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Emerging Markets Bottom!

“Black Monday” panic and the spike in VIX most likely signals the low

MSCI EM vs VIXSource: Short Side of Long

The panic we saw on Monday, as Volatility Index spiked above 50, was less to do with the S&P 500 (which remains overvalued) and more to do with EM economies. In the chart above, we’ve circled the previous spikes in VIX above 35 together with the developing nations equity index. Each instance, apart from 1997 Asian Financial Crisis, was either close to or at a major low. In 1998, the MSCI Index totally collapsed as Russia defaulted and the Rubble devalued by 70%.

Emerging Markets Index breadth went through a major washout like in ’08 & ’11

MSCI EM BreadthSource: GaveKal Research

MSCI EM breadth readings, tracked by the percentage of stocks trading above the 200 day moving average, collapsed into single digits this week. Whether we look at the breadth history of MSCI DM or MSCI EM, these type of oversold conditions tend to be a signal of a proper wash out or selling climax. During the Global Financial Crisis of 2008, breadth readings got as low as 0%, while Eurozone Recession in 2011 saw a capitulation occur at 4%. As of Monday this week, percentage of stocks above 200 MA was 6%, an extremely oversold level.

Furthermore, yesterdays blog post showed how NYSE 52 week new lows spiked to above 1300 issues or 40% of the exchange. MSCI EM Index went through a more serious sell off, where the number of issues that made 12 month new lows jumped to 60%. How does this reading compare to previous panics of 2008 and 2011? The former saw a spike towards 77% while the latter 51%. The important point here is that it takes a large amount of selling pressure and panic to accomplish these kind of breadth readings.

A large number of EM economies are either in a recession or a slowdown

MSCI EM vs Korean ExportsSource: Short Side of Long

Unless you’ve been living in a cave, you probably understand that the Chinese stock market is going through a serious crash. After the index rose vertically into summer months of this year and was goosed up by retail investor excessive speculation behaviour, the reality is finally setting in. This event is damping consumer confidence (stock markets always do that), which was already fragile. In turn, worries about the global economy slowing even further is real.

Chinese economic activity and trade figures in general should not be trusted (which government figures can?), so I prefer to look at neighbouring countries such as Taiwan, Japan, Thailand, Hong Kong, Singapore and in particular highly cyclical export powerhouse of South Korea.

Constant negative earnings reversions shows how pessimistic analysts are

MSCI EM EarningsSource: Short Side of Long

I am a huge believer that the current contraction in South Korean annualised exports is a strong signal that a decent chuck of the world’s growth is currently contracting. This was the case during Asian Financial Crisis in 1997/98, Technology Crash 2001/02, Global Financial Crisis in 2008/09 and the Eurozone Debt Crisis in 2011/12. As exports collapse so do earnings, so it is no wonder analysts net earnings reversions have been so negative for so long (currently 1 standard deviation below a two decade mean). However, readers should remember that as contrarians, we are meant to buy recessions and panics.

Valuation wise, developing nations index became almost as cheap as it was during March 2009 (MSCI EM Index went as low as 762 points). Since 1996 the average Price to Book ratio for MSCI Emerging Markets Index has been 1.8 times. Stocks are considered expensive when the ratio is above 2.2 times (1SD+), with subsequent annual returns very volatile. On the other hand, stocks are considered cheap when the ratio is below 1.4 times (1SD-), with subsequent average annual performance of almost 50%. However, it is important to note here that valuations are NOT dirt cheap as they were during the 1997/98 crisis, when EM stocks traded below book.

Policy makers have learned from ’97 AFC by borrowing more in local currencies

EM Bond BorrowingSource: Wall Street Journal

Is it possible that EM stocks are still not at secular cycle lows?

Yes, it is. We believe that valuations will once again trade below book, most likely during the next major crisis. However, EM economies and Asia in particular, are not as vulnerable as they were during the late 1990s. Firstly, majority of the EM currencies are now free floating and discount fundamentals ahead of time. Secondly, it seems that policy makers have learned from their mistakes by borrowing more in local currencies.

In summary Short Side of Long is calling a major bottom in the MSCI Emerging Markets Index. It is important to note that we shorted MSCI EM Index (NYSE: EEM) as of $40 per share, catching the technical break of multi year support level. We are now preparing to close these shorts and initiate long positions. We want to make it perfectly clear that we do not believe in V-trough bottoms and we expect the recent lows to be tested during substandard seasonal months of September and/or October.

Bottoming Process

The number of NYSE 52 week new lows jumped to 1342 during Monday

Stock Market BreadthSource: Short Side of Long

Earlier in the week we discussed the fact that US equities are currently going through a crash. The same is true for just about all global equity indices. The first two charts in this post show the panic selling we are currently experiencing. On Monday the Volatility Index (VIX) spiked above 50 (second highest level in two and half decades) and the number of New York Stock Exchange 52 week lows jumped to 1342 issues (highest since 2011 Eurozone Recession).

Furthermore, the chart earlier in the week also showed that the VIX spike was so surprising with market participants completely caught of guard. The so called fear gauge jumped 230% above its 200 day moving average, which is second highest on record and only behind the catastrophic 1987 crash.

