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Quotidian Investments Monthly Commentary – August 2015

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September 7, 2015

So much for the lazy, hazy days of summer. As you will have seen, extreme volatility and fear bordering on panic returned to haunt global stock-markets from mid-month onwards and kept us glued to our screens.

Rather than rehearse much of the detail with which you will already be familiar, let me precis the salient points which led to stock-market conditions last seen at the height of the global financial depression in 2009-2010.

On Tuesday 11th August China wrong-footed financial markets by suddenly devaluing its currency, the yuan, by nearly 2%. That may not sound like a lot but it was their biggest downward currency move in two decades.

Superficially, China’s motivation for doing this was to make their exports more competitive in foreign markets and, on the other side of that same coin, to make imports into China more expensive.

This move caught equity markets completely off-guard and was interpreted as a desperate attempt to jump-start China’s sagging economic growth. Currency markets immediately marked the yuan down by yet another 2%. According to market analysts, though, it would take a much larger depreciation in the yuan to significantly boost exports. It is estimated that a 10% drop in the currency’s value would be needed to fully restore China’s export growth.

At a more profound level, this devaluation was in keeping with Beijing’s long-term goal of opening up its financial markets and being more flexible with exchange rates. The US and the International Monetary Fund have insisted on this more open approach as a prerequisite for the yuan to be more widely used in global commerce.

The risk in the move they have made is that a sliding Chinese currency could trigger massive money flows out of China in exactly the same way as we’ve seen with capital flight from other troubled parts of the world over the past two years. Of course, this would then deal another blow to China’s already struggling stock-market.

Whilst one might view the actions in Beijing as being entirely self-interested and self-serving it is difficult to be too critical or proscriptive. China has simply followed a well-travelled road. Quantitative easing, currency manipulation and protectionism have been hallmarks of US policy for many years and indeed of the UK and major European countries too. Likewise, China’s neighbours and biggest trading partners (Taiwan, South Korea, Malaysia, Singapore and others) have for years been depreciating their own currencies at China’s expense.

It may be over-generous but it is tempting to interpret Beijing’s actions as being more naïve than devious as the old guard gives way to the new and China slowly mutates from a command-controlled communist style economy towards a more capitalist free-enterprise system.

According to Bloomberg, dollar borrowing in China has expanded five-fold since 2008 as Chinese companies and also individual equity investors have taken on billions in dollar and euro denominated debt in order to leverage their investments. The costs of servicing that debt were substantially increased by the yuan devaluation and this is likely to have contributed to the stock-market sell-off which began on 12th August and continued to then escalate around the world.

Factors which exacerbated the gyrations and general decline in equity prices include the forced exit of investors from over-leveraged positions, computer-based trading, low trading volumes and therefore low market liquidity, market makers cynically widening spreads and emotional investors being dislocated.

The financial media is not blameless. Too often they seem to prefer to manufacture ‘crises’ and then fan the flames of fear by using extremely emotive language to ultimately generate panic. Good news does not sell newspapers nor television advertising space. Sadly, creating and promoting bad news is a self-fulfilling process that helps only to exacerbate ugly days in the market

The breadth, depth and speed of intraday market action over 10 consecutive trading days was extraordinary. Ten successive days of relentless downward pricing culminated in a very steep markdown on 24th August by which time all major equity markets had fallen beyond the level usually accepted as being a correction. Even the razor-sharp minds and professional Cassandras inhabiting much of the fourth estate have cottoned on to the fact that their long-touted and heralded global market correction has now actually taken place.

On 31st August the FTSE 100 closed at 6248 (which equates to -4.85% for 2015 to date). This represents a decline of 6.70% in the month of August.

By comparison the Quotidian Fund at the end of August was +14.82% for the year to date….being a decline of 7.82% in August. Despite the downward revaluation in the month, we remain strongly in positive territory for 2015 and 19.67% ahead of the FTSE100 index.

As long term readers will already know, our research indicates that it normally takes no longer than 54 trading days for markets to regain the ground temporarily yielded through a market correction.

To further support this assertion the CBOE Volatility Index (VIX) is an objective measure of stock market fear. On 20 August, volatility as measured by the VIX index was still well below several of the panic-striken peaks seen in previous crises. However, the extreme VIX frenzy on 24th August (at one stage it spiked to a reading of 90) was the highest recorded in the past six years. Historically, over the past 30 years whenever the VIX has spiked sharply higher (and above a reading of 50) it has almost always been at, or very near, a stock market bottom.

We believe this to be a reliable signal that stocks are grossly oversold and we expect a strong rally in the weeks and months ahead (although, no doubt, there will be further bumps along the way).

The most important economic and potentially market-moving news in September will be the Federal Reserve’s decision on US interest rates at their mid-month meeting. They have signalled their intention to increase rates for the first time since 2006 and it will now be very interesting to see the effect of August’s extreme stock-market volatility on the Fed’s decision making process and timing.

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