Sunday, November 01, 2009

Running on Empty

This post is at least a week late. Various committments had conspired and led to what should have been a late October post to turn into a 1 Nov one.

About ten to eleven months ago, we asked whether "we can have a last flutter?". Many readers were astounded and questioned our sanity. Fortunately, equity markets have heeded our request and delivered one of the most stunning recoveries since the Great Depression. The recovery in price performance is so strong that it seems detached from the underlying economic and market fundamentals. So it is worthwhile to check back to ascertain whether this is inherently sustainable.

First, it is important to understand why we wrote that in Dec 08 that we "cannot rule out the possibility of the largest ever January effect taking place". Our call was made on the back of the direct consequence of the monetary easing and fiscal expansion; actions coordinated by all global economies. Hence, the strong subsequent surge in equities was due to the flood of liquidity or easy money in the system, not an actual recovery in fundamentals.

Fast forward nearly a year. Things are indeed looking up but it would be foolhardy to think that we are out of the woods yet. A debt deleveraging crisis is inherently debilitating and countries like the US still have a ton of debt, including that in commercial property space that remains yet to be tackled. However, a lot of emergency stimulus measures put in place last October at the height of the crisis expired in end October this year. Whilst the market does not require some of these measures such as those designed to restart money markets, due to the inherent recoveries, liquidity in the system cannot be said to be as abundance as before.

Likewise, in China, whilst Premier Wen may be asserting that headline monetary policy stance remains loose, folks on the ground are reporting otherwise. Bank lending in 4Q09 are not as easy as that of the record RMB 7 trillion extended in the first nine months.

Also, certain governments such as that in Australia are mindful of inflation, and have started hiking rates.

We write this with the STI closed at 2651 and S&P 500 at 1036. At these levels, we feel that the downside risk outweights the upside potential because (a) liquidity conditions are not as strong as before, (b) fundamental recovery has not taken root to support current equity valuations. In plain English, MOS expects markets to correct in the months ahead.

Despite the bold assertion in the preceding paragraph, we have to stress that we do not possess any magic crystal balls. It is just an outcome we believe should happen given our analysis of fund flows and market dynamics. If we are right, MOS will be in a much better position to capitalise on the resulting carnage. As net buyers in the long run, we welcome any correction in the market as we plough through company after company in search for fundamental value. This is also not a recommendation to short markets as they can stay irrational for longer than one can stay solvent. It however should represent an opportunity for an investor to trim or unload any fundamentally weak positions into this period of strength, given that we expect rougher waters ahead.

We had a good time last night, indulging in the various "Trick or Treat" festivities that characterize Halloween. But without future government intervention, we leave the month of October with a niggling suspicion that the haunting and spooking of markets could linger on for much further, into the weeks and months ahead.