#1 Investment Weekly – Amber light

The three parts of a financial markets (up or down) cycle can be visualized as a traffic light (just as Karl Marx envisioned that capitalism destroys itself in three phases). Since the bear market officially started in January 2008, the lights have been red. I think it is safe to say that the lights have just changed to amber. Get ready, but don’t go yet.

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Judging the change of the lights is partly intuition (after experiencing several such turning points in the past), and partly based on data. My feelings about equities right now are decidedly calmer than they were late last year, while the media seems to have swung around from reporting nothing but doom and gloom. Politicians are saying things that, if they were said during the stresses of last year, would have been suicidal (“maybe unpeg the HK$ when the time is right”, “use SDRs as the world’s reserve currency” etc), but the reaction was quite calm and collected.

However, when sifting through the fundamentals the picture becomes quite frantic and noisy. There is no point talking about historic norms, or Gaussian copula formulas, because current market prices and correlations are still stressed compared with long term averages. Returning to the mean no longer works, because investors cannot know what is “the mean”, because prices have moved so sharply lower. Intuition is probably not much better as a guide, but, as stock prices are heavily influenced by sentiment, calling a turn on gut feeling is just as valid as ploughing through the fundamentals.

However, for what it’s worth, here’s a fundamental view point. The long term returns for equities have been so low now that the real return for investors has been what they have received as dividends. So, perhaps it is worth looking at this valuation aspect rather than judging equity values based on PE or price to book or (heaven forbid) discounted cashflow. The average real dividend yield of the HS Index since 1995 has been 2%, which currently matches the compound annual average growth for the Index in the same period. Assuming companies will cut their dividend payments in half for 2009, then half the current historic dividend yield is 3% – with the prospect that dividend payments will be restored over time. That could mean current stock prices averaging a dividend return of 4% by year three. However, if one assumes inflation of 1-2% in the next two-three years, then the real return is no better than the long term average of 2%. From a long-term equity investors’ perspective, there is no incentive to own shares at current prices. The big variable is the forecast for dividend payments. As a large portion of the Index is fast-growing China plays and slow-moving, but family owned, local companies, the chances of a cut larger than 50% in dividends this year is quite remote. So, a 2% real return would appear to be at least some sort of base-line return. However, the switching of the traffic light to amber suggests that investors are more confident that dividends will be paid, and that the cut may be less than half.

HS Index’s real dividend yield (%)

As the chart shows, the current real dividend yield for the HS index is not as attractive as it was at the two previous troughs in 1998-99 and 2003. However, a chartist would point out that the falling highs suggest that the current high should be below the prior peak, suggesting, therefore, that the index is at, or near, a turning point.

Technically, the Hang Seng Index is overbought (the RSI at 63 hasn’t hit these heights since May last year), and is due for a pull back after three weekly gains (something that hasn’t happened since April last year). Although Treasury Secretary Geithner’s “toxic asset” plan seemed to have been greeted positively by equity markets, the reaction in credit markets was markedly less enthusiastic, while the rise in the price of gold and oil, a still elevated VIX (it failed to break below 40) and negative Treasury bill yields suggest that underlying sentiment did not, in fact, improve at all. In fact, most commentators believe the PIPP will not work, or, if it does, the consequences will be the need for more government capital injections to plug the gaps in bank balance sheets. There is a good consensus that, next week, FASB will allow banks to put untraded investments in level 3, but this is a specific issue for bank stocks, which have led the local rally in equities (+31% vs +24% for the HS Index).

I only work for a bank, but this newsletter’s model portfolio isn’t constrained by accounting rules and it doesn’t own any bank stocks. However, as I promised a month ago, I’m going to take advantage of the current bear bounce to reposition the portfolio for the amber light phase of the bear market. To that end, I have sold Esprit at HK$48.00 (because the dollar’s weakness is temporary and HK$50 looks like a strong resistance level), Cheung Kong at HK$71.40 (because the portfolio has too much exposure to KS Li and the 12% capital gain in five years has failed to match the HK$14 in dividend the portfolio received), and China Communication Construction at HK$9.07 (because there’s profit to take). The portfolios’ annualized return, on this its eighth anniversary, of 7.5% includes dividends. That’s better than the 3.2% dividend and zero capital return on the HS Index since the portfolio was launched in March 2001.

