Plunge, massive震荡! The Strait of Hormuz, engulfing the world! How should investors respond to this conflict?

Source: Guohai Golden Shell

Recently, anxiety over the Strait of Hormuz has been roiling global capital markets. Countries such as South Korea and Japan have even seen the most severe volatility since the pandemic. The A-share market has also experienced intensified fluctuations, and the Shanghai Composite Index once fell below 3,800 points.

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We should see rationally that the volatility in the A-share market is mostly driven by factors at the trading level. Since April of last year, the Shanghai Composite Index has basically not undergone any major corrections. It surged in one go from 3,300 points to nearly 4,200 points. A combination of profit-taking after the rally, crowded trading in overvalued sectors, and factors such as margin-call positions and quantitative trading’s automated stop-loss all contributed to heightened market volatility.

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Looking at the fundamentals of the A-share market, the current valuation of A-shares is at a historical low. The dividend yield is far higher than the risk-free interest rate. Both the buyback rate and the dividend payout rate are rising, while hundreds of trillions of yuan in time deposits are seeking alternative yield. Global funds are also looking for safer destinations. China is the world’s “foundation of certainty” and “harbor of stability.” The renminbi will slowly appreciate, and A-shares will inevitably become a destination for global risk-averse capital.

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In addition, investors do not need to be held hostage by anxiety over the Strait of Hormuz. Currently, crude oil is overall in a state of oversupply; there is no underlying basis for a material supply shortage. Investors should avoid an excessive reaction to geopolitical conflicts. Worth mentioning is that during the two oil embargo periods in the 1970s, inflation and unemployment rose together; interest rates once reached two digits. Even Buffett, in such a harsh macro environment, also held a full position and rode through.

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Buffett said: “Every ten years or so, clouds will cover the sky over the economy. At that time, the sky will suddenly drop a ‘golden rain.’ When that happens, you have to carry the bathtub and rush out, rather than bringing a soup ladle.” For investing, it is this series of difficulties that brings about the stock market’s extremely low valuations. And these difficulties will ultimately become things of the past. However, the buying window offered by extremely low valuations will not always be there.

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Panic is the biggest enemy of investing. Investors should maintain resolve.

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Four factors intensify volatility

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The recent volatility in the A-share market is mainly due to four reasons:

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First, the 2.6 trillion yuan in margin financing positions are extremely sensitive to stock-market volatility. When the stock market falls, some margin financing positions are forced to sell, amplifying both the upward and downward moves;

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Second, the 2 trillion yuan in quant funds automatically executes stop-loss when there is volatility. The concentrated selling by automated stop-loss orders increases the magnitude of the swings;

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Third, some high-valuation sectors have crowded trading. Once the wind shifts, selling can be extremely swift, driving the overall market’s volatility;

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Fourth, it has been more than a decade since the A-share market’s previous round of highs in 2015. The market has gradually grown numb to the pain of declines. New investors enter the market actively, but their tolerance for falling prices is limited.

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But all of these are trading-level disturbances and do not affect the investment value of the A-share market. With A-share valuations at historical lows, a large number of asset-heavy companies representing sustainable development that overturn conventional assumptions are trading at low valuations, providing China’s “hard assets” with a long-term stable dividend yield. According to statistics, as of March 27, the Shanghai Composite Index’s trailing price-to-earnings ratio is 16.52 times, with a dividend yield of 2.54%; the Dividend Index’s trailing price-to-earnings ratio is 8.86 times, with a dividend yield of 4.32%; and the SSE 180 Index’s trailing price-to-earnings ratio is 11.92 times, with a dividend yield of 3.27%.

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On the criterion of return, large asset classes can be compared, and it’s obvious which is more attractive: the annualized return of the stock market is approximately equal to the dividend yield plus the economic growth rate, which is currently about 8%. The current yield on the 10-year government bond is 1.8%, while bank fixed-deposit rates are about 2%. The rent-to-price ratio of homes in Tier-1 cities is about 2%. However, the stock market’s annualized return is achieved over the long term amid volatility.

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The recent weak performance of assets such as gold and Bitcoin is because non-yielding assets are inherently just a game of trading; the peak of conflict for such assets may be the high point. But “hard assets” with stable dividend yields have a floor. When conflict is at its most intense, the low point of stock prices may already be behind us, because falling stock prices only makes companies that were already attractive even more attractive.

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Against a favorable backdrop such as China’s economy continuing to improve steadily, the renminbi slowly appreciating, and ample liquidity, investors may have overreacted to anxiety over the Strait of Hormuz. In a recent article, Yin Yingnan, a researcher at the Renmin University of China Chongyang Institute of Financial Studies, said that America’s strategic predicament determines that the war will not escalate for long. At present, crude oil overall is in a state of oversupply. China’s strategy of diversifying import sources has been implemented for more than ten years, continuously reducing reliance on a single source.

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Cheap is the hard truth

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Recently, the U.S.-Iran war involving the U.S. and Iran has triggered market associations with the two oil embargoes in the 1970s. The two oil embargoes indeed dealt severe shocks to the global economy at the time, with the U.S. experiencing stagflation such as double-digit inflation, double-digit interest rates, and an unemployment rate approaching double digits.

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However, Buffett held a full position in stocks during both oil embargoes. Especially during the first oil embargo that began in October 1973, Buffett had left the overvalued U.S. stock market in 1969, but he returned to the stock market in 1973. Because he wanted to buy too many stocks and had too little of his own capital, he expanded his principal by borrowing interest-bearing government bonds.

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He invested a total of $10.62 million in 1973 and bought a 9.7% stake in the Washington Post. The Washington Post’s intrinsic value was around $400 million, but at that time the Washington Post’s market value was only $100 million. This investment was Buffett’s classic feat, which later brought him gains of more than a hundred times.

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Investing is against human nature. When stocks are cheap, a series of difficulties often scare investors away from buying. But looking back, cheap is the hard truth.

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However, going against the grain during stock-market panic requires tremendous courage. The book Where’s My Yacht? published in 1940 described Wall Street during the Great Crash of 1929. Back then, the book’s author observed: “You can’t ask an experienced Wall Street person to buy stocks just after freight tonnage has dipped below a new low, unemployment has peaked, steel production is no more than half of normal, and a big-shot man is fully confident in telling him that a major underwriter in the Midwest is in trouble. For everyone, unfortunately, this is the period when only stocks are declining.”

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The market will also, over the long term, adequately reward the courage and patience of contrarian buyers. “How can I buy stocks at extremely low prices?” When he was very young, the late global “contrarian investing master” John Templeton asked himself this key question. His answer was: “Unless someone is in a hurry to sell, there’s absolutely no other factor that would push a stock down to extremely low prices.” It was this answer that led him to borrow money to buy $10,000 worth of stock during the harshest period of World War II, and after holding for four years, sell it for a threefold gain.

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