We have circled all the capitulations during the previous two decades in the chart below. The facts are, whether the trend is bullish or bearish, VIX spikes almost always signal an intermediate degree bottom at hand. In other words, 3 to 9 months out, stock markets usually rally strongly even if it ends up being a dead cat bounces.

At its highest high, VIX index spiked into the capitulation zone 

Volatility IndexSource: Short Side of Long

With capitulation in progress, should we buy immediately? Definitely not. Prudent investors need to understand how previous panics have bottomed out. The chart below shows all the crash events and their bottoming process post the VIX spikes (includes all major sell offs from 1987 until present). Let us make a few observations.

Firstly, it is important to note that 2001 sell off was the only one to bottom on a V trough, while all others went through a double or a triple bottom. Furthermore, certain sell off events were mild relative to some of the other crashes. Half of the sell offs since 1980s  were smaller than 20%, while the other half were larger. It is important to remember that smaller sell offs usually occur during external events such as Japanese Bust in 1990, Emerging Markets Crisis in 1998 and Eurozone Crisis in 2010/11. The current sell off is sparked by Emerging Market recession and Chinese slowdown.

We will continue to post this analogue in coming weeks as we track the bottoming process and the up-and-coming buying opportunity in stocks.

As VIX Index spikes the bottoming process can take anywhere from 1 to 4 months

Stock Market BottomingSource: Short Side of Long

Chinese Catastrophe

After rallying 55% above its long term average, Chinese stocks are now 20% below it

Shanghai Composite vs 200 MASource: Short Side of Long

Regular readers and newsletter subscribers should remember the warning of more downside for Chinese mainland shares (NYSE: ASHR) we have been dishing out for several months now. One of our main views was expressed in July of this year:

Historically, periods when asset prices trade excessively above the mean, are usually followed by a reversion where prices also trade below that mean. In plain English, I believe that a best case scenario for Shanghai Composite will be a period of consolidation, as the index waits for its moving average to play catch up, testing its recent bottom at 3300 points, established Wednesday last week. Vigilant investors among you should notice that the index is still trading more than 16% above the 200 day MA and if history is of any guide, price will eventually find its way below this mean. Several investment banks that missed almost the entire rally, as they stubbornly carried on with their neutral outlook (code word for remaining bearish) through the 2013-14 bottoming period, have recently started recommending their clients “to bottom fish” the crash. Majority of these investment bankers are usually too early to buy the fall and always too late to participate in the new rally.

Well… here we are. Shanghai Composite is now down over 25% in 7 days alone and down over 42% in the last two and half months. A notion that Chinese government (or any other for that matter) had the capacity and capability to backstop the crash was a ludicrous idea in our view. Traders should remember that real bottoms, proper bottoms, sound bottoms are always made when markets are allowed to clear and reset. A major buying opportunity is approaching, but it is prudent to let the current panic turn into outright selling climax.

Shanghai Composite in a serious crash, down 42% in two and half months

Shanghai CompositeSource: Short Side of Long

Global Stock Crash

Major stock markets around the world are now in crash mode

Global Stock MarketsSource: Short Side of Long

Major economies in the world are United States, China, Japan and Germany. Let us quickly observe their stock markets, as the world is going through an equity market meltdown. It is plain and obvious that these indices have fallen very rapidly in recent days, however one has to admit that we have not yet seen serious technical damage. Developed markets priced in US Dollars (MSCI World Index), together with the S&P 500, Dax 30 and Nikkei 225 all remain above their long term bullish uptrend lines (for now).

Chinese H Share Index has broken below it this week, while the mainland A Share Index is going through a catastrophic crash (Shanghai Composite has touched 3,000 points as I write this). As stated in the previous post, we believe that the panic has started and that selling pressure should last for awhile yet. Most likely outcome is for bearish exhaustion sometime in the coming months of September or October.

Capitulation Bottom!

Volatility fear gauge spikes as investors panic sell stocks around the world

Stock Market PanicSource: Short Side of Long

Short Side of Long is calling a bottom on this stock market correction. We want to make it perfectly clear that there is a very good probability that one should expect a turbulent bottoming process with more selling. A retest of the lows will most likely be in the cards, as V trough bottoms are very rare. However, the panic has already happened as Volatility Index (VIX) jumped to almost 54 points. This was the highest reading since the Global Financial Crisis and second highest reading in almost three decades (’08 was the highest).

However, certain indicators like the one in the chart above show that the overreaction is actually worse than the Lehman Bankruptcy of ’08, with the VIX moving 232% away from its 200 day moving average. Basically, two weeks ago everything was calm with the world expecting Fed to hike rates and now the a lot of investors are talking about QE again. We must say… an incredible change and shift in thinking.

We want to repeat ourselves, there is real panic out there right now and contrarians should be ready to act on the buy side. Seasonality for equity markets is usually weak into September and October and we here at Short Side of Long expect either September or October to mark a major low this year. We saw similar outcomes in October 1987, October 1990, October 1998, September 2001, October 2002, October 2008 and October 2011.

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