#1 Investment Weekly – Right to mark dates

There are three dates coming up that investors should pay particular attention to. Two of the days are known, March 31 and April 2. The other date depends on when US Treasury Secretary Geithner is ready. The outcomes of the three days are skewed towards the downside for global, and therefore, Hong Kong equities.

The first known date is the last day of trading of HSBC’s rights. The tug of war that will commence today and continue through to March 31 will be titanic. On the one hand, there are the underwriters who are duty bound to ensure that don’t end up holding any HSBC shares: on the other hand, there are small, retail investors in Hong Kong, who do not own enough shares (960) to qualify for a full lot (400) of new shares. These investors will sell their rights immediately. Then there are those large institutions which own lots of shares (ABN, Royal Bank of Scotland etc) but can’t afford to subscribe to the rights. They should sell a portion of their rights allocation too. Although we know that ABN etc have been selling their HSBC shares to raise enough money to subscribe to the rights, it would appear they have not sold enough to meet a full commitment. Finally, there are fund/pension managers that are constrained by rules regarding concentration of individual stocks/sectors. They too will be selling their rights. Against this backdrop, one would think that HSBC’s share price would be under severe selling pressure this week. However, as the selling is only likely to be focused on the rights, the ordinary shares should be more stable. After all, the price has already gone ex-rights, meaning that anyone that wanted to sell should have done so already. Volumes of the ordinary shares have decreased since it went ex-rights on March 12 in Hong Kong, while short selling of the stock has dropped off a cliff. However, the impact of the selling of the rights (and scaremongering by the local press) will mean that the recent heightening of volatility in HSBC’s ordinary shares will persist until March 31. PS: Goldmans’ analysts (which have just removed HSBC from its Conviction Sell list, upgrading it to Neutral) should not be allowed to make comments about HSBC while the firm is underwriting a rights issue. Sorry Roy, you’re a nice bloke and all, but it just doesn’t feel right!

HSBC volume (m), short selling (m) and volatility (%) pre/post ex-rights

HSBC’s heavy weighting in the Hang Seng Index means the index will continue to jag around too. However, stripping out HSBC, the Index is outperforming its peers YTD with a 5% decline.

HS Index with and without HSBC (rebased to 100 – YTD)

Most of the Index’s outperformance against the MSCI Global Index (which is down 12% YTD), has been due to the performance of Shanghai (which Hong Kong usually tracks quite closely), but there has also been an element of support for equities in general in recent weeks. This support was sparked by comments by Fed Chairman Bernanke that mark to market accounting should be reviewed to ensure that the rules do not exaggerate cycles. The Fed itself has acted by delaying the implementation of rules that would restrict what banks may count as Tier I capital until 2011. This important move was announced after the US Financial Accounting Standards Board (aka FasBee) threw the first frizbee of the party. FASB has started a 15 day consultation period, which ends April 2, regarding proposed changes to its mark to market accounting rules. The board voted 3 to 2 in favor of a proposal allowing banks to decide if an asset should be marked to market if there is no market for the asset. Currently, very few assets are treated as Level 3 assets (about 9%) because accountants have insisted that there is a market for the assets (when in fact it has been clear as day that the prices being quoted were fire-sale). The value of Level 3 assets can be assessed by the bank itself using forecast cashflows. The proposal should be agreed before banks start preparing their 1Q results. Generally, this should provide a positive outcome for financial stocks and equities in general – although it has to be said, a lot of the good news has been baked in recently (the Obama Index – based at 100 when he recommended buying stocks for the long term on March 2 – is currently trading at 110).

The gum on the pavement is Mr. G. Will he mark his pants again? The signs are not good. In fact, they have not been good since the news broke of his appointment. Remember, he had to think about whether he wanted to job for quite a while before he accepted. He has a young family, and, although he has had to take flak for the financial markets meltdown last year, he was relatively sheltered as New York Fed Governor. Now, he’s right in the spotlight, and so far, his performances have not been good. However, he has a chance to redeem himself when he unveils his good bank:bad bank proposal. If he walks out to the media and Congress with a two page outline again, financial markets around the world will collapse (partly in disbelief or maybe hilarity, but also from a sense of being cheated once again by a Wall Street Johnny). He must deliver details on: how and at what price toxic assets should be removed from bank balance sheets and transferred to a publicly owned asset management company; which viable banks should be recapitalized; and which insolvent institutions should be closed or temporarily nationalized. The problem has been that he has no one to help him. No one wants to be associated with the mess that is currently unfolding. He is hiring retired university professors to run departments in the Treasury. None of the Masters of the Universe that are needed to help him are interested because: 1) they would not be trusted by either the public or by career civil servants in the Treasury 2) they wouldn’t take a pay cut on a four year contract or 2) they are too busy counting their bonuses and preparing to set up new (short) hedge funds (to replace the 177 that went bust in 4Q 2008). My feeling is that Geithner will flop again, and so will the world’s financial markets.

