Global market volatility does not change market fundamentals

Although South African investors displayed resilience to global market jitters, sparked by China when the Shanghai 180 index fell over 9.25% last Tuesday, the local stock market did not escape the sudden volatility.

Graham Mason, CEO of Prudential in South Africa, says while the JSE All Share Index got off reasonably light in rand terms - a 5.1% drop from last Monday nights close to Friday night's close - the trouble in China resulted in a double whammy for South Africa.

"Not only was value shaved off local equities, but concerns about growth in China, a major importer of South African commodities, translated into concerns over the rand which weakened the rand by 4.1% over the same period.

"A weaker Rand means that the 5.1% drop in the JSE All Share Index last week translated into a 9% decline in dollar terms. Compared to global markets, South African equities therefore recorded one of the worse losses in the world.

Nevertheless, Prudential does not believe that last weeks decline marks the beginning of a bear market as the fundamentals supporting the equity market remain intact.

The trouble with China

Mason says that with China suffering the biggest equity sell off in 10 years last week, a myriad of post-event rationalisations were being put forward.  These included fear over possible interest rate hikes, mutual funds selling to pay March dividends, as well as the speculation over the consequences of Chinas National Peoples Congress session.

"We believe, however, that in reality the reason behind the sell-off is straightforward - domestic Chinese shares, trading on a Price / Earnings ratio of close to 40, are amongst the most expensive assets in the world.  This over-valuation, combined with a 52% rise over the fourth quarter of last year alone and a whopping 130% rise for the year ended December 2006, fully explains the sell-off in the market."

When investors suddenly started selling Chinese equities last Tuesday, investors around the world followed suit.

"Given the obvious expensiveness of the Chinese markets, this widespread contagion was surprising," says Mason. "But what was not surprising, was that those markets that have risen most on stretched valuations also fell the most.  For example India, which is the second most expensive market in the world, on a Price / Earnings ratio of 20, suffered the biggest decline after China."

Following on from China, Asian stocks were hit next, experiencing their biggest fall in more than eight months. This fall accelerated last Wednesday and by mid-morning, Singapore had fallen nearly 6%. The US Dow Jones Industrial Average fell 546 points at one stage, the largest fall since the September 11, 2001, terrorist attacks.

Latin American markets fell by just under 6%. Both UK and euro area markets fell by over 2.25% and just under 3.0% respectively.

Staying focused

Mason says that since it is impossible to forecast short term price movements, investors should focus their energy on looking for sustainable long-term returns.

"At Prudential we seek out mis-priced assets where the skewed return distribution greatly increases the chances of delivering positive results in the longer term. As with any longer approach, investors need to tolerate short term volatility."

Sympathising with investors, Mason says having the strength to remain calm during periods of market volatility is crucial, despite the short term pain involved.

"Rather than engage in short-term noise trading, we need to assess whether there is any genuine information, economic or price wise, that would lead us to change our previous conclusion.  Our answer to this in relation to last weeks volatility is no."

Improved valuation
 
Mason says that prior to this weeks correction, some global equity markets had risen strong enough to bring them close to fair value.

"However, recent falls have improved valuation once again. Meanwhile global bonds have experienced a safe haven rally which has brought yields close to the lows experienced in early December."

Mason says Prudential maintains the belief that equities remain the cheapest asset class both locally and globally.  However, within equities, Prudential has been underweight China, Hong Kong and India, given their expensive valuations.

"Our funds are thus generally well placed to weather the current turmoil. With the fundamentals intact, last weeks selling has not altered Prudentials stance."