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.

Canaries in the Chinese Coal Mine

In MOS' last post, we spoke about the possibility of how this global exuberance may all come tumbling down when China's searing run stops. In today's column, MOS explains why we now net sellers of holdings after evaluating the Chinese environment.

Bubbles usually come to an end when the common man gets overly involved in the stock markets. In the local Chinese press, a cleaning lady was actually feted as a "Stock market Wizard" after managing to double her money in recent months (And we know that tomorrow's weekend papers in Singapore will carry an article about a gentleman who made S$100,000 in the last few months). Stories of rapid and large gains are abound in Asia today. As such, the public without trading accounts have rushed to open one, eager to partake in the strongest bull-run since 2000. Figures we have seen suggest that the number of A share accounts opened in Apr 2007 have more than doubled that of Feb 07.

"Liquidity" was certainly awash in the markets for the average Chinese household has one of the highest savings rates in the world. Hence, another milestone was brushed aside with ease last week. The turnover of the Chinese domestic markets hit US$50 bil, more than the rest of Asia combined. Its mind boggling for the latter pool includes the more established financial centers of Hong Kong and Singapore. The measure of trading mentality also shows that participants' trading horizon has also shortened considerably. The turnover velocity measured by the annualized daily market turnover as a percentage of free float market capitalization, has been rising steadily; underlining the extent of churning in the Chinese market.

Older investors blessed with elephant memories will recall how the Taiwanese stock market staged a similar rally in the early to mid 1980s. Tellingly, before the Taiwanese bubble cracked, everyone was dead certain that the "liquidity" will keep the party going. As a result, the turnover of a single Taiwanese market had also exceeded that of other Asian exchanges as everyone had to jump onto the back of the raging bull. We run the risk of performing "mental data mining" but doesn't this remind you of state of affairs in the mainland market today?

The Chinese stocks have come a long way since bottoming in the summer of 2005. In 2006, the Shanghai index was up 130%. We believe, from memory, that it has turned in another sterling 50% in this year to date. Simple valuation measures, if anyone is still looking at them, such as the PER indicates that over 1000 Shanghai A shares are trading at close to 50x last year's earnings. Simply put, a investor today will recoup his investment only in half a century’s time unless earnings surge by leaps and bounds. The typical retort when we raise the foregoing is that earnings growth can justify such valuations. But in a country where data availability can be slow and unreliable, it is difficult for us to conclusively put a finger on earnings momentum. It is also MOS' belief that if one searches hard enough, one would stumble upon a valuation yardstick which justifies today's price. If all else fails, try eyeballs or cash burn rate.

Since we are in this light hearted vein, it is worth pointing out the exercises which some undertake to support today's prices. The latest we have read is in a prominent Hong Kong newspaper. The author moved the Shanghai index back by almost two decades to illustrate its parallels with the Taipei bull-run in the 1980s. The result? The former potentially have room to quadruple (yes, quadruple isn’t a typo) in the next year. Despite proffering some economic similarities between the two markets, we cannot help but wonder if this is a case of data mining. However, it is to the author's credit that the article ended with an ominous warning - that the resultant crash in Taiwan was so hard that today's prices are barely half of the peak then.

The other must be the prevailing "market wisdom" about the Chinese market. That the Chinese government cannot let the euphoria vanish abruptly because the 17th Chinese Communist Party Congress meeting and the Beijing Olympics which will be held at the end of this year and in 2008 respectively. We have not been able to fathom the economic reasoning behind this but financial history is littered with examples of how "wisdom" came unstuck. Or how the "January calendar effect" disappeared after investors engaged in one-up-man-ship and started buying in the prior December.

The canaries in the coal mine have started chirping. In recent months, it has almost become an agenda item for Chinese officials to talk down the market. The latest to warn about this irrational exuberance was "Superman" Li Ka-shing, arguably Hong Kong's most shrewd businessman.

