#1 Investment weekly – Press the press

It must be hard being so disliked, but HSBC is not making life any easier for itself. Fortunately, because of its financial muscle, it has the advertising-starved press on its side. So, while its competitors 1) complain that HSBC’s massive advertising campaigns are vulgar – considering the times 2) are revolted that HSBC has not had to ask for Government assistance 3) are horrified by the bank’s very public criticism of Government capital injections 4) grieve that HSBC saw things coming well before they did and 5) are bursting with envy that the bank can book profits by shorting property deals or because it has the capital/temerity to offer US$5 billion in extra loans to its customers, the bank is seeking ways to prop up its benevolent public image (just like your average run of the mill short seller) via the media.

Local bank customers are up in arms that HSBC has been lifting interest rates on mortgages, and more recently, credit cards, at a time when consumer confidence is fragile. However, the press coverage has been on the money on one important point: it wasn’t HSBC that raised rates first. HSBC’s communications people are working hard to ensure that this point has been included in all local press comments regarding its decision to follow the market. It has been difficult for investors to believe this because everyone knows that HSBC is the market here and nothing gets done unless it decides. However, there is good evidence that in fact HSBC was following its competitors on both the mortgage and credit card rate adjustments. The fact that neither type of loans is generating growth for bank balance sheets at the moment is secondary to the psychological blow that the two announcements delivered. Analysts are at a loss to explain why the interest rates were raised when bank’s cost of funds had fallen to zero. They assume that the increases were a reflection of bank concerns about the rising risk of default. This, of course, is nonsense. If a bank believes that there is a chance of default, the loan does not get extended or if it does, the amount will be less – simple. The increases in interest rates were, in fact, a proactive move and a deterrent. Banks are not writing mortgages right now because there are no buyers, so the rate hike on mortgages reflects the probable 0.25% cut in the HK$ Prime rate this week. The credit card adjustment was a deterrent, because the relatively profitable tax loan season has arrived, and banks are always concerned that tax payers may be tempted to use their (undocumented) credit card limits to pay their taxes, rather than use their lucrative installment tax loans (which requires documentation). In a sense, the increase in credit card interest rates was a form of credit check.

Consider HSBC’s use of the media to get its messages across, and how that most high-profile of short sellers, James Chanos, is milking the press (in particular those fawning floozies at CNBC) to get his strategies to work. This dopiest of looking fund managers has changed his object of attack (now that US financials have been decimated). His latest target is mighty China. I’m sure he was in the mix here in 1997-1998 (when the attack the peg:short HS Index futures gambit was in play). He may have ended up slightly battered at the end from that experience, but if he tries to take on the Chinese again: he will fail. His reasoning for believing that China will be the next shoe to drop is premised on the belief that China’s GDP growth figures don’t make sense (this has never been disputed by economists). How, Mr. Short-seller, reasons out loud, can China’s GDP grow by 8-9% when electricity consumption is falling?

Obviously, he has never heard of energy conservation, increased power efficiency, China’s efforts to green its economy or price elasticity. This makes sense because apparently, although he took economics at school, he was too busy partying to remember all that text book stuff. In particular, Chanos says he is shorting China’s construction companies (because electricity consumption is falling?). Can you see the logic? Neither can I. However, it is important to take note of what he is up to, because, just as the herd followed the investment gurus as the market rose, so they will follow a leader on the way down.

Goldman Sachs’ local analysts are certainly following him. As soon as Chanos revealed his short PRC construction company idea, Goldman analysts severely downgraded target prices for China Communications (1800.HK) and Shanghai Electric (2727.HK) (I exited the latter position in the Model Portfolio as soon as the Goldman note appeared last Tuesday because it was a major change in view). Goldmans followed up with the most bearish macro forecast of China on the street (6% GDP for 2009 – because of falling electricity sales). These “favours” were delivered despite the fact that Chanos and Goldmans are at odds with each other (after a fracas about a widening of a path at his beach-side home mid-last year, Chanos withdrew US$3 billion from his trading account at Goldmans). Maybe now they are pals again. He’s certainly buddies with the press – judging by the coverage he’s getting.

