#1 Investment Weekly – Passing passions

The passionate state of denial of Wall Street’s remaining independent investment bankers is palpable. How can so many smart and innovative people not see the changes on their way? Passion is a powerful force, and it is working its way through the world’s financial markets. Fear, as equally destructive as any of the other four human passions of love, hate, avarice and jealousy, has swept all before it, while avarice, the most cunning of the senses, sits back and wonders what went wrong.

The denial that massive changes are required to the global financial system has been evident since August last year, and was reiterated recently by comments from the two remaining Wall Street investment banks that they can remain independent. True, they have plenty of capital, relative to their recently demised peers, but the issue has never really been about capital – Bear, AIG, IndyMac, Countrywide and Lehman had liquidity problems. Why? Mostly because their business model was reliant on short term funding from other (competitor) banks. How can so many have forgotten Continental Illinois – which grew too fast, got caught and became too reliant on European interbank lines? (see page 242 of the FDIC’s History of the Eighties, Lessons for the Future – http://www.fdic.gov/bank/historical/history/235_258.pdf). Although Bank of America and Citicorp have suffered from the mark down of their investment portfolios, eventually, these portfolios will be entirely written off, but both banks have a rich pool of stable, cheap, retail deposits to fund their remaining assets so they can rebuild their depleted capital. Goldmans and Morgan do not. JP Morgan (Chase) can fund Bears’ businesses, while BoA can fund Merrill. The other part of the equation was leverage and the SEC’s relaxation of this key ratio in 2004. The quote I always use from Willie Purves, the former chairman of HSBC, applies now more than ever: “a bank can never have enough capital”. However, I’m sure Willie would like to add, in the same breath, that the ratio of assets to capital should be prudently managed at all times (good and bad). On both the issue of investments and capital employment the principals have failed the agents. Bosses somehow where so busy counting their bonuses (and figuring out how to avoid paying taxes and which charity/foundation to aid/form) that they were not watching what their agents/traders were doing. They delegated responsibility because they were unfamiliar with what the agents were doing. The bottom line, preferably every three months, was showing wonderful bonuses ahead, why probe into something that wasn’t broken. Also, principals/regulators were watching their leverage ratios rise, but seemed oblivious to the dangers. This was partly due to the relaxation of supervision by central bankers, which had slowly allowed Capital Adequacy Ratios to fall over the years. Even the most conservative of regulators like the Hong Kong Monetary Authority were happy to let the CARs of local banks fall in Hong Kong (although this reversed in 1Q 2008, as the regulator realized the error of its ways).

Capital adequacy ratio of Hong Kong banks (%)

So now we have a situation (actually the same situation of the past nine months – only more pronounced) of banks unwilling to lend (unsecured) to each other because they are not sure they will be repaid tomorrow. Central Banks have solved this issue by opening their balance sheets. This is what central banks are supposed to do – so no problems there (the short term revulsion of doing this will eventually be proven to be wrong – as Hong Kong has learned after the HKMA’s intervention in the local equity market in 1998). In order to solve the rest of the problems, eventually three events will have to happen: 1) the US housing market related investments will be written down to zero (this has almost happened in Hong Kong and the Treasuries’ so-called Troubled Asset Relief Programme will produce the same result) 2) the investment banks will have to find new, cash-rich, business partners (not shareholders), who can finance their very profitable businesses and 3) banks must start lending to each other at rates that reflect no repayment fear. The credit crunch would have happened anyway because commercial banks were running of capital (as they always do as the economic cycle turns down).  On the regulatory side,

When the dust finally settles several investment themes will present themselves. First, many asset prices are currently at big cycle lows. Second, economic activity is still expanding (albeit quite slowly). Third, in order to preserve the new found confidence of the world’s financial system, interest rates will remain low. Those banks that survive the current shake out will be required to live by a new set of rules, which will include a need to rebuild capital ratios back to the levels of the past. This will be achieved with the help of a steeper yield curve. Based on these premises the following actions will prove very profitable: buy equities:sell bonds.

The crush of Hong Kong equity prices in the past week is not justified based on fundamentals, with the equity risk premium currently trading at historic highs. At 10x earnings, the index is at its historic low valuation. This is not a consolidation area, this is a cycle bottom. The overshoot last week means I am keeping 18,700 as the cycle bottom, until it is confirmed that the measures introduced last week are working (i.e. market volatility declines, Libor settles and credit spreads narrow). 