We are not full time journalists or bloggers. So thoughts for this piece were progressively jotted down since Thursday evening. But before this was fit for public consumption, we hear news of that the Chinese authorities have put in a "triple whammy" of measures to rein in the market. This includes widening the RMB's trading limits, upping the domestic interest rates and reserve requirements of banks. The latter two may cause a liquidity retrenchment and panicky retail investors who have not experienced a bad hair day may stampede for the doors.

We are also not fortune tellers with a crystal ball on markets. We are strictly "extreme value investors". Hence, we often have cakes in our faces when our macro calls go awfully wrong. But, to us, it’s better to be safe than sorry. Hence, we have raised substantially more cash than before by liquidating our non core positions. For we prefer to bypass the last few pennies on the financial highway rather than risk permanent capital impairment.

This Time It's Different

Regular readers of MOS will know that we have turned bearish several months ago. The market may go up tomorrow and the day after but the probability of a huge crash simply increases. In fact, we have been issuing "warnings" about possibly how hyper-extended this market was. But, a complete correction never quite came. Yes, we were prescient in calling the February sell-off; but the massive bloodshed that would create enormous value on the Street never quite materialized.

So, is this time different? Absolutely. We are living in unprecedented times. Unprecedented to the extent that every conceivable asset class that we know of, from real estate to infrastructure to commodities to junk bonds, are trading at steep valuations. Look at the estimates in the list below. Simply put, there isn't any asset that is sufficiently cheap to entice loss averse guys like us.
Estimated cumulative performance of key asset classes (Mar 02 to Mar 07):
Equities -

• S&P 500: 36%
• Russell 2000: 68%
• Energing Market equities: 221%

Bonds -

• US government bonds: 28%
• US junk bonds: 64%
• Emerging markets debt: 87%

Many institutions still keep an eye on US numbers to serve as a barometer to the world economic growth. This is in line with the thoughts that "when Uncle Sam sneezes, the world/tiny Singapore catches a cold". But MOS thinks that this exercise is becoming increasingly meaningless. We should instead be looking to China. The rising superpower that is mopping up American debt. The "Joe Chink" that is working hard and lapping up assets of the "Stars and Stripes". It has kept the latter from imploding despite running a trillion dollar current account deficit. Indeed, one of the indicators investors buying into emerging countries watch is the current account deficit as a percentage of its GDP. 5% is usually the level institutional managers get nervous and when they would prepare to yank their monies out and sending its currency in a downward spiral. Is the US too big that it defys the laws of conventional macro-economics? Or will there be a time for payback?

Its true that Chinese companies are, likely to be at the behest of the government, making attempts to correct the deficit. PC maker, Lenovo, recently inked a deal to purchase operating systems from Microsoft. There will be more purchases to come. But we consider this to be just a signaling exercise which will not correct the root problem.

We are big fans of the Americans. A global policeman, friendly people, beautiful cities and of course, who can forget the American Dream. But unfortunately, trees do not grow to the sky. The Chinese have decided to set up a national agency to invest their assets into "solid"/hard assets. They will be cutting down on their purchases of American paper, to gradually stop funding the American debt. Isn't it almost like dishing out the cold turkey treatment?

Its almost like the leadership baton of this century will be passed from the Americans to the Chinese. Sure, the UK had its glory days, two centuries ago. The last one was America's time in the sun. This century, as it is increasingly suggesting, is going to be China's.

There is a huge construction boom, a housing boom, a stock market speculation fever. Folks on the Mainland are rushing to open security trading accounts. Admittedly the Chinese government has done a great job, in managing to keep affairs humming along. Selective curbs on infrastructure investment, small hikes to bank reserve requirements. Things have been kept on the slow boil. But there will surely be growing pains along the way. When? After the 2008 Beijing Summer Olympics did someone guess?

We do not know when and what will cause this bubble will pop. But the clock will strike twelve and turn much to mushy pumpkins, to many party goers' dismay. But if asked to venture a guess, we will put our money that this house of cards will start unraveling from China.