The financial positions HSBC and Chanos (two media-manipulating pals in a pod) are to be applauded. They both saw the current downturn well in advance, and acted. However, their increased media presence in recent weeks is giving investors greater belief that the worst is nearly past for equity prices. This has been manifested mostly by the ability of equity markets to absorb bad news currently spewing out of the media recently. The market has discounted a major economic recession for at least six months, with consumer prices turning negative (from an oil-induced high base) and interest rates staying low (i.e. steadily rising real interest rates). However, there is no discount for another blunder by US politicians. As the Senate has rejected the US automakers’ demands for a loan to tied them over, the prospect of three million Americans out of a job would require major changes to forecasts, and more discounting. I was sure that Lehmans would be saved – and paid the price. I’m sure traders are not willing to assume the best again (hence last Friday’s aggressive profit-taking). However, HSBC’s change of tack on a possible HK$ interest rate cut this week, and Chanos and Goldmans talking their positions up would have also contributed to the downturn. However, what broke the back of the recent rally was the breaking news that the FBI has arrested prominent fund manager Bernard Madoff because he had been, for many years, operating a US$40 billion Ponzi scheme (paying dividends with inflows). This is a story that has shaken the very foundations of Wall Street, and will probably bring the already crumbling wall down. HSBC and Chanos will be left picking up the pieces – publicly. This newsletter will be there too, because, after the current rally fizzles out at the 16,000-17,000 range, the final drop in the market that will follow will be the last of this latest, most amazing, bear market.

As a final aside, I am quite sure that the people at the stock exchange who approved the introduction of the day-end auction system did not believe that the arrangements they put in place would be so blatantly abused by its participants. I shall apportion no blame on them, and would applaud any decision to halt the practice until systems can be implemented to stop the abuse. As an example: last Friday, HSBC’s share price closed at 4.00pm at HK$83.00, with the stock trading steady at that price for the last 20 trades recorded at the exchange. However, during the auction period, the average price (and therefore the final closing price) was HK$82.25 (-0.9% from the close). Worse, 4.8 million shares were put up for auction. This was equal to 25% of all shares of HSBC traded on that day. The weighted average traded price for the day was HK$83.66 (1.7% higher than the closing price). The weighted average price before the auction was HK$84.15 (2.3% above the close). Admittedly, Friday was a volatile day, with HSBC’s share price swinging 5% during the session, but it smacks of an unfair system when institutions are allowed to manipulate the largest Index component to such a degree. HKEx officials have been silent on this issue, because 1) it is in their interest that large institutions show an interest in trading Hong Kong shares because their bonuses are tied to the turnover of the stock market. If it means allowing institutional proprietary traders free rein to decide the closing price of the market, then so be it. 2) Hong Kong has positioned itself as a global financial centre. Manipulation at the end of day stock market auction is the price we have to pay to maintain this so-called status. 3) The only people that are interested in the closing price of the stock market are prop traders, so let them battle it out (this is another fine example of Hong Kong’s laissez faire attitude to governance). There are several problems with these arguments. The compensation of the overseers of the exchange should not be tied to turnover performance. There is a conflict there. Financial centre and laissez faire are dirty words right now. Clean it up before the short sellers come a riding into town again.

#1 Investment Weekly – Superstitious minds

For a while I didn’t think it was possible, but after a lot of hits and misses, and after repeated efforts, I think I’ve managed to disguise a message in the following text. An event, I believe might upset some readers, but I’ve always wanted to be a radical empathizer of a lost cause. This week’s newsletter is unusual in that it contains a lot of tantalizing hidden messages, as well as insights about how traders have always been intrigued by the workings of the human mind – in particular, how, as a species, we are bound by our instincts rather than following the logic that is sometimes so obvious – even to an untrained mind. Consider, for a moment, the happy coincidence of the very timely joining of planets and the moon last week.

