12th January 2009

When Pessimism Can Be A Good Sign!

If last year’s predictions were far too optimistic then I suppose we can draw some comfort from the fact that this year’s commentaries seem universally depressing. However, we cannot get away from the fact that the financial news and the background economic environment is bad and likely to get worse before it gets better – well a happy new year to you then!

The good news though is that a lot of this bad news has already been factored in, with some investment houses thinking that the fall in certain valuations may have already gone too far.

Credit Suisse in a recent paper highlighted the risks around the debt and bond market “Overweight corporate bonds. We believe credit offers exceptional value. We continue to believe that credit offers much better value than equities,” and further“the implied 5-year cumulative default rate is 64%. This implied default rate is considerably higher than the historical peak in 1935, when the 5-year cumulative default rate hit 46%”. They would also stay slightly overweight equities... for an impressive six reasons, which one may or may not agree with:

1. Credit offers very good value—and if corporate bonds rally, so should equities.
2. Equities offer deep value as long as we avoid sustained deflation.
3. Equity markets trough 2 quarters before the trough in earnings (this can be up to 5 quarters) and about a quarter before the trough in the ISM survey.
4. Policy makers have recognised the severity of the crisis—and are responding.
5. At the November low, this has been the worst year for equities on record (with data going back to 1871).
6. Bear markets can see rallies of up to 50%.

Most of the tactical indicators suggest that the preconditions exist for such a rally even if it is just a bear market rally. So there are positive indicators around for those who wish to see them - but in markets like this, such attitudes are usually ignored - bears go deaf.

Anger... however, the feeling I have is not so much that the world is just pessimistic but rather that it is angry over what has happened and how people feel. The riots in Greece are just one symptom of what is happening. There is anger over bailouts for bankers (even if they are needed), anger over politicians for getting us into this situation (even though many others are to blame) and anger that the good times are over, along with fear as to what might happen next. With falling living standards, which is also a euphemism for some of starvation, higher unemployment and lower growth, many will have good reason for their anger.

One of the angriest groups is likely to be the seething population of the Chinese conurbations. Although still growing, the Chinese economy is stalling. From double digit growth to levels down to 4 or 5% may still sound positive to us in the West but feels like the brakes being slammed on whilst travelling at 70mph – it will feel like the worst of recessions to those suffering it.

The fury will come from the disillusionment of all of those who feel that their opportunities have been taken away from them – through no fault of their own. Revolutions have started on less – not good news for the communist government who must also be grating their teeth that their dragon economy has been brought low not by the failure of communism, but by the crisis of capitalism. 2009 will be a sensitive year for that nation and no doubt disturbances will occur - perhaps some may recall that it is the 20th anniversary of the student uprisings of 1989.

Following on from the Madoff scandal (and one of the clues has to have been in the name!) the crucial issues here are not so much the fraud that may exist elsewhere, but rather a series of related issues. These would include in my view:

• lack of clarity in that you cannot see what is really going on.
• lack of understanding and evidence of investment process and discipline.
• lack of liquidity in assets invested in. So when withdrawals are requested the firms cannot pay – these are the wrecks left high and dry in the bay after the tide has gone out.
• but crucially the asset cannot be “marked back to market” for a real valuation.

Those investment managers who do not carry out this due process and discipline will be found wanting – as some have already. There is no replacement for due diligence on investment funds and managers and committing substantial sums of clients’ money on what seems to be no more than a blind bet is not stupid – it is irresponsible.

Thus I believe that there are going to be various fund houses in London who may well come under such pressure where and when more investors want their money out than those who are putting money in.

More pain here I suspect. This is not a “might happen” in my view – but a “will happen”.

Just how big is the US bailout? My colleague Alex Scott found this fascinating pair of pie charts which I think puts into perspective the cost of the US bailout. These figures, which have been adjusted for inflation, are still huge but at least it shows the extent and value of the actions being taken. Whether this is value for money we will not know for some time to come.

Happy New Year to our Orthodox cousins.

Justin

Next Week

Monday 5 January

Tuesday 6 January

Wednesday 7 January

Thursday 8 January

Friday 9 January