It was all going so well for stock markets.
Since markets bottomed in March last year, stocks have marched relentlessly higher. The FTSE gained 60% from the bottom, the US Dow Jones 65%. No amount of bad news about the state of the world economy was enough to derail the rally.
Until now, that is.
Suddenly investors are in a panic again. Shares have been falling for the past two weeks. We saw two consecutive triple-digit falls in the US last week. As always, the FTSE followed suit.
What’s changed? In a couple of words: China and Obama.
Is China’s boom turning to bust?
“Once again the market is worried about China and the risk of it overheating,” explains Mathias Wikberg of our Profit Hunter team. “ China’s GDP numbers last week were very strong: +10.70% over the last four quarters.”
And whilst that might sound like a positive thing, Mathias points out that these fantastic numbers have actually spooked the market. They were, as he puts it, “a little too good for the market.”
“As soon as the numbers were out, investors around the world worried that China’s growth may be too strong and that the central bank may have to start raising interest rates to curb economic activity.
“This would have a big effect on the world economy as right now China is the engine for global growth. There are signs that some parts of the Chinese economy – in particular real estate prices – could be overheating. The policy makers are worried about this and have instructed banks to slow down lending.”
And as Mathias explains, this would have a knock-on effect around the world. Less lending means less credit available means less growth in consumption, indus trial production and economic growth.
When China sneezes…
In the aftermath of the 1929 Wall Street crash, it became clear that America’s problems soon became problems for the entire world economy.
But now there’s a new saying: “When China sneezes, the world catches a cold.”
Quite simply, a major problem in China could tip the world back into recession.
The events over the last two weeks are yet another sign of world power shifting eastwards. And the knock-on effect has been a substantial pull-back in western markets.
What is also clear is that the macro picture is overriding the micro picture.
You see, markets should be bullish on the back of on the whole decent fourth quarter earnings reports we’ve been seeing in the US. Markets should be marching higher at the prospect of economic recovery.
But they’ve shuddered to a halt and reversed. And it’s not just down to China. We should also look to what’s been going on in the US. Our macro trader friend, John Lewis, picks up the story…
“First of all, a couple of weeks ago the President announced his plan to slap a tax on US banks. It’s his attempt to recover the cost of the financial system bailout. This knocked confidence.
“The markets had understood the US authorities would be happy with the funds they advanced to the banks simply being repaid. And that is something that many of the banks are currently doing. So it's not surprising that the fear of another hit to the banks would cause a bit of panic.
“That was bad enough. But markets were showing signs of coming to terms with this. Then, something else happened...
It’s all about the fear of the unknown
“Late last week Obama announced he intends restricting the proprietary trading risk taken by US Banks. ‘Prop trading’ is when a bank trades its own capital for its own gain rather than acting for clients.
“But why should this unsettle markets? The prop trading activities of banks only accounts for about 5%-10% of their revenues. So how much damage to earnings can restricting this activity do? The answer is: not too much.
“The problem is that we still don't yet know exactly what Obama intends. What has rattled equities (e.g. risk assets) and sent Government bond markets (e.g. safe haven) higher, is exactly that. It's the fear of the unknown. Markets hate that.”
And just look how Obama’s plans showed up in the ‘fear gauge’, or the VIX. You get a low VIX level when the markets are relaxed, happy, complacent even. But when markets are spooked, the VIX moves higher.
Here’s what Obama's plans for banking reform caused – a 57% spike from 17.5 to 27.5 in days. You can see it on the chart below:
As John Lewis explains, “No one knows what Obama is planning. But in the absence of detail it sounds business unfriendly and that has upset equity investors.”
A simple tactic to keep you in the trend, but protect your profits
Markets look to be finishing this week on a strong note, as I write. Does that mean that the ‘wobble’ is over? We don’t know.
A glance back at my first chart shows that the uptrend in stocks is still intact. And as the old saying goes, “let the trend be your friend.”
So stick with shares that you own. But at the same time, it makes sense to get out if things turn ugly. That’s why it makes sense to use a simple tool called a trailing stop loss.
It’s a very simple idea. Whenever the price of a share you hold falls backs by 25% from its recent high, sell it. (I say 25% as a general rule. But actually, the percentage amount should vary depending on how volatile the stock in question is – or your risk appetite. You might prefer 15%. That would preserve more of your capital… but you risk getting stopped out more easily.)
So let’s say you buy a share at 500p, and it rises to 1000p. You would sell that stock if it was to fall to 750p – 25% below the new high. If instead of falling back to 750p the stock had risen to 1200p, then you would raise your stop loss to 25% below the new high – i.e. at 900p.
The point is that from day one, you limit your loss to 25% of your investment. And as soon as the share hits a new high, you raise that stop loss, trailing it up behind the price. That way you are always reducing your risk on the table... and eventually locking in profits.
But you have to be hard about it. If a stock hits your stop loss, don’t question it. Don’t even think about asking whether it maybe a temporary pullback and consider staying in. Stick to the rules and over time you should make money.
Best wishes,
Frank Hemsley
For The Right Side
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