The weather in Hong Kong has turned cool and dry. It’s the best time of the year to visit. Get wrapped up and admire the clear blue skies during the day and the crisp skies at night, particularly around dusk. In particular, anyone who had bothered to raise their gaze to the skies during twilight last Monday, in the general direction of the south west, would have seen a sight that will not occur again for another 46 years – the bright planets of Venus and Jupiter positioned just above a crescent moon. The sight of a smiley face beaming briefly over Hong Kong’s skyscrapers was a heart warming sight, made more prominent by the fact that the Hang Seng Index had closed two hours earlier above the 14,000 barrier. Unfortunately, the following day, again at dusk, the picture was completely the reverse, with the crescent moon hovering above the two planets, which, when looked at upside down presented a rather glum looking combination. The index on that day had just fallen 700 points – just to confirm the point. Ancient Chinese culture was heavily influenced by the alignment of planets and stars. Were our modern day traders telling us something that their ancestors would have recognized as a bad omen? The superstitious among you would say: yes. The grim-faced smiley face in the night sky was an omen that 14,000 will not be breached any time soon, and the Index will bounce along the bottom of its Ichimoko Cloud for the rest of the month.

Another portent of gloom/bloom was announced last week. Hong Kong’s Azaleas’ are blooming early (five months too early). Although our urban landscape means that natural phenomenon are usually overlooked or missed, the finding sent shivers down the spine of Hong Kong’s chief weather man. Was it global warming or a sign that the world’s cycles (meteorological or financial) have been seriously disrupted. In other words, has the bottom of the market arrived earlier than most investors believe? Or are the cycles of the past irrelevant in the new economic environment? When China was pre-dominantly rural based economy, early blooming crops/flowers were a sign of impending disaster and famine.

I don’t want to panic you dear reader, but geologically-inert Hong Kong is due to feel an earthquake. Since 1999, there have been nine cases of earthquakes with epicenters less than a 1,000km away that were felt in Hong Kong. Of the nine, three happened in December (1999, 2003 and 2006). In those three years, the index was rallying from lows. If the sequence of difference between the years continues (4, 3 and now 2), then we are due a little shudder this month. Although there is unlikely to be any structural damage (because Hong Kong is not situated near any major fault lines), the psychological impact on the market could be greater because superstitious traders will interpret a quake as another bad omen. As a quake in December would be about 40 days from the year low of 11,014, a quick check of the Hang Seng Index 40 days prior to the last three quakes showed that on each occasion the index rose ahead of the event (in decreasing magnitudes (excuse the pun)) but was flat for the next 40 days (I’m using 40 days because of its biblical significance, but Chinese mythology frequently uses the same time frame). On this basis, the Index would be trading at 12,000 by the time of that most superstitious of all Chinese festivals, the Lunar New Year (which next year, like the Azaleas, will be arriving very early).

Now, I have to say, I don’t believe my prediction of an earthquake will come true. How am I to know what the tectonic plates are doing right now? However, the logic to my prediction is fairly well laid out (high incidence of quakes in December, declining gap between years, and the movement of the index before and after each quake has been quite consistent). But here’s the key, predictions can never be correct until they are correct. Omens such as the smiley moon and the early Azaleas can be interpreted as being correct only after the event.

