Bubbles Popping, China Slowing, Greenback Strengthening…

Wednesday, 10 March 2021
Wollongong, Australia
By Greg Canavan

[3 min read]

There’s been quite a lot happening this past week or two, hasn’t there?

Bubbles have popped in some of the more overheated parts of the market. But as I point out in my Life at Zero presentation, you don’t have to take crazy risks to make money in this market.

You can play it the smart way, or the dumb way. In my view, chasing hot money is the dumb way to go about it.

Which is why I’ve targeted companies like Afterpay Ltd [ASX:APT] and Tesla Inc [NASDAQ:TSLA] a lot in The Insider lately. But I’ve also been at pains to point out the market as a whole isn’t a bubble. Just some elements of it.

And those two stocks certainly qualify, in my humble opinion. But it’s not just those two. There are many others riding their coattails. Which is why you need to be careful in how you go about picking stocks in this market.

To illustrate the popping bubble, let’s have a look at a few stocks. I’ll show you a longer-term chart to put things into perspective.

Here’s Tesla…

Source: Optuma

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As you can see, the ever-inflating share price hit a pin in late January. It then started to deflate rapidly. However, nothing goes up or down in a straight line. There was clearly some short covering overnight. The stock soared by nearly 20%!

That doesn’t happen in an orderly market. Make no mistake, Tesla is crashing.

It’s a similar story with Afterpay…

Source: Optuma

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Today you’ll see a big bounce. It might even get all the way back to $130 in the next few days as the bulls try to keep the dream alive.

But my guess is that it’s all over. The share price is heading back towards some semblance of value…wherever that is.

When a share price falls so dramatically in such a short amount of time, it tells you that something has changed in the psychology of the investor. They no longer believe. Belief is what kept the share price rising.

Without genuine valuation fundamentals to fall back on, belief (or the lack of it) can create and destroy a lot of share price value.

Let’s have a look at another stock — cloud-based accounting software company Xero Ltd [ASX:XRO]. In terms of the business model, XRO is miles ahead of Afterpay. But the valuation is so far ahead of what is reasonable, that shareholders are looking at deep losses here too.

The company has a market value of around $16.5 billion. Based on FY22 forecasts, it trades on 17 times sales, 200 times earnings, and 27 times book value. I know investors aren’t buying it for next year’s earnings, but that’s still crazy.

I mean, it’s not as if the company has outstanding profitability or anything. Its return on equity is forecast to be an average 12% in FY22, rising to a decent 18% in FY23.

But to justify 27 times book value, it should be much, much higher.

Maybe it will get there down the track. But I’d much rather buy this company at a third of the price it is at now. Who knows, maybe it will get there in the years ahead.

I could go on about these pockets of extreme valuation and popping mini-bubbles, but I think you get the picture.

China is entering a slowdown

For now, I want to have a quick look at China. Because signs are pointing to a slowdown over the second half of 2021 and into 2022. I don’t think it will be anything too dramatic, but it may have implications for the iron ore price.

Global bond fund manager PIMCO recently wrote:

China’s central bank announced it has begun to reduce coronavirus-related stimulus early – a decision that may be far more relevant for policy evolution in developed economies than presently perceived.

Policy tightening in China is already being felt domestically in the form of tighter money market liquidity, moderating private credit growth, and reduced government bond issuance. China’s credit impulse, a measure of changes in new public and private credit as a percentage of GDP, which typically marks turning points in economic activity, appears to have peaked (see chart below). We believe it’s likely to decelerate through the remainder of 2021. The central bank is targeting overall credit to grow in line with nominal GDP, implying the credit impulse will fall to around -3.5% of GDP by year-end, from a peak above 9% in the fourth quarter of 2020. All else equal, this may slow China’s economic activity to below-trend levels by late 2022.

Source: PIMCO

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Perhaps that is why the yuan is beginning to weaken against the US dollar?

As you can see in the chart below, it peaked in late January but has since turned down. The upward trend is still intact, but if China’s credit growth is set to slow from here, that may have an impact on the currency.

Source: Optuma

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The reason why this is an important currency to watch is because its direction could have a big impact on Australia.

This next chart overlays the iron ore price on top of China’s currency. The correlation, as you can see, is high…

Source: Optuma

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The yuan is the black line and iron ore is in blue. There are occasional divergences, but they usually catch up with each other. So from here, either the yuan rallies again, or iron ore starts to fall.

Given BHP and RIO are trading at or around all-time highs, this relationship is an important one to keep an eye on.

The emerging weakness in the yuan is just the other side of the coin of US dollar strength.

The chart below shows the US Dollar Index. It bottomed early in the year and in recent weeks has moved sharply higher. On Monday, it nearly hit a four-month high.

Source: Optuma

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This is another key chart to keep an eye on. Downward moves in the US dollar are usually bullish for equity markets. Upward moves are usually bearish. So if the trend does turn, expect more market volatility.

I’ll keep a close eye on these charts and keep you updated…


Greg Canavan Signature

Greg Canavan,
Editor, The Insider