Contrarian Perspectives: A Case Study in evaluating risk-reward of 2024 China
Contrarian Perspectives: Asset Strategies & Allocation
“Be fearful when others are greedy and greedy when others are fearful.” - Warren Buffett
Adopting a contrarian viewpoint can yield significant insights, revealing opportunities in moments of general skepticism. Essential to this, or any, strategy is the rigorous evaluation of its foundational elements: the assets themselves. Precise assessment of these assets is crucial for the efficacy of investment strategies. In the article “A Quantitative Approach to Asset Allocation” we learned that there are standard sets of variables necessary to compute these allocation formulas and the limitations of mathematical optimisation -
- An asset allocation model’s performance is dependent on how we determine the risk-reward variables of these assets (which are components of the strategies).
*not all mathematical models suffer from these limitations
Evaluating the balance of the risk-reward ratio—is pivotal in determining the outcome of investment strategies. This process requires an in-depth analysis of market-wide strategies and an appreciation of how both quantitative and qualitative factors impact an asset's expected performance over various time horizons. A thorough comprehension of these dynamics is essential for accurately determining risk-reward variables, which includes:
Expected ReturnExpected LossCovariance and CorrelationVolatility
The question then arises: How do we identify the strategies that offer a high level of confidence in their true expected risk-reward outcomes? The answer largely relies on the proficiency of the fundamental analysis at play.
Case study: China HKEX-listed companies Nov’23 - Mar’24
This case study explores the intersection of diverse opinions, analyses, and perspectives that occur when differing methods are used to assess risk-reward, focusing on the period from November 2023 to March 2024.
This period, marked by significant market fluctuations, showcases the impacts of economic challenges, policy measures, and investor sentiment on market behavior.
Background Context
Since 2021, China and Hong Kong's stock markets have lost $4.8 trillion in market capitalisation. This decline was notably reflected in the continuous fall of Mainland China's CSI 300 index over three years, ending with an 11.4% drop last year, and Hong Kong's Hang Seng index marking its fourth consecutive year of decline, finishing 13.8% lower. These downturns rank them among the bottom performers in Asia-Pacific markets. Contributing to these challenges, China's property sector has notably struggled, affecting investor sentiment and impacting the Hong Kong market where many Chinese real estate firms are listed.
Despite setting a 5% growth target for 2024, skepticism remains around China achieving this goal, with predictions suggesting a slower growth due to ongoing property market issues and limited government policy support.
Diverse Analytical Perspectives
Market players adopted varied analytical lenses in response to these trends. Some saw the declines as indicative of deep-rooted economic malaises, focusing on the troubled property sector and the skepticism surrounding China's growth target. Others, however, viewed these downturns as potential opportunities, aligning with the contrarian philosophy of seeking value in fear-driven market conditions.
Bears on China's Economy: Pessimists highlighted the continuous struggle of the property sector, interpreting it as a sign of prolonged economic downturn. Their analysis often factored in the high covariance and correlation of Chinese real estate firms with broader market performance, particularly in Hong Kong, where many such firms are listed.
According to the IMF, Real Estate accounted for as much as 20% of China’s GDP. The implosion of the Real Estate sector, from bond defaults, liquidation, and major restructuring of debt, has sent shockwaves through the financial system, undermining investor confidence and economic stability. With uninspiring growth recovery post-COVID, bears have every reason to believe the economic challenges facing China are far from over.
Bulls Eyeing Recovery: Optimists, or the contrarians, looked beyond the immediate turbulence. They assessed the volatility and expected losses as temporary, focusing instead on the long-term expected return. This group believed in the potential for technological innovation and policy adjustments to spur recovery, despite the overarching negative sentiment.
Amid the prevailing economic landscape, stock values plummeted across the board, reflecting widespread skepticism and apprehension towards China's economic revival strategies. Nonetheless, bulls recognised an opportunity in this downturn, identifying undervalued stocks with solid fundamentals, unjustly dragged down by the prevailing negative outlook. They saw this as a chance to capitalise on deep value, undeterred by the broader market sentiment.
