Thursday, December 29, 2005

The Big Picture - Yielding to a Recession

The value investing technique is essentially a bottom-up method which focuses first on the fundamentals of a business. So, does the noises coming out of America about the inversion of the US bond yield curve fore-warning an impending recession to their economy matter?

Lowdown on the Yield Curve
First, the lowdown on the inverted yield curve. The inversion occurred post Christmas. The yield on the 10 year US Treasuries has remained in the range of 4.4% - 4.6% for much of December, reflecting the strong demand largely from Asian central banks for the long bond. It was, however, a different story for the 2 year note. Its yield has trended up on the expectation that the US Federal Reserve will raise the benchmark fed funds rate at least once (if not twice) to 4.75% by early 2006.

On Tuesday trading session, the yield on the 10 year Treasuries did indeed fall under that of 2 year notes, reflecting the market expectation of slower economic prospects in the months ahead. But some normalcy resumed when the 10 year yield inched higher to 4.36%, one basis point above the 2 yield subsequently.

Why the nervousness?
All of the six recessions which US experienced in the period of 1965 - 2005 were preceded by an inversion of the yield curve. But before you ring the alarm bell after reading the foregoing statement, let it be clear that there were two other instances of inversion, in mid 1966 and mid 1998, after which no recession ensued. A closer look at the extent of inversion was performed at the risk of data mining. The negative interest rate spread for this two time periods in question was noted to be minimal; only about 30 basis points.

This is in sharp contrast to the wider spreads seen in the other dips; particularly those which transpired prior to 1989. The earlier four recessions (of 1970, 1973, 1979, 1982) in the period under study were all foreshadowed by spreads of at least 100 basis points for at least a year. As for the two more recent recessions (1990 and 2001), the spread was narrower - only about 50 basis points but still wider than the two inversions which occurred in 1966 and 1998 when no recessions happened subsequently. Hence, the above observations from the historical data suggest that the yield curve has to invert by more than about 50 basis points before a recession materializes. Another noteworthy point is that the negative spreads which fore-warned the six recessions took place over a longer time period than the two dips in 1966 and 1998. As the extent of the recent inversion is relatively minimal, the jury is still out on whether it truly signals an impending recession.

With interest rates having a direct effect on the housing demand in US, the US Fed would do well to take a leaf out of the Bank of Japan's books. After spending nearly a decade in recession, Japan appears only to be coming out of the quagmire today. One of the causes of Japan's long recession was the collapse of the real estate market. To cool their housing bubble (and stock market) then, the Japanese benchmark rate was raised swiftly from 2.5% to 6% within a space of 15 months. The result was a sharp slow down in the demand in both markets leading to a hard landing for the entire economy. Hence, the US Fed will probably look to keep the rate hikes, if any, measured to gradually take the wind out of the housing bubble.

Value in a Recession
A market downturn will be a true test of an investor's financial and mental mettle. As Warren Buffett once famously remarked, "you don't know who is swimming naked till the tide goes out." Shares buoyed by strong growth expectations will come crashing back to earth when they are not underpinned by earnings growth as the economy slows. On the other hand, stocks correctly selected using the value investing technique, distinguished by its emphasis on margin of safety, should offer considerable downside protection.

A depressed market often offers an opportunity to a shrewd value investor to deploy any idle capital. In fact, sound businesses may be going for a song, ideal for picking by the value investor.

Should the macro picture gets more grim with other indicators such as falling consumption numbers, rocketing inflation (oil included) figures, defensive measures may be taken for the portfolio if one is of the view that a recession in the US is imminent. This may be achieved by placing a macro overlay over your stock selection - choose sound businesses that are less reliant on the state of the US economy. This may also entail diversifying out of a US only portfolio, leaving only core holdings, into international stocks to position one's portfolio for the headwinds. Accordingly, good businesses which will benefit from a resurgent China and, to a less extent, India or Asia, should merit a second look.

The future is always before us but it is never certain or clear. But, as before, we tread bravely on.

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