China Crisis? Risk-parity meltdown? Or financial gravity at work?

The last few weeks have seen equity markets around the world register significant losses. Sudden downward price movements can be stressful and the conflicting analysis and advice can be confusing. Although I cannot give specific advice on what to do, perhaps I can point out some issues that might have been overlooked and would be useful to consider.

The general consensus is that the current market woes began with a crash of China’s equity markets on Monday, 24 August. The 8.5 per cent drop in the Shanghai Composite Index is what many market commentators agree triggered the global wave of selling. What is not made clear is why the Shanghai tanked and why this would trigger a global crash. The answers proffered are that China’s economy is slowing, and that this in turn will trigger a slowdown in the global economy. This is puzzling because the slowdown has been common knowledge for quite a while now, and anyway Chinese growth is still running at about 7 per cent a year. So what news came out to trigger the price plunge? Nobody seems to have an answer.

Even more perplexing is the effect of China’s economy on the world. The narrative that a brake on China’s economy would slow down global growth has things backwards. China is a supply side economy and depends on robust global demand. It is only if global demand, in particular the United States, were to slow down that we would expect a slowing in the global economy, including China.

So at best, China had a bit of a panic attack with no real news driving it and no clearly explained link to the effect on the global economy. What other excuses did asset managers give for losing their clients’ money? The back-up excuse emerging is computer based trading strategies, in particular the risk-parity strategy.

The risk-parity strategy was made famous by Bridgewater, by some measures the largest hedge fund in the world, and their All-Weather fund. The details of the strategy are not relevant other than it dynamically buys and sells assets as their prices move. The argument is that as prices fell these strategies automatically dumped assets which drove down prices further in a vicious feedback loop.

This argument is nearly identical to that levelled against portfolio insurance strategies in the wake of the 1987 stock market crash. Today’s arguments fail for the same reason that the arguments against portfolio insurance strategies failed. These are neither the sole strategies, or even the largest strategies by assets, and therefore one has to take into account all the other strategies deployed by asset managers. If prices were indeed dropping below value, then where are all the value-based investors, think Warren Buffet, who would love to buy stocks at an ever lower price?

It seems that the world of equity markets is not ending. So what is one to do in such a case? Let us use two actual examples – Emaar, a perennial favourite in the local markets, and Union National Bank (UNB), a personal favourite. All data is from Bloomberg for Thursday, September 3. Also, please read the disclaimer below.

Emaar closed at Dh6.42 whilst UNB closed at Dh6.00. Is this good? Is it bad? In terms of price information, this simply is not enough to tell. How have they been performing? Emaar has a one year return of -34.19 per cent and a year to date return of -9.90 per cent. For UNB the numbers are -12.80 per cent and +7.95 per cent respectively. UNB looks to have performed better, but is past performance indicative of future performance?

In terms of price information, share price is almost meaningless, but the well known price/earnings ratio, which effectively gives us a price per dirham of earnings, is a much better gauge. The P/E for Emaar is 12.35 and for UNB it is 7.71. A dirham of earnings generated by Emaar is 60 per cent more expensive than a dirham of earnings generated by UNB. That means that all other things being equal, Emaar must increase its earnings by 60 per cent to match UNB’s P/E. It makes you think, doesn’t it?

The idea here is not to present an investment analysis methodology but to apply well-known ideas to the current situation to get a directional idea on what is going on. Price movement not linked to announced economic data should not be blamed on said economic data. The effect of one strategy on the market should be evaluated in the context of all other strategies, not as if it existed in isolation. The share price of a company is almost meaningless without context, not least of which is the price relative to earnings.

Disclaimer: The author is an active investor and may benefit from price movements in the securities discussed in this article.

This article was originally published in The National.