I couldn’t resist it: as soon as I got home last Monday, I searched the web to listen to the jolliest song about Armageddon I know: REM’s “It’s the end of the world as we know it”. I was particularly keen for my children to listen to song and the punch-line, “and I feel fine”. It may turn out that October 27th will be the bottom of the current down-cycle that many commentators are dreaming of, and that, from now on, the world as we knew it prior to last Monday has ended and a new era has just begun.
It is important to point out that the Index closed above 13,000 on October 31st. That was crucial because 13K represents the bottom of the rising corridor that the HS Index has been traveling through for the past 20+ years. This means that, assuming the bottom of the range remains in tact in the next few months, the HS Index can continue to achieve new all-time highs in the future. But how will it get there this time around? And how different will this be compared with the past?
Bull markets are characterized by favorable comparables and the prospect of economic recovery. The standard tool for economic stimulus is interest rates. Cheap money encourages risk taking (by driving cash to work harder than simply leaving it on deposit) and supports existing businesses (by lowering operating costs). Interest rates are trending lower on a global scale – thus aiding economic activity. As interest rates fall, the desire for higher yields on cash will naturally distribute cash into various asset classes depending on their risk profile. Equities have, and always will be, a high risk category. But, efficient frontier theory consistently shows that including equities in an investment portfolio can lower risk and increase returns. With cash levels at institutional investors at record high levels, demand for equities should eventually kick in.
Although conditions remain for a normal cyclical upturn in equity valuations, there maybe some stumbling blocks to hurdle as the new cycle unfolds. First, equity risk premiums of the past may not be a good indicator of what should be used as an historic average. Conditions after the debacle of the past 12 months will be very different to anything seen before.
There will be some basic similarities. First, anthropologists can attest that changes in the basic characteristics of complex living organisms take eons to fully establish themselves. I am assuming therefore that human nature has not changed despite the turmoil in the world’s financial markets. We will continue to want the best for ourselves and our offspring. If that means being selfish and greedy and all the other passions that mark the human race, then I believe these foibles will continue to dominate human behaviour in the near future. Although I lambasted our passions for getting us in the current mess, I do not believe that the drive to innovate and succeed will simply vanish.
I’ve heard tell that, for most of the 1970s, investors shunned equities after the terrible experiences of earlier investments in the 1960s (the oil shock didn’t help sentiment). This explains why the 1970s were such a terribly depressing time (I should know, I grew up through it). Risk aversion was at its height and social discontent was everywhere. Instead of starting a mechanical war (i.e. as the world contrived to create after the 1930s depression), there was a class war which lasted most of the 1970s, and which was eventually won by the free-market capitalists. That hard fought win cemented the world we know today. Although I am sure that as global unemployment rates rise, labour unions will attempt a come back, but I can’t see a Democratic run US, or Labour UK, giving up on the centrist positions that have served the left so well. The right to choose will remain.
Portfolio management (also known as choice amongst asset classes) will remain the cornerstone of the capitalist system, and within this framework, there must always be room for equities. However, there is no doubt that, in the early stages of recovery equities will be afforded a higher than average risk premium. This should diminish over time, but I believe it is fairly safe to say that I will not see a negative equity risk premium in my lifetime. The Hang Seng Index traded at an earnings yield below the 10 year bond yield in October 2007 – never again.
The main drivers of the risk premium are: price, earnings and bond yields. As it is relatively certain that interest rates are going to remain at depressed levels for a while, the main focus for investors wishing to determine the fair price of a stock should be its earnings. Most concerns are focused on the impact of a recession on Hong Kong non-financial corporate earnings. Currently, most profit warnings have been related to losses on derivative-linked investments (CITIC, BEA, BoC (HK), HK Catering, Kowloon Development etc), while borderline companies (U-Right, various restaurants etc) have taken the opportunity presented by weak sentiment to exit businesses. Even assuming Hang Seng Index profits decline by an unrealistic earnings depression-like 50%, this would raise the PER to 18x, meaning the index’s equity risk premium is still 3% (1/18*100 – 2.4%). This would put the premium at a standard deviation (1.93%) above the long-term average of 1.09%. This should be more than enough buffer to satisfy nervous equity investors. Fortunately, earnings had not been inflated prior to this bear market, so we are unlikely to see profits decline by 50% (the last time Hong Kong saw 50% declines in earnings was after the tech bubble burst).