HS Index equity risk premium (%)

Trading patterns confirm that the decline in prices in the past week was due to liquidation pressures (AIG, Lehman, UBS, hedge funds etc), which will eventually abate. There were few buyers during the sell-off on Wednesday/Thursday, as Hong Kong’s up-tick rule effectively bars short selling in Hong Kong (something that is now being implemented elsewhere). But, there was plenty of elevated action in the Index’s futures contract (150k trades a day) because it is possible to leverage (expect the margin to be lifted this week) and short it.

Short-futures covering started the V shaped recovery that I predicted in the last newsletter. The index is now at a cycle bottom, but how it recovers from here will depend on several factors: 1) whether the factors listed earlier will prevail, 2) what will HSBC reveal when it finally decides to do something with its supposed US$8 billion in free capital (besides pull out of the Korea Exchange deal), and 3) how long it will take for the panic to cease (which is highly related to the first two points). There are more changes ahead.

One thing that doesn’t ever change is that horrible sinking feeling in your stomach while watching stock prices fall 10% in a day, for no apparent reason (de-leveraging is causing de-risking, which throws fundamentals out of the [discount] window). I experienced that feeling again this week, and I had to remind myself that it was the same feeling I felt during all the other market meltdowns I’ve seen over the years. It’s a feeling that you can never get used to, but it is also a feeling that eventually goes away, to be stored away in the memory banks until the next time it happens. It’s just a passing passion.

#31 Myopic capital

I’ve described Hong Kong as many things in this blog (artless, apolitical, safe, an illusion etc), but the myopia capital of the world may seem a little far fetched. However, even without searching for information about how myopic various cities in the world are, I would guess that Hong Kong people’s ability to see into the distance is very low. This is not very surprising when one thinks that a building erected in Hong Kong in 1938 is considered an historic relic and should be preserved. Anyone that thinks like this cannot have a real sense of the future.

 

A quick survey taken at a local shopping mall (done while waiting for my wife to finish shopping in a boutique) showed that, of the 101 people that descended the escalator I was staring at, 31 of them wore glasses. I know this might not be a very large sample size, but I reckon 30% might be a pretty accurate picture of the whole of the post-teen population of Hong Kong. But here’s the crunch, it’s this lack of vision that symbolises the short-sightedness of Hong Kong people.

I’m not sure how this thought fits in with the latest fad in Hong Kong right now: the wearing of glasses without any lenses. This new idea seems to cover two bases at once: first the idea that in order to blend in with the majority, it is advisable to wear glasses, even though you don’t need them (in a recent case I noticed a young girl reading a newspaper in the MTR while wearing a pair of black-rimmed lenseless spectacles), the second is that Hong Kong people’s propensity to see short term is in fact an illusion, to disguise the fact that, underneath, we can see as clearly into the future as anyone else.

#30 Wool pulling

Hong Kong is an illusion. Its gleaming skyscrapers give the impression of wealth and stature, but in between the glass and steel there is a massive chasm between the haves and have-nots (gini has been rising steadily), between the cultured and the unwashed masses, between the designer bag and the fake polo T shirt. It could be said that these dichotomies are present in all of the world’s major cities, but, whereas these characteristics tend to be hidden under the surface, in Hong Kong they are open for all to see.

 

Examples of the deception that is Hong Kong can be found at every turn. Advertisers are right at the forefront in the wool pulling stakes. Property developers are particularly brazen, with over the top advertising campaigns that give the impression that they assume the viewer is a complete incompetent, with a few million dollars to spend. I could go into great detail about how the developers use old Europe as a draw card for their latest sales pitch. I have no idea how they are allowed to get away with it, but every new property development since Laguna City has some sort of French word in it. This is a pity, because most Cantonese speakers have a great deal of difficulty pronouncing anything in French (I should know, my wife took French lessons for a while, and her pronunciation of “je” was horrible). The Cantonese palate is not designed to master the sound “je” (or the letter “r” in English for that matter). Italian names are slightly easier to pronounce, but the Italian Riviera is not as well known as the French. Of course, most people will use the Chinese name, which I’m sure are no where near as glamorous sounding as the French or Italian version.

