I’m going to move away from the week-in week-out noise of the market and look at how plants and the markets intertwine. It’s the only way to stay sane with volatility this high.
Last week I discussed what the world of investing in Hong Kong equities will look like as the new era begins. In summary, perceived higher risks will lower future returns on Hong Kong equities relative to past performance. Here’s how the next cycle will look – flat.
HS Index joining the lows
The chart is a simplification of the downside of the HS Index since 1987 and includes a forecast to 2013. The line representing the data is derived by taking the last five bear market lows (including October 27, 2008). Subtracting their differences and dividing this by the number of months between each low to derive a points-per-month average for each cycle.
Forecasting the next bottom
As you can see, the Index has traversed three cycles that were quite long (over 60 months): while the nineties produced two quite short ones with the 1995-97 bull market being one of the shortest in HS Index history and the 1997-98 bear market the shortest ever confirmed bear market (July 1997 peak – August 1998 bear-end lasted only 13 months). The current bear market has also lasted 13 months, while the severity of the downdraft is of a similar dimension at 65% vs 71% for the 1997-98 bear phase. However, I must insist that while October represented a bear market clearance crash, the similarities with 1997-98 pretty much end there. In 1997-98, Asian excesses were the cause, this time, the bubble burst in the Anglo-Saxon economies. The financial tsunami that everyone keeps talking about is adept in that the wave has crashed on the shores of North America and Europe, and the ripples are being felt in Asia.
What is most interesting about the chart above is that the shape of the 1987-93-trend was similar to the current bear market. There are some good reasons why: 1) the 1987-93 trend was a transformation period for Hong Kong, with the first red-chips (and some early H shares) listing in Hong Kong. In the current period, the transformation had come in the form of large H shares. 2) In the late 80’s early 90s, overseas investors were beginning to understand the potential of the opening of China’s markets, and Hong Kong’s role in this opening – Deng Xiaoping had only visited Shenzhen and uttered his famous battle cry “it’s ok to be rich, bitch” in 1983. In the past trend, the importance of China as a trading partner and global player increased to such an extent that China has been pushed to the forefront of global economic debate. Hong Kong, during the current period has been seen as a proxy to the appreciating RMB (remember 2003-04?) and an increasingly beneficial offspring of China’s economic might (CEPA, through train etc).
As far as I can tell, the next cycle theme for Hong Kong equities is not very visible. This explains why I have assumed a falling monthly average from the current bear market low to the next one. I am also assuming that the next low will be quite a long time in coming (although it will be shorter than the average of 67 months). The longevity of the next cycle may also be explained by the nature of the recovery of equities that I pointed out last week (risk aversion, demographics and the regulatory environment).
The most important issues facing Hong Kong equity investors right now are earnings, liquidity and confidence. The best way to imagine the interaction of these elements is to consider that a plant needs three ingredients to grow (sunlight, water and carbon dioxide). Sunlight (earnings) is essential for all life (markets) and is present to varying degrees all the time; water is fluid and therefore moves about and is unpredictable (even weather forecasters aren’t sure when it will rain next), while carbon dioxide is what we exhale when we breath or, in this context, talk.
I think it is safe to say that credit and interbank markets are beginning to become unstuck. So, now is the time for investors to closely watching analysts’ comments as they visit companies and report back on the impact of the previously frozen financial markets on corporate profitability. Unfortunately, this is not being done, and if it is, the analysts are not asking the right questions. As far as I can see, analysts have been busy downgrading their price targets again (see newsletter February 4th 2008 – TP downgrades everywhere), while maintaining their ratings (always a curious phenomenon). Profit changes have been minimal until a warning appears.
Local bank investments, marks to date & potential impact on profits
I find it quite curious that the raft of profit-warnings coming from Hong Kong companies almost always include some mention of investment problems, rather than an emphasis on the weak operating environment. Here are some examples: Dah Sing Bank says it has significant investment losses in 2H; CCT Telecom (telecom service provider) says its securities business has lost money; City e-solutions (a hotel software provider) says it has HK$59 million in forex and investment losses. Problems are never revealed until the company wishes to say so. Cathay Pacific’s lack of downside protection on its oil hedges suggests that members of the CITIC group have never heard of puts, collars or straddles. I find it mind-boggling that a company as financially sophisticated as Cathay Pacific could make such a basic mistake (Martin Cubon/Robert Atkinson are a experienced financial officers, one or both of whom will probably be quietly leaving Swire soon. That’s a shame really, although Cubon’s insistence on “very early in the morning” company visits won’t be missed). Perhaps Cathay/CITIC officials should watch those terrible public service announcements from the Government warning us poor citizens that the value of things can go down as well as up! As I often mention to people who want to listen: “you don’t make a loss on something you have bought until you sell it”. The mark to market façade is starting to crumble, thus putting a put under the market for now. Fortunately, the Beijing authorities are better advised than CX, and have basically put a floor under China Inc by openly bailing out CITIC Pacific. It appears lessons from Beijing’s failure to uphold loan guarantees to its collapsing ITICs of the late 1990s have been learned.
The issue of liquidation is a lot more serious and unpredictable, in my view. Although the world’s banking systems are now flush with much cheaper cash, banks are not performing their fiduciary duty to use the cash both for the good of their shareholders and the general public, which fund loans with their deposits. I can understand reluctance to lend to new customers at this time, but cutting lines bites the hand that feeds you. Hedge funds are bank customers just like you and me, and when lines are being considered for cuts, leveraged fund managers are considered on the top of any high-risk loan list. I hear hedge fund liquidation all the time when someone describes what is happening when the market tanks. The threat here is that the liquidation pressure will intensify ahead of year end.
Hopefully, someone somewhere knows this and is coming up with a way to avoid a pile up ahead of December 31. Unfortunately, with transitions going on in the White House, the markets might want to hear that New York Fed’s Tim Geitner is going to take over Treasury Secretary’s Paulson’s work, to ensure continuity. Geitner’s relative youth should be offset by his linkage with the US Central Bank (and therefore global central banks) which should put him in a prime position to react to the final set of problems facing the world’s financial markets: liquidation, accountancy (another issue looming at year-end) and window-dressing. President-elect Obama as well as incumbent Bush should be concentrating on reviving consumer confidence (and therefore the housing market) with plenty of talk with an emphasis that help is on the way from the government in the form of spending and tax breaks. In other words, as Samuel Brittan so rightly suggests: a fiscal policy financed by money creation.
