Tuesday, December 23, 2008

Death by a Thousand Cuts (But can we have a last flutter?)

In the past post, MOS ruled out the prospect of a quick recovery for global markets but are we at the bottom yet? I admit to being a bear, a six foot one. But I cannot help being so in recent times especially in seeing how ailing the US and by extrapolation, the global economy is or has become.

These days, I feel out of sorts and uneasy. There appears to be many other shoes waiting to drop; particularly in emerging/Eastern Europe where certain governments may be behind the curve in terms of policy moves. It is apparent from asset prices that capital markets are discounting bad news aplenty. Prior to the relief rally in the recent past month, global equities have tanked by approximately 40 - 50%. We all know that no one can catch the market trough; well, maybe except for Mister Liar. But that has not stopped many from trying to do so.

Elisabeth Kubler Ross introduced the world to the five stages of grief in her 1969 book "On Death and Dying". The stages are:
1. Denial
2. Anger
3. Bargaining
4. Depression
5. Acceptance

Doctor Ross is a psychiatrist and the Kulber-Ross model she developed was a process which people subconsciously use to deal with tragedy and grief, especially when diagnosed with a terminal condition. Over time it is apparent that these stages can apply to any form of catastrophic personal loss, from love (out of love to divorce) to even jobs (unemployment or income loss).

Given that financial markets are also driven by the manic emotions of humans (say hi to Mister Market!), wouldn't the Kulber-Ross model apply to market cycles and consequently asset prices too? Recall the famous "Death of Equities" magazine cover in 1981. It is at the "acceptance stage" of capitulation where a bottom in equities may be found. It is only at such extreme depths when the seed of the next super bull market is planted. In which stage do you think we are at for equities?

With regulators sleeping at the switch and sold out on the story of self regulation, the US maneuvered itself into a big tangle of having high leverage and deflation. Household wealth has shrunk with collapsing housing prices. Debt levels, unfortunately, remain somewhat unchanged. The resulting fire sale of assets will set off a reverse spiral in asset prices and trigger off more margin calls. Truth be told, this evil spiral has started and the US Federal Reserve is throwing the kitchen sink at it to stop the rot.

To fight the deflationary beast, the Fed has wielded the big axe by dropping policy rates next to nothing. If you think about it, zero rates implies free money! Its tantamount to Governor Ben going up to his helicopter and throwing down cash. Unfortunately, since no one has decided to pay another when the latter borrows, zero is as low as rates can go in setting monetary policy stimulus. In its breach comes the unconventional tools of "quantitative easing" through the use of the central bank's balance sheet.

Given that markets are so sickly, my mind cannot help but to conjure up another medical analogy. To fight cancer, there is front line conventional medicine and then, there are experimental drugs for the seriously ill. The fact that such unconventional tools of quantitative easing are being employed to resuscitate the economy indicates how bad the situation is and how desperate we have become. Are we all grasping at straws? No wonder bond futures are discounting in approximately five years of deflation!

We are all in unchartered waters today. Sadly like all test drugs, the efficacy is unclear. The same can be said with quantitative easing based on the limited empirical evidence available. Hence, the US and by virtue of our close interconnectivity today, global economies are a huge trial in Governor Ben's petri dish. Roll out the printing press! Crank up the bubble machine! I am no economist but short of the liquidationist policies which bordered on Darwinian style economic cleansing (ie, the weak must fall for the strong to rise again), what other choices do we effectively have when we cannot stomach the pain of bank collapses to purge the system's excesses? I, for one, will not be able to tolerate the systemic failures because I want to remain in finance and not go into farming just yet.

Compared to mainstream medicine, experimental treatments usually bring side effects which may not be tolerable. Will the global economy face a death by a thousand cuts? As this will probably go down as the most morbid post, allow us to explain the phase. It refers to slow slicing - a form of torture and execution originating from Imperial China where many cuts were gradually applied to keep the victim on the edge of death. Our economy had many recent near death experiences. The last was in 2002 in the aftermath of the tech bubble wreck. Today, besides the Fed, central banks all over the world from the Reserve Bank of Australia to Bank of England have all fallen over themselves to cut interest rates. Like a floored individual, the policy makers are hoping that timely cardiac cardioversion can jot the collapsing economy back to life.

If we succeed in getting the credit creation process going again (probably more likely than not), another rally in equities would be inevitable. This is not totally tongue in cheek but I cannot rule out the possibility of the largest ever January effect taking place next month!

That said, the direst consequence of this massive pump priming is hyper-inflation if the easing stimulus is not withdrawn in time. We are footing the bill today in 2008 because of the party we started in 2003. It is widely acknowledged that policy rates were held overly low for too long a period of time and it resulted in the housing bubble. So how confident are we in the authorities to pull back the life support this time as we tread the thin line between deflation and inflation? Weren't Mr Bernanke already on the Board of Governors of the Federal Reserve System in 2003?

Let's not for a moment forget the situation in Harare, Zimbabwe where the annual inflation rate is an astounding 231 million (no typo here, its over a two hundred million) percent. We agree that figure sounds pretty bleak and too much of a stretch but if it helps to put things in perspective and raise an early warning, it would have served its purpose.

I recognise that Christmas is upon us. It is this time of the year when we, as kids, would write to Santa to have our wishes fulfilled. But with time and age, we soon realize that Mister Claus is very much, sadly, only make believe, a figment of adults' fertile imagination. As things stand, it does also appear that our goal of having a Goldilocks economy of sustainable moderate economic growth with low inflation will also remain a fairy tale.