 

The advertising visuals are probably as offensive as you can image. The push is hard and would be very illegal anywhere else. It usually involves a very handsome, young, foreign couple, frolicking about enjoying themselves somewhere Rivera looking. They then usually enter a chateau and are carried off into some sort of wonderland of butlers, servants, horses, Louis XVI furniture, towering pillars and vast vistas. Recently, one of pair of floozies will be a Miss Universe. I find it totally baffling that local advertisers use foreign models for their ad campaigns. I have always insisted that the company I work for only use local people in our advertisements. I do admit it is very difficult to find good looking local models, but I argue that surely there would be a great connection with the target audience if the models are familiar looking.

 

The deception by property developers doesn’t stop at the Rivera and the models, but it extends to the actual object of desire they are selling. The view from the show flat is never typical of the other 99% of the flats for sale. In many cases, the view shown is completely unrepresentative of reality. There is a good reason for this. The depiction of the inside of the flat has been computer generated, because flats in Hong Kong are sold before they are actually built. Amazing, but true – in Hong Kong you have to buy your home upfront before you can live in it. Obviously, the depiction of your dream home in the advertising is exaggerated to the extreme. It’s only when you move in that you realize how unbelievably noisy the place is (road traffic or your mahjong/piano playing neighbours), or how terribly dark the whole place is, because there’s a new building being built right in front of yours. None of these major irritations were mentioned in the advertising – you were told that the chateau in fact represents the teeming club house and the chintzy lift lobby, while Miss Universe is a representation of the beautiful décor of the building. Amazingly, despite the tenacious efforts of the developers, no one in Hong Kong is actually deceived by the crud they deliver. Hard nosed Hong Kong consumers see right through the deceit. Therefore, there is no need for the Government to regulate what the developers say.

#1 Investment Weekly – Hurricane symmetry

For a while, I have to admit, I was very unsure about what exactly was happening to the Hang Seng Index. The index had been whipping around the 20,900 neckline support, while individual stocks were doing things that were not consistent with the news-flow. Then it suddenly dawned on me: the irrationality currently being exercised is the same that was very evident in the 3Q of 2007. However, instead of prices rising for no rational reason: they are falling for no rational reason. This is further evidence, in my view, that the index is reaching some sort of big cyclical bottom.

Here is how the index has performed since the two key days of July 23rd and August 8^th, with a forecast path for the next two weeks. Think of it as the track of a rather erratic hurricane.

Hang Seng Index’s Hurricane path

 

Our big bottom call of 18,700 has remained unchanged since the beginning of the year. Now that the 20,900 neckline is being tested, it is only a matter of time before the rest of the scenario shown on the chart is played out. The decline to 18,700 matches the decline from the July 23 high of 23,100 to the neckline (2,200 points). The perfect balance of the chart (to a chartist) is just like the symmetry of a hurricane – too terrifyingly beautiful to ignore.

A recent hurricane in the Gulf of Mexico turned out to be not as strong as expected, because, according to the meteorologists that study these things, the funnel in the middle of the storm was tilted to one side after it hit Cuba (why this fact has only been revealed now is unknown). The fact that the storm did much less damage than expected has given traders hope that the current downdraft in global equity prices may not be as strong as expected. When it was reported that the US economy grew by 3% in 2Q and Eurozone economic growth is slowing to zero, this was the equivalent of Gustav glancing off Cuba for the US$. With the interest rate differential between the US$ and Euro expected to narrow considerably in the next 12 months, the US$ is sure to benefit, while the price of oil is sure to lose the benefit of its supposed investment safe-haven status. The sharp downturn in oil and commodity prices has introduced some equity liquidation selling pressure, just when equity markets were starting to stabilize. Margin calls on commodity funds are likely to persist for a while which will encourage the dotted line on the Index chart to play out. Always remember that equity markets are primarily a source of liquidity.