This brings me to the interpretation of the current financial crisis by the media. The turmoil in the markets has provided newspaper editors with reams of screaming headlines. However, I have to point out that many of the headlines are misleading. For instance, Hong Kong’s unemployment rate rose to 3.5% in October (from 3.4%). The headlines were nothing but doom and gloom, with the main text full of predictions about how the unemployment rate is set to rise (to 10% according to some). However, a look at the data from the government showed 1) employment was at a record high and 2) the number of unemployed actually fell by 3,000. What happened was a technical adjustment to the unemployment rate due to seasonal factors. There is good news for the 130,000 unemployed in Hong Kong – some may end up working on new infrastructure projects or could end up getting one of the 7,000 (cushy) civil service jobs now on offer. This was not mentioned anywhere in the articles I read. Another piece of new economic data was Hong Kong’s trade performance in October. Hong Kong’s exports rose 9.5% YoY in the month (+12% MoM). This is not too shabby when you consider how terrible, economically, October turned out to be. Even more amazing was the fact the value of exports was a record for a single month at HK$277 billion. Most economists were expecting an annual drop in exports for the month because the growth in September was only 3.6%. They still expect exports to decline in coming months. Demand for China’s exports is weak, they say. How can this prediction be trusted? Commentators have learned some valuable lessons from the last time Hong Kong experienced a financial crisis. It’s better to be wrong on the downside because no one remembers the person who called the bottom of a market. The current Chief Executive was the Financial Secretary in 1997. He will never be able to live down his prediction at the time that the Asian Financial Crisis would be over by Christmas. His current administration and the local press is not taking any chances this time around, with officials warning of a recession while, at the same time, trying to talk up the positives coming out of China. Although Donald Tsang may have got his prediction wrong in 1997, his short term fix for the battered stock market at that time was spot on. He bought stocks and killed the shorts that were attacking the HK$ peg. Apparently, a similar tactic is being discussed in the US right now. We know that China has been propping up its stock market, allowing the Shanghai Composite to break above its medium term resistance (see newsletter November 24th 2008 – Rebalancing exercise). Is it possible US Treasury Secretary Paulson was getting some tips from the masters of central intervention last week? The signs looked suspiciously ominous, as the talks were described as “robust” (which is politic speak for “he got an ear full”). I’ve read several other suggestions in the Financial Times regarding how to fix the current financial mess, with the most interesting being: replace fractional reserve banking for narrow-banks, delay the introduction of FSA 140 (which would bring banks’ off-balance sheet items on-balance sheet), as well as several reminders that stock prices reflect claims on the long-term future cash-flows of a company (not based on a daily headline, or next quarter’s or even next year’s earnings, or even the rantings of a newspaper editor or a series of ominous omens).

#1 Investment Weekly – Empathy and sympathy

I have some empathy and sympathy for the author of Liar’s Poker, Michael Lewis. Empathy, because I joined the investment banking industry as an analyst in 1988 knowing little or nothing about financial markets (other than a two year stint as the editor of a banking magazine). I left the industry, disillusioned, 10 years later. Sympathy because of the poor state he’s in.

I was introduced to investment banking by the head of research at a UK bank. He was also the publisher of the magazine I was editing. The bank’s previous bank analyst had returned to Canada, and they needed a replacement. As I had been editing the bank magazine, I had some idea about what banks do, but the stock market was something that was only mentioned as an afterthought (banking and equity markets were fairly well separated at the time. Although banks in Hong Kong all had established brokerage subsidiaries, investment banking was left to foreign banks). Anyway, after arriving fresh and innocent, and after having being shouted at and threatened by aggressive sales people, I finally found my feet, and realized that equity analysts in Hong Kong were put on some sort of pedestal and adored by the general public. It was a great way to generate self publicity, even if you had no idea what you were talking about. Turning a catchy one liner was all that was necessary. I still find it amazing that I was actually asked to write articles for glossy high net worth magazines about which way the stock market was heading, without anyone ever asking whether I knew what the hell I was talking about. The name card was enough (it didn’t matter that I hadn’t even been to school).

Talking was about as good I could manage, with constant conversations to newspaper reporters, radio stations and even a spot on local television. However, there were downsides to the exposure. If you said something too negative, the subject of your scorn would send the boys around. It got so bad, that at one point I was dragged in front of the board of directors of a local hotelier because I had put a sell recommendation on the stock. At the time, the bank was renting floors in a building owned by the family-owners of the hotel. There were two meetings that I remember, one with the finance director at the time (he was away on his honeymoon in Scotland when I wrote the report, so he was unable to respond to any of my concerns), and the other was lunch with the board, at which I was told to apologize and retract my rating. I did, but I stuck with my views privately, and was proven correct. The stock has underperformed consistently since my sell call. That incident and the time the bank’s UK analyst for HongkongBank walked out of a meeting with the Bank’s corporate affairs people, leaving me to continue the meeting, because the po-faced spin doctors refused to answer his questions about the Bank’s non-performing loans. Both these and other instances sowed seeds in my mind that investment banking is just an illusion (write what I tell you or else), with the business run by a bunch of spoilt brats (who spit their dummies out if they don’t get what they want).

In fact, no one can predict the future (whether it’s the corporate people at HSBC, analysts or short sellers), which means that one person’s view is as good as the other. It’s just that I could somehow write about the future in a style that was easy to read (or alternatively too difficult to understand, therefore making myself sound mystifyingly certain). This is still true today. No one can predict the future, so, as long as you have a reasonable argument (or even better loads of different arguments, therefore increasing the chance of success), anyone can write investment newsletters every week.