That could mean a retest for the Hang Seng Index of the 11,000 lows of October 27 and March 9 (when, rumour has it, a fat fingered trader at Deutsche sold 4 million shares of HSBC at a 12% discount, 4 seconds before the end of trade). Before that happens, the index needs to break below the uptrend formed since March 9 which currently stands at 12,700. A break below this would put the 20-day moving average in danger at ~12,500 and would eventually reverse the market’s parabolic which stands at ~11,900 and rising.

The upside of 13,400 (the bottom of the Ichimoko cloud) indicates a risk/reward of 15:4, which, with Geithner set to disappoint, is not a proposition investors should be comfortable with.

#1 Investment Weekly – Can’t be a pimp and a prostitute too

“What! Americans! Nothin’ better to do? Why don’t you kick yourselves out, you’re an immigrant too! Who’s using who, what should we do? Well you can’t be a pimp and a prostitute too!” – Lyrics of Icky Thump by White Stripes.

Protectionism is starting to appear, and Bank of America’s decision to ban the hiring of foreign MBAs is probably the tip of the wedge. Protecting your corner has been the driving force of capitalism for the past near 50 years (think not what your country can do for you etc). This greed, selfishness etc has had its comeuppance, and President Obama (the figurehead for those hard-line Socialists Pelosi and Reid) is tearing up the rule book. Worker power is taking over manager power: but only after the managers make one last attempt at stiffing the system by attempting to be both pimp and prostitute. The biggest pimps of course are PIMCO (pronounced pimp co) and their ilk. Someone needs to tell Mr. Big and his side-kicks that you can’t have your cake and eat it too.

A solution to the problem of banks’ toxic assets is to strip them out of their balance sheets and put them somewhere else. The Socialist-Chinese did this prior to the listing their state-owned banks. There was no way that China’s banks could have listed with non-performing loan (NPL) ratios of 10% and CAR ratios of 3%. Stripping out the NPLs improved both ratios at once. However, China was able to agree a transfer price because it was taking from the left hand and giving it to the right. In the case of the US/UK, the giving and taking is being negotiated between two parties – with very different agendas. The short seller prostitutes and the pimps of the world want to buy the toxic assets as cheap as possible: the banks and the Government want to sell as high as possible. The pimps clearly have the upper hand in this all-you-can-eat buffet. Warren thinks banks’ toxic assets are the most attractive assets they have on their books because they are already undervalued. But the shorts and pimps want a discount on those discounts, as well as financing from the Government and a new condo and a private jet and……. And no changes to the mark to market rules until after they have extracted their pound of flesh.

Has anyone noticed that whenever someone talks about getting rid/adjusting of mark to market accounting (except “one-one-listens-to-me” Forbes), the world’s financial markets rally? Is it possible that this is not a co-incidence anymore? It is possible that amending accounting practices that exaggerate swings in corporate profits (quote: Bernanke) is a good thing and the markets are telling the accountants this? Is David Tweedy listening?

I’m pleased to hear that the SFC in the US is listening and has said it will not implement the liability caps that Europeans have agreed with the big accounting firms. This smacks of protectionism of the most devious type (i.e. protecting incompetence). I presume the cap is aimed at their dealings with financial institutions. In a sense, the accountants have finally realized that their illogical rules could now backfire on themselves. It’s like Treasury Risk Management saying they will only take responsibility for their decisions, up to a certain point. Do the accountants not know that the annual tripartite meeting between the regulator, bank and accountant is a meeting of three groups of concerned parties, not a meeting of two and half? Still, the accountants are certainly doing a good job of stating their case for protection against rogue managers. I’ve never seen so many accountants (PWC’s Wyman) and bankers (HSBC’s Flockhart) strutting their stuff in the media recently.