This explains why good solid fundamentally sound companies are seeing their share prices plunge, while stocks that are considered less strong (like Cheung Kong) are outperforming on the downside. Take some examples of good doing badly: Esprit reported an in-line set of final results, paid a higher than expected dividend, and announced that it will be keeping its HK$7 billion cash pile dry until economic conditions are right. The stock has fallen 27% in heavy volume since the announcement. This means that the stocks’ forecast dividend yield of 8%, almost matches its 9x PER (a classic buy signal). In the meantime, the company, which bought back its stock at ~HK$75, has not done so at ~HK$60. Naturally, a stock with heavy exposure to German retail sales would come under selling pressure on news of a significant Eurozone slowdown and a weakening Euro, but is wiping out HK$25 billion in market value justified – or is a widely-held, widely-researched cash rich retailer being burnt for being too well liked in the past? Only time will tell. PetroChina’s share price has fallen 18% since this newsletter followed Warren Buffett out of the stock in September 2007. However, 4% of that decline has come at a time of rapidly falling oil prices, which is supposed to be good news for an oil processor. Holders of PetroChina basically can’t win: if the price of oil rises, its margins are squeezed leaving the company beholden on a reluctant, inflation-fighting government to lift price caps on its end products: if the price of oil falls, margins are squeezed less, but the chance of a tax break or rise in its product prices recede. Simple solution: don’t own it. The divergence in performance of HSBC’s Hong Kong and London shares has also been skewed by the currencies they are denominated in. Sterling’s recent plunge has meant that, for owners of US$, the London-priced version of HSBC is much cheaper to buy than the HK$ issue. The parting of ways started on August 8, and the 7% divergence between the two prices has been consistent with the plunge in Sterling (or rather the rise of the US$) since then. Although the ECB’s change in rules regarding the haircut on collateral for its liquidity window is a blow to the revival of financial stocks recently, I doubt HSBC would have used the window extensively, and would have played by the rules (unlike Macquarie and Lehmans). However, it will continue to suffer with the rest of the sector (in either Sterling or HK$ terms).

While the US$ continues its one-way ticket upwards, the RMB’s appreciation is showing plenty of signs of stalling. China’s authorities are unhappy that overseas traders have been able to take advantage of the RMB’s straight-line appreciation since July 2006. The authorities are attempting to introduce volatility to the RMB in order to halt the hot money coming into the country every month. The threats from the authorities are seemingly doing the trick. For the first time in two years, the onshore RMB 1-year Non-Deliverable Forward is stronger than the offshore rate. Investors in Hong Kong equities, therefore, have had to deal with two major changes in direction of the currencies most associated with Hong Kong equities – at the same time. I suspect this is the main reason why Hong Kong equities have persistently underperformed the rest of the world in recent weeks.

HS Index vs Shanghai Composite, EAFE and DJ Industrial (rebased to 100)

 

Despite the doom and gloom, not everything is quite as bad as it seems. Coca-Cola’s bid for China’s biggest juice maker is a timely reminder to investors that there is huge potential in the mainland’s consumer market. Telefonica has increased its stake in China Netcom. While, it’s not too surprising to hear that Wal-Mart has just chosen Hong Kong to be its regional headquarters. A local bank has just splashed the cash on a new commercial building in Central, paying a record amount per square foot, while a Kuwait housing fund has just spent billions investing in a property development by Nan Hai close to the border in Shenzhen. In other words, when prices eventually become compellingly cheap, as equity price will be with the index at 18,700, smart investors will be vigorously snapping up the bargains in expectations of a one-way-street to higher prices. This should produce a V-shaped bounce, with a strong chance that the index will be at 24,000 in October. As far as I can see, there are no more asset bubbles around, except the massive cash holdings of institutional fund managers. So, be patient for a few more weeks, as the final storm of the cycle is about to pass.

#29 Hong Kong songs

I can only think of two songs about Hong Kong, that are any good (although there is also an honorable mention in a third). The first is Siouxsie and the Banshees’ “Hong Kong Garden”, and the second is Gorillaz’s “Hong Kong”. I reckon both songs were written based on personal experiences from visits to Hong Kong by the authors, otherwise they would not have been able to paint such an accurate picture of Hong Kong. Elvis Costello’s Oliver’s Army is about the British army’s role in keeping the peace, so Hong Kong is mentioned as being “up for grabs” in this 1979 political commentary.

The Siouxsie Sioux version was written in 1978, and is therefore quite dated. Although the song was influenced by a Chinese takeaway in Chiselhurst, she has inadvertently added sights and sounds that would have been quite common in Hong Kong at the time. Damon Albarn on the other hand has produced a more up dated description of Hong Kong, with the change-over in sovereignty mentioned in the lyrics, as well as references to RTHK and the border. I’ve posted versions of both songs here with my interpretations of what the authors were trying to say.