Sunday, December 07, 2008

Under the Mattress or A New Mat?

What a year it has been! 2008 will go down into financial history as the worst collapse after the 1929-1932 crash.

About a year to six months coming into this, we at MOS have been forewarning of what is to come, with posts last May like Canaries in the Chinese Coal Mine, etc and This Time It is Different. In the latter, I almost shudder at how prescient we were in calling then that "every conceivable asset class that we know of, from real estate to infrastructure to commodities to junk bonds, are trading at steep valuations." This time is, indeed, very different; in that, there is no hiding place!

As this is no self praise exercise, we must confess that the extent of the deleveraging that followed had totally escaped us. Perhaps many investors would have wanted to take heed at our advice in February 2007 to pack up for a getaway to Phuket to enjoy the Andaman Sea breeze and sun instead. Whilst you would have missed the market roller coaster, your pocket will probably be lined with more cash these days.

And so the demi-god Warren Buffet was spot on again. The carnage left by what he famously labels as the "weapons of mass destruction", which took down one of the oldest bank on the Street, Lehman and left several other reeling for the count out, showed that many market participants were actually swimming naked as the tide washed out.

Daddy once warned us that it is liquor and leverage that destroys grown men. The banks have pulled the lines on businesses and individuals when credit was needed the most. No particular reference is intended but it is almost like the banker removing the umbrella when it starts to rain, isn't it? As a result, asset prices have tumbled. The CMBS and private real estate markets have frozen. The volatility index, VIX, is making new recent highs. Prices of several commodities like oil and copper have been trashed. Corporate bond yields have spiked out. US investment grade corporate debt have widened to record levels of more than 6% - spreads last seen during the Great Depression! (if the editor allows me to slip this in - these are levels which we find increasingly attractive).

In Singapore, you can find stocks trading at 2x historical earnings, while some trade way under book. A simple screen would indicate that the market is pricing them as being worth more dead than alive. By that I mean the shares are available for less than the net cash (net of total liabilities sometimes) on their balance sheet. So, such companies are better off being taken private and liquidated. Many of these are the much maligned S-Chips such as China Taisun who have fallen out of favour as liquidity was totally retrenched from the system. It is ironic that a lack of scrutiny of corporate balance sheets brought us to where we are. Investors had blindly piled into growth stocks. Debt was cheap then so we hailed firms with business models which promised growth and more. Alas, it turned out to be blind and misplaced faith. Yet today, this same investor is ignoring how cheap things have become - relative to what is available on the balance sheet.

REITs are yet another asset class which are offering some of the widest spreads I have witnessed in my investing career. Sure, some of them are trading on a cum rights basis and are factoring a downturn which necessitates the loss of tenants and rising vacancies, but a judicious investor can surely sieve out those unduly battered from the deserving.

Our regular readers, if there are any, know we spilled a fair amount of ink on these pages poking fun at those who bought into CapitaRetail China Trust in Jan 2007 when it traded at S$2.10. Today, the same REIT is available for about S$0.46. It is pretty much the same business except maybe without the visionary Pua who have gone on to bigger things. Granted that the land title system in China is not the most developed in the world (but it is inconceivable to me that things will not improve over time) and cap rates will increase, but the current price offers one nearly 50% to last appraised value. If you can get comfortable with its debt expiry profile, one is essentially enjoying a healthy yield with an option on rising Chinese middle class consumerism which these malls are aiming to tap. To us, that's almost like "Heads I win, tails I win too" - akin to holding a distorted call option with premium paid to us! This is certainly a proposition we much prefer over the put options which investment banks have insidiously made retail investors sell through structured notes so that Grandma can earn a paltry 1% spread in return for taking on the credit risk of hedge funds disguised as banks.

If we were to put all this witch hunting and crucifying aside and peer into our crystal ball, what do we see in the months ahead? In a market this volatile where writers can be made to look foolish almost within a day or two after publication, we can only venture our best guess.

Whilst we do not think the US will slip into the 1930s style depression, our base case still assumes that they pull out of their rut only gradually over the next few years. We have completely ruled out a V shaped global recovery. In fact, we think that there will be another few shoes to drop, particularly in Middle East. With oil prices back at around US$50 (which we think is undervalued!), the rapid rise of the Gulf States will surely be under tremendous pressure.

What worries us most is that the American policymakers are cornered. Rates cannot be lowered further without raising concerns of trapping the American economy in the Japanese style liquidity trap. But the swift and decisive steps to pump prime through fiscal policies - ie, printing greenbacks will surely help and sooth the frayed nerves. The fact that inflation will rear its ugly head when the dust settles appears to be besides the point now. Fortunately for the Americans, the world still lack options and the Chinese remain happy holding onto US IOUs even though a critical analysis of America's balance sheet leaves a lot to be desired. Perhaps the Chinese are trapped in a "chicken and egg" loop and they cannot afford for the American music to stop.

We are definitely sanguine about the long term prospects of China but unfortunately, the Middle Kingdom is but a nascent piece in the global economic jigsaw today. In a world where the American consumers are swiftly deleveraging - after spending a dollar fifty when they have only a buck in their pockets, there remains a fair bit of slack for the thrifty Chinese to pick up. After all, the Chinese like the Japanese have, in general, a habit of keeping money under the mattress rather than splurging on a fancy new mat. So, we see that the net effect on the global economy would be one of a gradual recovery.

We will write again when we have more to get off our chest or if we find some time to leave the candy store of value this market has presented to us. Until then, stay liquid but don't ignore the apparent values.