There is a simple rule of investing: don’t get emotional. Breaking this rule, in public, on a television programme watched by millions of local punters, is a big no-no and explains why i-Cable’s stocks presenter Agnes Wu is no longer a broker at HSBC (they call them financial market actors). Her tearful breakdown, caused by the sight of HSBC’s share price getting marked down to HK$33.00 at the close last Monday, was somewhat reflective of the investor mood in Hong Kong right now. It’s been a tough slog downwards for the Hang Seng Index, investors are getting weary after 16 months of downturn. Many are giving up any hope for the future. The news from overseas continues to be depressingly grim.

However, the profit announcement of worldwide HSBC weren’t too shabby (compared with Citi, UBS etc). After stripping out exceptional items, profits fell 23% (from a high base – especially HK). Most analysts seem to think that the bank will make US$9 billion this year, which means provisions eating 77% of the bank’s revenue, compared with 58% in 2008. For what it’s worth, here are my back of the envelope calculations for HSBC’s profits in 2009, and its worse case (losses at Europe and US) value – which is about HK$40.00.

HSBC’s pre-exceptionals profit breakdown and value

The bank’s provisions are going to be huge this year, with losses in the US continuing, and worsening profitability in Europe. Apparently, all the focus on the US has distracted attention away from 45% of the bank’s loans – which are in Europe (particularly corporates). If Berkshire Hathaway and GE are no longer triple A, then what does it mean for corporate ratings globally (is AA+ now the new AAA?).

HSBC’s loans and provisions in 2009

There has been a lot of weeping and comments made about HSBC’s results, future provisions/write-offs and the rights issue. The only comment I would like to add is that this is a good-cultured, conservatively-run bank with a unique franchise. At the time of its acquisition of Household, I remember most commentators were happy with the deal, saying that HSBC had bought on the cheap and that “there is nothing wrong with sub-prime lending: it’s just how it’s executed”. In hindsight, HSBC has made a mistake and is paying top dollar for it. Unlike those wretched shorts and their pimp cousins, who are looking for one more last payout before the bear market ends.

#1 Investment Weekly – Careful what you wish for

There is a real possibility that if the shorts are not careful, they could end up with everything, but it would all be worth nothing. The general rule of investing in equities is that it’s a zero sum game. However, in the current environment (Moody’s is forecasting 300 investment grade companies will default on their debt this year – compared with 101 last year) the shorts with their millions will have nothing to read, no where to wine and dine, nothing to listen to, nothing to buy. They may well still have friends, but they will mostly be other short sellers, and, to be honest, short sellers don’t sound like very interesting company to me.

For a long only equity investor, this may sound like sour grapes or a touch of jealousy. But there is a fundamental question that needs to be answered at this point in the current downcycle: what if economic conditions become so bad that there can be no hope of return. There are many instances in the history of humankind of ancient civilizations rising to a pinnacle, only to be wiped out by various factors. I’m referring to Mesoamerican civilizations such as the Aztecs or perhaps any of the great ancient civilizations that were established between the tropics. Modern civilizations have been established in the globes’ colder climes – north of the Tropic of Cancer. If the current cold morphs into something like an incurable cancer, perhaps the concentration in power could return to the religiously dominated regions of the world (i.e. in the band between the tropics). Obviously, the shift will be very slow, but a world dominated by religiously minded peoples doesn’t hold much appeal to me. The worship of God could replace the worship of money.

At this moment, I have to have faith that the current system will survive what is becoming a painful wound, rather than a mortal blow. However, this is based on the belief that the pessimists (realists?) are smart enough to know that if the system completely breaks down, there will be nothing left for them to look forward to in the future. You could say that this is the same mistake that Alan Greenspan admitted to, when he confessed that he had presumed that bankers had an inherent interest in shielding their institutions and their shareholders from risk. The same assumption now is that short sellers have an inherent interest to ensure that when they complete their scrubbing clean of the system, there will be something left at the end.