So, while earnings look close to the bottom and valuations look compelling, there is still likely to be a premium attached to the equity risk premium going forward. This means that future returns of Hong Kong equities are not likely to be of the same magnitude as before.
Demographics will also play a part in determining the risk premium of equities over bonds. As the baby boomers reach retirement, their demand for bonds should rise, and equities should fall (the proportion of bonds an investor should own within a portfolio of investments should match the investors’ age – 50% for a 50 year old etc). Finally, I am still hearing investment advisors talking about structured equity investments as a means of providing downside protection as well as the upside gain (although I’ve also seen write-ups by experienced fund managers describing accumulators as something more associated with a racecourse). The private banker may well continue selling structured deals to her customers, but their general acceptance will not see the light of day for at least a generation. The prevailing rule of thumb will be: if it’s too good to be true: it probably is. This means that derivative traders and structured creators are going to be a lot thinner on the ground in the future. This is generally good news. It pains me to see good, solid, family-run, companies like Kowloon Development and Hong Kong Catering suffering huge mark to market losses on structured investments sold to them by fly-by-night investment bankers who don’t even live here and have pocketed last years’ bonuses. I have less sympathy for bankers that are marking down their investments – they should know better because they are selling these same products to their customers. Simple: if you don’t understand what it is your investing in, don’t buy it.
Another major change will be the attitude of commercial bankers (investment bankers will no longer exist in their current guise – so we can dismiss discussing them). Plain vanilla will be a phrase that will gain in popularity in the future. No more of this cross selling of products that commercial bankers have no business dealing with. The instructions from bank board rooms will be: don’t show me a yield enhanced product, we will accept lower net interest margins while interest rates are low, because protecting shareholders’ funds is a strict priority (as if it wasn’t before!). The basics will rule: bankers make as much money losing less (i.e. through risk assessment) than they do chasing returns. This attitude will alter the investment environment, with credit lines and margin more closely scrutinized. It will also result in greater demand for straight up and down government bonds that will be held to maturity.
Talking of held to maturity: Deutsche Bank’s 3Q numbers were better than expected because of an accounting rule change allowing the bank to book investments as held to maturity, thus allowing any mark to market differences to go direct to reserves, rather than via the bank’s profit and loss account. The new rules were revealed at the result announcement, even though the accountants approved the change in early October. Isn’t it ironic that the accountants’ main argument for sticking to their guns/principals on mark to market accounting is because it improves transparency? Yet, the market seemed surprised that Deutsche was allowed to make the changes that lifted their profits. It would appear that the accountants or the banks had not informed the market of these changes. How transparent is that? I am sure that when the dust settles, the accountants will slowly, without warning or public announcement, change the way that investments are carried on bank balance sheets.
No more Alpha. Hedge fund managers (and their Private Equity brothers) have, for many years, believed that with all their brains, egos and computer modeling, they can not only beat the market, but produce positive returns – even in down turns. They were incentivised to try, and while the markets rose four years in a row, it looked like they could do no wrong. This model is now unraveling and those that have attempted to replicate the alpha model will have to rethink how their businesses will be conducted in the future. For one thing, I suspect the hard-sell approach adopted by many local banks will be dismantled. Bank sales staff will be released from the burden of meeting monthly/weekly/even daily sales quotas, while commission based compensation will also have to be reviewed. I suspect that your local bank officer is going to be much less pushy, and more content to listen to your needs, rather than constantly thinking about meeting sales targets. I also believe that quarterly reporting will not be introduced in Hong Kong and could even be reversed in some major markets in the future. The new philosophy for CEOs should be: you can’t beat the market over the long run, because eventually, everything returns to the mean.
This week’s action will be dominated by those meanies at HSBC who will be reporting 3Q results today. Most analysts are very negative on the stock. This is partly because management has been talking down markets as much as they can. This bleating has upset Hong Kong officials to such an extent that HSBC’s seat at the Government’s Financial Crisis Taskforce was filled by a general manager. StandChart’s Chairman and the Chairman of Morgan Stanley in Asia were given seats at the table, but HongkongBank was only given a stool. Personally, I think HSBC’s profits will surprise on the upside because they have been short practically everything. In the meantime, any money coming into Hong Kong has been channeled through HSBC. Its dominant position here is worth a lot more money than people realize. A good result from HSBC should remove the pressure on the Index and allow the current retracement of the decline from the September 22 high to the 11K low to settle at 5/8ths or 16,400.
