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Friday, August 24, 2007


The amazing aspect of this financial crisis was that the financial sector actually fared quite well compared to others sectors. Partly this reality can be attributed to concerns about sub-prime exposure earlier in the year and partly to the fact that the energy & raw material sectors had performed the best before the crisis. As a consequence, in the year to date financial stocks fared the worst on the S&P500, falling 7.2%, but in the month of the crisis they fell only 5.25% compared to a 6.8% fell for the broader S&P500 Index or the 10.5% ($2.2 trillion) during the 4 week crisis, compared to a loss of $5.8 trillion between Mar-2000 to Oct-2002, which was accompanied by a short recession. The implication is thus given the health of US balance sheets a subdued US economy, but not a recession.
Given that this was a financial (sub-prime) crisis you might have expected the losses to have been largely restricted to the financial sector. But it was not just a case of investors worrying about non-disclosed non-performing loans, the sell-off reflected a deeper problem.

The rationale for the equity sell off
The rationale for the sell off lies in the nature of the crisis itself. The panic arose when the sub-prime mortgage-backed security holders realised that they couldn't sell or price their exposure in the market so that they could sell them. This forced these investors to raise capital, and by the time the problem had hit the market, their financiers were demanding margin calls. This forced sub-prime security holders to sell their quality assets to cover their illiquid positions. Hedge funds and others were thus forced to sell everything as markets continued to fall, so a snow-balling liquidity problem emerged, which was only stalled when the central banks and bargain hunters moved back in the market.
Clearly there was a ‘flight to quality’ which resulted in a stronger USD. Surprisingly the panic resulted in even low-risk investments like municipal bonds and hospital stocks being sold off, whilst quality smaller stocks fared even worse, particularly those stocks exposed to the discretionary consumer, energy and raw materials sectors. The sell off was not totally irrational, given that during a credit crunch small stocks have the greatest difficulty raising capital – whether as loans or equity. Thus its understandable that the Russell 2000, a small-cap index, should fall more than the S&P500 or Dow Jones Industrial Average (DJIA). But the extent of the fall should highlight the systematic risks inherit in the market.
Individual investors added their share of panic to the market as they were not immediately in a position to know the extent or ramifications of the crisis. All 10 sectors of the S&P 500 fell between 2.6% (for consumer staples) to 12.76% (for the energy & raw materials sector). The reason of course is that investors perceived this crisis as signalling a downtrend in the economy and a softening in retail sales and commodities demand. Its interesting that the contagion was even worse in commodity producing countries like Australia, South Africa and Canada, which experienced plummeting currencies that would only preserved their local dollar earnings, even though commodity prices did not fare so bad.
But there is another reason why certain high-yielding currencies were signalled out – the carry trade. The yen carry trade involved Japanese financial institutions placing their low-yield institutional funds in higher yielding commodity markets. When there is a loss of confidence in Australia and other countries, the Japanese unwind those currency trades, resulting in a rapid drop in the $A and NZD. The worst performers were the smaller, less liquid stocks. But we must remember that the smaller stocks were trading at significant premiums prior to the crisis so they were always more vulnerable to a correction.

What can we say about the meltdown?
1. There is no question that markets are unstable, and for this reason markets are in need of greater information. This is a financial crisis, not an economic crisis. The problems started in the sub-prime credit market, investors panicked masse, leaving the Fed merely trying to prevent a self-fulfilling prophecy.
2. The sub-prime crisis took on a global magnitude as a result of European and Asian bank exposure to property foreclosures in the US market, giving investors reason to think the crisis was bigger. In reality the risks were distributed more widely.
3. The confidence problem emerges because the financial industry has created an array of new debt instruments that are hard to price, particularly in times of uncertainty. Really they were attempting to make products commodities (securities) which were never really commodities. Because these products don’t offer the same level of transparency as simpler instruments, in bad times the liquidity evaporates and the result is a market crisis. The problem was this crisis arose in one of the biggest credit markets, even though it represents just a small fraction of it. The problem was inadequate disclosure to reassure markets.
4. The crisis does however highlight a poor capacity of credit rating agencies to quantify risk, or a preparedness of the agencies to overlook certain risks for the sake of profits. The situation is reminiscent of the auditing fiasco a decade ago when the major auditing companies came under attack for conflict of interests. The credit rating agencies or investors needed to understand the nature of the instruments they were trading – they didn’t. The risk assessment was just not adequate.