A vague hope for long only investors, wishing for the slide in equity prices to stop, is that the authorities introduce another ban on short selling. There is plenty of ammunition for another halt following the debacle over the sharp declines in the share prices of insurance companies in the UK last Thursday. Aviva’s use of more stringent accounting treatment, the payment of a generous dividend and assurances from management (and therefore, by extension, the companies’ auditors and regulators) did not warrant a 30% single-day decline in the company’s share price. Lansdowne’s investors were not complaining about it, because they had a Stg36 million short position that profited from the collapse of Aviva and other UK insurers. Across in the US, James Chanos was spouting on at CNBC that he was slightly long financials, while (long-short) ICP Capital’s Carlos Mendes also said he was slightly long on Monday’s CNBC show. I’ve decided I’m not going to listen to the guest fund managers on CNBC anymore, because they are clearly either very stupid or they are talking up their short books. Chanos was long John Thain and HSBC when asked on a Financial Times TV pop-quiz show in late-January called Long:short. Thain resigned from Merrills on the day of the prediction and HSBC’s share price has fallen 23% since then. He also said he was long Google and Citi. Piffle.

The main risk for the destruction of everything by short sellers is that most of the time these fund managers work out of black boxes. Also, even if they do spend time analyzing a particular situation it is not possible to check the tyres of Aviva, Citigroup or HSBC because finanacials don’t actually have anything to kick. There are many examples of black boxes causing major economic destruction, with the 1987 crash and Long Term Capital Management being two such instances. I would hope that someone somewhere is making sure that these black boxes are being monitored. If they overheat, the meltdown could be disastrous. If there is any hope, it is this: the closer prices get to zero (i.e. think Citi), the closer we are to the bottom.

After a year of underperformance, the Hang Seng Index is actually starting to outpace the MSCI Global Index. The chart below is interesting because it shows how the Hong Kong and Shanghai stock markets raced lower much faster than the Dow Jones Industrial Average last year, but, since late November, the two China markets have outperformed the Dow by 10-22% respectively. This has occurred despite the dilutive effect of HSBC’s rights issue.

On the last point, if you own HSBC shares, I would recommend not taking the rights, because you can buy it cheaper ex-rights. Even if you do decide to take it up, sell the equivalent dollar amount that you are entitled to now, and subscribe so as not to get diluted. As for those wondering if HSBC will do another rights issue after this one, the answer is it can’t, because, if it has to do so: 1) it would mean the Bank is in deep financial trouble and 2) no one would therefore underwrite it. By the way, my target price for HSBC is HK$1.00. That should put paid to the current game amongst so-called responsible analysts of “who can cut HSBC’s target price the most”.

Dow Jones Industrial, Shanghai Composite and HS Index (rebased to 100)

Some of the outpacing of Greater China markets was because US financials can’t get access to real capital – so they are having a hard time fighting off the short sellers – while the banking systems in Hong Kong and China are not broken (otherwise Goldman and JP would not underwrite the HSBC rights issue). Some of the Hang Seng’s recent outperformance was also due to proposed Mainland stimulus packages (infrastructure spend, lifting of restrictions on the property market, help for exporters etc), and, more importantly, the impact of these efforts on confidence. The turnaround in China’s Purchasing Managers’ Index in the past three months has been particularly encouraging, with de-stocking almost complete and good signs for new orders.

Whether a new order will emerge from the current global economic wreckage will depend on when the shorts are happy with their gains, while allowing enough of the world’s economy to remain in tact so that fresh shoots of growth can appear.

#1 Investment Weekly – Why be public?

Isn’t it ironic? The last of Socialist-China’s big four state-owned banks is preparing to go partially public, just as that bastion of capitalism, the US Government, is about to make some of the country’s major banks partially state-owned. But there are a couple of questions Beijing should consider before deciding to allow Agricultural Bank of China (ABC) to list its shares on the stock markets of Hong Kong and Shanghai. First, the bank is healthy enough to seek a public listing because Beijing has cleaned up its balance sheet. So why does it need new capital? Why seek cornerstone investors/punters that are likely to take the discount to the public IPO, and run off with a fat profit when the holding moratorium ends (as Royal Bank of Scotland and others have just done or are about to do)? Why submit the bank’s “value” to the vagaries of fickle equity investors? Why risk public confidence in the bank when the next bear market trundles by? Why bother?