Equity research is all about being in the right place at the right time. Lewis points out in his recent piece appropriately called “The end” (catchy, sure to get lots of eyebrows raised etc) that Meredith Whitney’s call on Citigroup in October last year was as much about luck and timing (and self publicity, she’s married to a wrestler) than anything else. She almost immediately left CIBC, probably because they refused to match the pay offer of her current employer. Lewis and Whitney empathized because they were both responsible for bringing down big Wall Street names (Gutfreund at Salomon and Prince at Citi). Unfortunately, I can empathize with Lewis, rather tenuously, again, because I was involved in the demise of the entirety of Salomon Brothers. County Natwest decided to close down its Hong Kong office as early 1990s recession had forced cost cuts. I was immediately asked to join a new Swiss research team, but I only managed a year there, before getting a big phone call to set up Nikko Research Center’s Hong Kong office. After five years of goofing about pretending to be serious investment bankers, Salomon Brothers could resist the temptation no longer, and in 1998, offered to buy a stake in Nikko, and merge its overseas offices with Nikko’s (obviously attractive) branches. It was at that point I realized that investment banking is doomed. If Salomons saw any sort of value in Nikko’s franchise, then Wall Street was being led by blind people with too much ambition and money. As we now know, Salomons is no longer with us, and Citi (which absorbed it) was almost driven to collapse by the likes of Whitney and Lewis (and by a bunch of unpopular sour pusses).

My sympathy for Lewis extends from his long and patient wait for the “destruction of Wall Street”. He wrote Liar’s Poker in 1989. Since then, the Hang Seng Index has swung from the low of 7,000 in August 1989, to the 32,000 of last October. That was an annualized compound average growth rate of 17.6%. Being a permabear over the last 20 years would have left you very poor, with not much of a social life. Hong Kong’s most famous bear is “Dr Doom and Gloom” Marc Faber, who would be constantly wheeled out by Bloomberg or CNN when the markets were racing upwards – just so there was some semblance of balance to their reporting, and also, just for the entertainment of watching a middle aged Swiss with a doctorate squirm at being so wrong. He now spends most of his time hanging around his place in Thailand. When he’s introduced on CNBC, there are no “Dr Doom” monikers in his introduction (that mantle is now reserved for a mad cap professor who goes by the name of Nouriel Roubini). I read recently that Kynikos Associates’ Ursus Fund is up 58% so far this year. Ursus, of course, is Latin for bear (although a Wiki search reveals that Ursus is also the name of a district of Warsaw, an Icelandic Vodka and the name of several Christian saints). Have you ever seen James Chronos, the Greek owner of Kynikos (Greek for doglike), on TV testifying before some committee, trying to justify his existence? He looks completely dopey and spaced out. That is what permabears look and act like. They have taken so many knocks that when the good times come around for them they are too beaten up to enjoy it. Lewis describes Steve Eisman and his associate bears in “The end” as a complete bunch of unsociable misfits from Queens or somewhere. They are on a winning run, but for how much longer (Chronos says he’s reduced his short positions on US financials and only has a large short position in Macquarie) and at what price?

The Hang Seng Index hasn’t managed a winning run of more than three consecutive days since July, so Friday was something to cheer about. The lack of sustainability of past rallies has been due to the discounting of economic/corporate news flow since the collapse of Lehmans. As the market reacts less and less to news-flow (which will continue to be bad because the press only reports negative news), so the market will move closer and closer to forming a bottom. The closing level of the Hang Seng Index on Friday was tantalizing, as it was trading above its 20 day moving average for the first time since the one-off events of 5 and 10 November, it was also poking at the bottom of a falling Ichimoko Cloud. Teasingly, the Parabolic could also reverse to an uptrend if the break into the cloud can be sustained this week. If the Central Economic Policy Committee, meeting this week, can clarify its spending objectives, then skepticism about China’s stimulus packages can be dispelled, allowing any breaks in resistance to be sustained. Here’s the technical situation as it stood on Friday in graph form.