What can we say about the Fed response?
The European Central Bank, the Federal Reserve and other central banks acted quickly to pumped hundreds of billions of dollars into the world's banking system, the largest injection since the 9/11 tragedy, when the Fed injected $334 billion into the markets between 12-19th Sept 2001. The actions by the Fed were an appropriate step towards restoring confidence in the banking system. Nevertheless:
1. Liquidity is only a short term measure. If the markets experience another shake out it will be because of further bad news lacking perspective. This just might give us a double-bottom entry into the market.
2. The Fed decided not to cut interest rates on the 7th Aug 2007, insisting that inflation was the greater threat to the economy - not credit disruptions. This is a sign that the Fed has a more realistic assessment of the problem.
3. The Federal Reserve will need to lower the Fed rate if they want to soften the impact of the sub-prime crisis.
I believe the Fed will NOT lower interest rates because of the greater concern about inflation, and its clear that a market anticipation of such a cut might undermine the market at a later date. I think at some point the market will conclude that the global economy is in good shape, even if the US market will be subdued for several years. It also makes no sense for the Fed to ease credit conditions for financial institutions since the financial institutions are only going to tighten credit conditions upon consumers.

What is likely to be the short term impact?
We can expect that there will be several short term impacts:
1. Credit growth will slow as banks lending activities take a hit, and their profits will tank for 2007. And credit growth is likely to fall longer term as interest rates rise. We can expect the banks to focus on their wealth management divisions as we experience a recovery in broad market equities.
2. Markets are in good condition: Investors need to place the current financial problems in perspective. The credit risk in the USA will affect only a small portion of the USA market, so the ramifications for the global economy are quite small. The global economic fundamentals are excellent. Equity market valuations are reasonable, interest rates are still relatively low, employment growth is strong, and global economic growth is booming.
Some of the selling is not unwarranted in those sectors exposed to the US property and financial markets, as well as US-based retailers who will face some exposure to lower consumer spending as US household mortgage payments rise.

So is there a long term crisis brewing in the long term?
As the dust settles it is clear that there is a short term and longer term problem. The central banks injection of liquidity was an appropriate response to the short term panic, so the immediate threat has been addressed. There is however the threat of more bad news, though it is likely to be tempered. Franklin Roosevelt once said that "the only thing we have to fear is fear itself". He made this assertion upon shutting down the nation's banks in 1933 as he assumed the Presidency. The good news is that the Fed will use this opportunity to assess the risk rating procedures of banks and credit agencies, to avert a similar flight of confidence in future.
There are 2 concerns for the Fed:
1. Inflation: The Fed, along with other central banks, are worried about inflation. This is a global problem of much greater global ramifications than a segment of the US property market.
2.. Weak property markets: We must remember that the sub-prime crisis is a problem for poor households as well as aspirational property investors in the USA. Regardless the weakness in the US property market will affect spending there, but we must remember that US households don’t look at their house values in a way which would affect their psyche, at least until it results in higher mortgage payments, and so far interest rate increases have been subdued.

So what is an investor to do?
BUY! BUY! BUY! The recent collapse in equity prices was an over-reaction sparked by institutional demands for liquidity. The global reach of the sell-off was really a manifestation of foreign institutional exposure. Clearly the best buys are those sectors that suffered the most during the sell off, so:
Commodity based currencies are going to benefit from retention or recommittals to the carry trade
Commodity (raw material & energy) stocks are likely to recoup the losses they experienced over recent weeks
Small cap stocks that we particularly punished are likely to experience the best recoveries.
There are already signs that this is occurring. The Yen was weak last weak, as Japanese fund managers re-entered forex markets to buy AUD and NZ. The commodity sectors were the strongest sectors of the economy – particularly the smaller quality stocks like Matrix Metals – up 40%.
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Investment Strategy

If you are investing for the long term, you still need an investment strategy. Dont be fooled by the rhetoric of fund managers. The reason they advise you to 'buy & hold' is because they dont want to compete with you in sell-offs. Markets and industrial sectors are cyclical, so they demand trading to get the best returns. Fund managers actually cant hope to match the performance of small investors (if you are half good) because they have to manage huge amounts of funds and charge you a fee besides.
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