Sunday, May 10, 2009

Life in Hamelin

It was only a few months back in December when we wrote the piece titled Death by a Thousand Cuts (But can we have a last flutter?). In that post, we stuck our neck out with a prediction. And with economic predictions, one will inevitably get it wrong:

"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! "

Well, we were partially right, save for the timing. The "inevitable rally" has occurred since the March 09 low. And boy has it been a strong one. One of the strongest post crash rallies ever. This has left everyone split and debating whether this is the birth of a bull or a suckers' rally?

As we take in the plaudits, we also take time to compile a list of FAQs which we have been asked and heard discussed regularly in the last few weeks. And we offer our best guesses to each of them.

(1) Birth of bull or suckers' rally?

Call it a suckers' rally, a dead cat bounce, a codicil or a last flutter at the casino. Call it whatever you like but the fact is that the market took off on a tear. We somehow saw it coming in 2009 because of the unconventional and the "do it at all cost" will of the measures undertaken by authorities. That resulted in truck loads of cash sitting at the sidelines and, when sentiment improved a little, led to them being pored into equities again. After all, near money supply growth, M1 and M2 measures are very good leading indicators of subsequent stock market performance.

Also, let us not lose sight for a single moment that we are in the business of buying cheap stocks. And a lot of equities were very cheap in March. They were really oversold. Some were trading at sustainable double digit dividend and free cash flow yields. These should have gone into your shopping basket. So, a rally from those levels is also inevitable.

(2) What to make out of the green shoots?

We think the low lying fruits have been plucked. The economic data is less ugly than before is because the US economy cannot contract at the same negative six percent every quarter. There is also a limit to the savings a corporate can generate through cost cutting. What happens to the next quarter's numbers when there are nearly 9% unemployment rate out there? Will these workers spend? And what in turn happens to corporate earnings then? Economists of a better ilk call it the paradox of thrift; in that, more savings is not necessary good for the wider economy. Paul Krugman had weighed in similar words recently too.

(3) Is the deflationary beast slayed and we are back on track?
It was a massive, do it at all cost boost given by the US authorities. Unlike Japan which used quant easing after the economy sanked into the pits, USA is using it before it really went into the quagmire. So, herein lies the crucial difference. The massive quant easing after Oct 2008 may well have plastered a lot of band aid over the sputtering machine to keep Pied the Piper going for a while more.

Its true that a lot of the quant easing programs have a short time span to it, ie, they will expire in the next 12 months or so. But we could totally see the authorities extending it again if it was necessary to prop things up.

(4) So what's next for the world?

We all knew the eventual destination of the rats in the town of Hamelin. We may be able to avoid hyper inflation. But higher inflation also seems like another inevitable too. So net net, the world could be a low growth and higher inflation place. Until maybe China changes its economic structure. So whilst focusing on cheap stocks, it will not hurt if you prepare for this next inevitable of higher inflation in the medium term because all the quant easing measures to fight deflation may well bring about higher inflationary pressures in the medium term.

In a few years out, asset inflation may also be inevitable then with real rates possibly being negatively currently. Shrewd investors may wish to consider how to hedge or position oneself to profit from this inevitability.

(5) Last Words, MOS?

If you have taken a monster coaster, you will know that the best way to go about it is to either look far out into the horizon or have your hands firmed gripped around the handle bars or do both.

Markets unfortunately are going to be very volatile from this point onwards. Participants in the market will find that they are almost like riding a monster coaster. To get over the fear of it, you should look out into the horizon - at the medium and the long run of the business. And by holding onto your handle bars or seats, the parallel would be having a strong grasp of fundamental valuations of your investee companies. That's has been and is the only way to "survive the ride".

Feel free to drop comments with your opinions.



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