The reasons for listing a company on a stock exchange have been repeated often enough during investment banker beauty parades: new capital for expansion, great PR, better visibility for counterparties, greater management scrutiny by investors etc. But surely, most of these reasons have been made redundant in the current environment. What good was it for Citigroup to be listed, when the regulators, board, management and shareholders were all asleep at the wheel during the last bubble (and the one before that, and the one before that etc)? Will ABC fare any better? I doubt it. I know one thing that will eventually happen: institutional investors and regulators will gather together and demand higher and higher returns from ABC. These outsiders will pressure management into making strategic decisions in their search for those returns. This is what happened in 2005, when the Hong Kong dollar yield curve almost inverted. Here’s a good example of what I mean: in 2005 many Hong Kong banks, under pressure to widen their margins by major shareholders/board members went to see the local regulator about investing in CDOs, SIVs etc. The regulator was highly accommodating to the idea, because 1) it solved the flat yield curve issue and 2) they had a long-held belief that the profitability of local banks was too sensitive to interest rate movements. The regulator wanted the business of banking to be shifted, to a degree, away from: borrowing short term and lending long term (thus picking up income on, at that time, a non-existent yield curve) – to borrowing short term and investing in long term credit-linked investments. The regulator and boards believed that banks make more money assessing credit risk compared with interest rate risk (see Investment Weekly June 9th 2008 – Who’s not overpaying?). But the real kicker was that with CDOs, there was no need to know your customer because the rating agency had done the work and the debts of most of the 100 or so names in the CDOs were of well-known, blue-chip overseas issuers. We all know what happened since, with Bank of East Asia reporting a 99% decline in net profits for 2008 as it wrote off its CDO investments. The bank avoided reporting a net loss because it booked “gains” of HK$2 billion on its debt.

I know another “local bank” that is having an issue with shareholder activists telling management what to do, while having to deal with some underperforming assets. I promised not to mention HSBC for a month, and I have been true to my word. However, I can hold back no longer because today is HSBC’s result announcement day – the biggest day in Hong Kong’s corporate result reporting season. The very detailed leak about the rights issue has removed an overhang and has also sealed the fate of the stock. However, it will be interesting to hear what the shorts are going to say now that the bank is about to raise new capital – as they have long argued. If they say the US$20 billion is enough, then maybe they might leave the bank alone and move on to another victim.

It never ceases to amaze me how massive China is and therefore how many potential victims there are. Consider that half a million people opened a new A-share trading account last week (the highest in a year). While these punters pushed turnover on Mainland bourses to new levels (about HK$230 billion a day), mainland institutional investors are openly selling into strength and are trying to ward off the punters. However, the stir-fryers aren’t listening, because they expect great things to come out of the National People’s Congress, which starts later this week. The punters are also heartened to know that the National Council for Social Security Fund has said it will be investing in local and overseas equities (HSBC?), rather than bonds this year. Why? because, besides the record issuance of global corporate debt in the current quarter, China’s bond market is about to be inundated too. These bonds will be used to pay for planned pump-priming projects in China which currently exceed the country’s GDP in 2007 at RMB29,230 billion. Whether this produces a short term V or U shaped recovery is debatable, what isn’t in question is that retail investors believe that, eventually, China will begin to emerge from its current funk.

This leads me to a major issue that China needs to address. All of China’s massive liquidity and all its much-needed investments are currently not merging efficiently – even with a plumbing system that is dominated by state-owned banks which still lend mostly by fiat. Having a publicly owned ABC will not solve this issue immediately, so foreign banks like HSBC can use their experience, know-how and (to some extent) capital to take up the job.

There is a danger that several opportunities could go missing in the coming weeks. Most immediately, 1) the reaction to HSBC’s rights issue, 2) the US Treasury could finish stressing the banks quickly and announce a plan to transfer the toxic assets (a la the UK model for RBS/Lloyds etc), recapitalize them (public and private) and set them on their way again, 3) China’s NPC could reaffirm its pledge to pump-prime the economy, while 4) Agricultural Bank could call off its IPO indefinitely or at least until the time comes when shareholder expectations are lowered to match the new paradigm and where time horizons are lengthened.

Technically, the HS Index has been trading along a narrow tunnel, with a support line around 12,700 since late January. At the same time, it has been framed on the upside by a descending line of resistance. The index closed at the very tip of this wedge formation on Friday. Today’s close will determine whether the index rises to the high of 15,500 or the low of 11,000 in the coming weeks. The risk:reward is 1:1.3 – in other words pretty even. Obviously, if HSBC announces its rights issue, then the index will head for the recent low.