact that most other stock markets are dominated by these types of institutions means they tend to be more robust, less prone to extreme swings and generally follow macroeconomic trends and reward (or punish) companies based on their financial performance. 

We think neither version - Mainland China vs. most other stock markets - is necessarily better or worse. But it's worth being aware of the fact that you end up with different market behaviour based on the difference in market structures and leverage (or more specifically, who is taking on the leverage).

The Pattern

Thanks in large part to the market characteristics described above, Mainland China stock markets sometimes fall into a familiar pattern. Market valuations at times like these are driven first by optimism, followed by greed, then euphoria, followed by anxiety, which gives way to fear and then downright, widespread, inescapable panic. Usually in this order. 

Today, it feels as though we are looking at a market which is somewhere between optimism and greed in the scale above, headed towards euphoria. If so, we might still have some way to go in this rally before markets normalise. 

It's also worth noting that Chinese authorities are working hard to provide a counterbalance to all of this. Regulations put in place following the last crash in 2015 mean leverage is around half of what it was back then. That hasn't stopped illegal margin lending platforms popping up to facilitate the thirst for excessive risk taking among Chinese individuals - the China Securities Regulatory Commission (their version of the SEC) closed down hundreds of these platforms on Wednesday.

It therefore remains to be seen whether we're in for another fast paced market rise & fall or whether this time, it'll be different.

Earnings season is upon us

Back in the western world, Q2 2020 earnings season is upon us now and it's going to be a fascinating one. 

As you can imagine, expectations are pretty low given Q2 is the quarter where the world stood still. It remains to be seen whether earnings come in even worse than anticipated, about the same or slightly better. 

We think the picture will broadly follow what we saw in Q1 with the digital economy likely to lead the way again. But this time, it seems like the rest of the investing world has been shaping up for this eventuality before the starting gun gets fired, based on the rally we've seen in tech stocks over the past couple of weeks. The NASDAQ Composite index - a who's who of US tech names - has been outpacing the S&P500 over the past month and is up almost 20% so far this year. 

This makes sense given investors want to shield themselves away from the dismal earnings reports which will likely come out of many "real economy" companies over the next few weeks, without losing out on any potential rally should earnings season go better than expected. Tech and digital stocks look like a safe harbour from that perspective. 

What's likely to be more important than the earnings themselves is how company management see their outlook for the future, and whether there are any early signs of positive momentum within their businesses in Q3 so far. We recommend looking for the mood music coming out from post-earnings conference calls to get a feel for this. 

We want to help you follow this earnings season given it's shaped up to be a pretty interesting one, so we'll be picking out and sharing a weekly list of upcoming earnings reports which we think could be of interest for you, starting with a financial industry dominated week ahead:

• 13 July - Pepsi, Wells Fargo

• 14 July - Citigroup, Ocado, JP Morgan 

• 15 July - ASML, Bank of New York Mellon, Charles Schwab, eBay, Goldman Sachs, Handelsbanken, Morgan Stanley

• 16 July - Bank of America, Blackstone, BT Group, Domino's Pizza, E*TRADE, EQT, Johnson & Johnson, Netflix 

• 17 July - Blackrock, Citizens Financial, Ericsson, Kone, Nordea, State Street, Swedbank, Telia, Volvo

Until next time ✌️

Please know, the value of investments can go up as well as down and you may receive back less than your original investment, meaning, when investing your capital is at risk.

Disclaimer: At Evarvest we believe in making investing and investment education more accessible, but we don’t provide investment advice and individual investors should make their own decisions. While we try our best, we cannot ensure the accuracy of the information we provide.

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