As the late great John Peel would say: here are Siouxsie and the Banshees:

Here are the rather clever lyrics – if you’d like to sing along:

Harmful elements in the air
symbols clashing everywhere
Reaps the fields of rice and reeds
while the population feeds
Junk floats on polluted water
an old custom to sell your daughter
Would you like number 23?
Leave your yens on the counter please
Hong Kong Garden
Tourists swarm to see your face
Confucius has a puzzling grace
Disoriented you enter in
unleashing scent of wild jasmine
Slanted eyes meet a new sunrise
a race of bodies small in size
Chicken Chow Mein and Chop Suey
Hong Kong Garden takeaway
Hong Kong Garden

The lyrics for Hong Kong Garden are crammed with stereotypes – most of them were correct at the time. One obvious mistake in the lyrics is the use of yen as the currency of exchange for Hong Kong. We have our own, quite unique dollar. I suppose the word “dollar” would have stretched the phrase, but she could have used “bucks”. The other “mistake” is that you can’t buy chicken chow mein or chop suey in a restaurant in Hong Kong. These dishes are American inventions, that have been transported over to the UK.

I‘ve posted the interesting part of the lyrics of the Gorillaz song about Hong Kong here:

Lord, hear me now
Junk boats and English boys
Pushing out in super malls
Electric fences and guards
You swallow me
I’m just a pill on your tongue
Up here on the 19^th floor, the neon lights keep me calm
Peer along the hill, what you’ve been learning in school, is the rise of an eastern sun, gonna be alright for everyone.
The radio station disappears
Music turned into thin air
The DJ was the last to leave
She had well conditioned hair
Beautiful, but nothing really was there.

For non-Hong Kong residents, these insightful lyrics by cyber-band Gorillaz’s Damon Alban require some explanation. The plea to the Lord, at the beginning, is to both the Lord above and anyone else in authority. He is begging for attention because he believes he is witnessing the decline of Hong Kong. The junk boats and English boys no longer exist. Alban is referring to Colonial Hong Kong and its (still) famed reputation for shopping. The electric fences are still at the border with China (but are slowly being dismantled – along with other signs of the colonial past like Star Ferry and Queen’s Pier etc). Hong Kong is being swallowed up, but it is bite-sized morsel compared to China. As we are constantly being told (re-educated), China (which can be seen from the top of Lion Rock Hill) is big and getting bigger – fast. She will therefore be able to save us from anything terrible that might crop up (SARS, stock market volatility etc). The radio station refers to the battle for control of the last bastion of “free speech” colonial civil service – Radio Television HK (stationed on Broadcast Drive). Alban assumes it will disappear and along with it Hong Kong’s relevance. Hong Kong is superficially beautiful most of time (in a concrete and glassy sort of way), but it has nothing at its core, (it’s just a vacuum with a wealthy benefactor).

Elvis Costello’s Oliver’s Army was written on a journey back from Belfast in 1978 and refers to the role of the British army in its various (fast reducing) outposts of the British Empire. This explains why Hong Kong was mentioned. The lyrics, “Hong Kong is up for grabs” may refer to 1) it’s a nice posting for a young soldier or 2) it could refer to the possible change in soverignty in 1997. However, as the negotiations for the handover had not really started when the song was written, I suspect Elvis may have been referring to the former of the two options.

Here are the lyrics that refer to Hong Kong:

Hong Kong is up for grabs
London is full of Arabs
We could be in Palestine
Overrun by a Chinese line
With the boys from the Mersey and the Thames and the Tyne

 

 

 

Despite the almost 20 years difference between the release of the two Hong Kong titled songs, both use the same visual images when describing Hong Kong – in particular the ubiquitous junk and the pollution. Both artists also mention the fact that Hong Kong can be quite a daunting place because of the crowds of people (“disorientated you enter in” and “you swallow me”). I think it’s fair to say that both sets of lyrics are quite naff and steriotypical, but bearing in mind the limited delivery channel (a 3-5 minute song) and the author’s brief knowledge of the subject matter, both are not bad attempts at capturing the essence of Hong Kong.