Government and Policy Measures:
During the months leading up to November 2023, China witnessed significant capital outflows, with investors pulling funds from the market. This exodus was exacerbated by crises within the property sector, including the defaulting on debt and major liquidation or restructuring efforts by some of the largest property developers. The ensuing public outcry and extensive media coverage drew the attention of the Chinese government's highest authorities, signalling a crucial juncture for intervention in the capital markets.
Initial optimism was sparked by the government's assurances of decisive action to support the market. However, this sentiment was quickly tempered by what many perceived as a lack of substantial policy measures. In response, the Chinese government undertook a series of steps aimed at stabilising the capital markets and bolstering investor confidence:
Protection Measures for Retail Investors:
The government introduced initiatives designed to protect the interests of individual investors. This included the implementation of stricter market practices and the enhancement of transparency, part of a broader commitment to safeguarding retail participants in the capital markets.
Leadership Changes at the China Securities Regulatory Commission:
In a strategic move, Wu Qing was appointed as the head of the commission. His subsequent actions have been interpreted as a concerted effort to regulate the market more effectively and ensure investor protection, marking a significant shift in the regulatory approach.
Regulatory Crackdown on Quantitative Hedge Funds:
To address concerns over market volatility, stricter regulations were applied to quantitative hedge funds. These funds, known for their high-frequency trading strategies, were scrutinized for their potential role in exacerbating market fluctuations.
Facilitating a State-Driven Market Rally:
The government initiated a series of actions contributing to a rally in the stock market, primarily fueled by purchases made by state-affiliated institutions. This effort was aimed at directly supporting market prices through strategic buying.
Major Investments in ETFs by State-Backed Entities:
The "national team," consisting of significant state-backed financial institutions, made a substantial investment of approximately $57 billion in local equities exchange-traded funds (ETFs). This move was aimed at providing stability to the stock market amidst the broader economic challenges confronting China.
Conclusion
Since implementing the measures, the CSI 300 Index has risen about 14% from its February 2024 low, and with the Hang Seng Index climbing more than 15% due to its high correlation to China’s economic and stock market sentiment.
Notable Bears:
Generally, most funds.
Notable Bulls:
Asia Genesis, a Singapore-based hedge fund closed its fund after experiencing an 18.8% loss in the initial weeks of January 2024. This downturn was attributed to unfavorable outcomes from the fund's positions amidst a stock market downturn in China and a rally in Japan.
Ray Dalio, the founder of Bridgewater Associates, the world's largest hedge fund, has been notably bullish on China, seeing it as a significant investment opportunity despite the challenges and skepticism it faces from many investors globally.
When observing from varied time frames, it's clear that the lens through which market participants view fundamental analysis and variables—such as expected risk-reward—can lead to markedly diverse outcomes. These observations suggest that, amid widespread skepticism and negative sentiment, there can be profound opportunities for those who diverge from the consensus.
However, despite having a strategic outlook poised for long-term success, Asia Genesis faced an 18.8% loss as the Chinese market experienced a sharp downturn at the beginning of January. Come February, the market saw a recovery, rewarding those investors who had adopted a more cautious approach into the market with gains by the end of the first quarter of 2024. China sentiment across the globe has now shifted to a slightly more optimistic tone. (End-1Q2024)
This case study highlights the crucial role of detailed evaluation and analysis in shaping expectations around returns, losses, and risk-reward ratios. Successful investment oftentimes require a healthy disregard for popular opinion and to adopt a contrarian approach. We also observed that evaluating long-term macro trends was not enough, the depth and degree of how you evaluate expected return/loss also plays a pivotal role as it significantly influences your investment positioning.
Links & References:
https://asiasociety.org/policy-institute/what-happened-chinas-two-sessions-2024
https://uk.finance.yahoo.com/news/singapores-asia-genesis-closes-hedge-035949487.html?guccounter=1
https://scholar.harvard.edu/files/rogoff/files/the_size_of_chinas_real_estate_sector.pdf
https://www.straitstimes.com/business/hedge-fund-stars-who-got-china-wrong-are-paying-a-big-price
Related Articles:
https://www.ray-kok.com/blog/a-quantitative-approach-to-asset-allocation
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