Friday, November 26th, 2021

Time for Some Bottom-Fishing

MAV this week and it also has an upward-sloping curve (which is actually better than the EM vs the World curve). Technically speaking, we still need this signal to be confirmed, but a conventional chartist would argue that major indices like the CSI300 are now sitting on their 2018 lows and look to be well supported in absolute terms. In our 42-country model, China is now out of the bottom decile for the first time since early July.We spend a lot of our time trying to dissuade clients from buying something just because it has gone down or underperformed. We have numerous studies which suggest that simple mean reversion strategies don’t work very well, even in assets which are supposed to be well-correlated. This is the “picking up pennies in front of steamrollers” critique – the modest gains which accrue when correlation is high and stable are typically overshadowed by larger losses when the correlation breaks down – as it nearly always does.

Even when correlation between two assets is high, the strategy is not particularly risk-efficient, because it typically involves buying the asset which has rising volatility and selling the one with stable or falling volatility. Most assets have a negative skew in their return distribution – the average daily decline is larger than the average daily increase.

That said, we recognise that there are occasions when the temptation is almost irresistible and that every investor has a contrarian itch which must occasionally be scratched. So, we do allow some bottom-fishing, provided that it is very carefully controlled. To us, bottom-fishing is more than the normal process of reducing an underweight position when the model says we should. It means having a much more positive view on the country or sector than the model recommends, effectively paying more attention to the short-dated part of the sample and ignoring the longer-dated part.

We can only justify this when we have upward-sloping lead indicator, a clear and decisive upward move in the overall trend and a recent confirmed break above the 26-week moving average. We typically recommend this when we think there is potential for a sharp rally in something that has been oversold – something like a bear squeeze. We only use this to protect ourselves against the risk of underperformance if the rally continues, which means we can only be neutral, not overweight, if the model says we should be underweight.

We think there may soon be an opportunity for some bottom-fishing in EM Equities. We have consistently argued that there are many individual countries which are attractive on a stand-along basis (e.g.  India, Saudi Arabia, Israel, Russia, Singapore and others) and that the asset class as a whole was dragged by the poor performance of China. In the last two weeks, three charts have arrived at point where the model would allow us to go bottom-fishing. They are EM Equities vs the World, China Equities vs the World ex US and Chinese Technology vs the China Index.

Our recommended weight for EM Equities vs the World broke up through its 26-week MAV in late October, but the lead indicator was not upward-sloping at the time, so we ignored this. Last week, it retested the average and bounced off it strongly and the lead-indicator is now positive. We have already filled in a significant part of our previous underweight position and we think the model is about to tell us to hurry up and do more.

The single most important reason why wouldn’t do this is the fear of further downside in China, but our recommended weight for China vs the World ex US broke above its 26-week MAV this week and it also has an upward-sloping curve (which is actually better than the EM vs the World curve). Technically speaking, we still need this signal to be confirmed, but a conventional chartist would argue that major indices like the CSI300 are now sitting on their 2018 lows and look to be well supported in absolute terms. In our 42-country model, China is now out of the bottom decile for the first time since early July.

And finally Chinese Technology, which is the single biggest reason why China underperformed so badly. Our recommended weight broke through its 26-week MAV two weeks ago and it has a very positive, high conviction lead indicator – albeit against a different comparator. There are concerns about a second crackdown on technology companies, particularly those with overseas listings, but it is possible that some or all of this risk is already in the price.

Chinese Technology is large enough to influence the performance of EM Equities on its own. In terms of downside protection, it is one of the few equity sectors anywhere in the world, outside the US, which is not significantly influenced by short-term fluctuations in the US dollar. This partly because of the nature of the business and partly because of the renminbi/dollar peg. We are not arguing that the geo-political risk of investing in China has gone away, or that there will be no further regulatory crackdowns by the regime; merely that they are now “known unknowns” which can and have been discounted by investors.

The upside is that if the Chinese leadership does not actively sabotage their investment case, Chinese Technology stocks may do surprisingly well, with knock-on effects in Chinese Equities and EM Equities as a whole.

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