#1 Investment Weekly – Bank stress

The market’s obsession with the US bank stress test is a curious one because bank regulators are constantly stress-testing the institutions under their watch – that is what they do: mostly. Hong Kong’s bank regulator, the Hong Kong Monetary Authority has built a reputation as being a ferocious stress-tester (particularly after the Asian Financial Crisis). This persona has manifested itself very clearly in recent weeks and is likely to be the considered the template for other, “less stringent” regulators in the future. Unfortunately, if not handled correctly, this could result in below-average bank profitability and possibly a delay in economic recovery.

The HKMA is furious with itself. For years, the regulator had allowed local banks’ CAR ratios to fall, while encouraging them to build their, less-capital intensive, fee businesses. The reasoning had been simple: Hong Kong had hollowed out its industrial base to the Mainland and had become a servicing centre for southern China. Local banks could not continue to grow and prosper by servicing loans that were geographically, culturally and legally so far away. However, as Mainland-based factory owners brought their wealth back home, Hong Kong banks could serve as their financial advisers and earn wealth management fees to compensate. This, the HKMA reasoned, is Hong Kong’s long term future (see Special Newsletter July 2007 – The rise and fall of Venice – a lesson for Hong Kong). Unfortunately, the financial crisis of 2008 has put the wealth management business model of local banks in serious jeopardy. The HKMA is screaming blue murder and is imposing Glass-Stegal like arrangements on local banks. The collapse of Lehman Brothers and the subsequent complaints from Lehman mini-bond holders that they were mis-sold the product by retail bankers has focused attention on the HKMA and has tarnished its image (thus putting Hong Kong’s long term future at risk).

Basically, the HKMA overestimated the intelligence of Hong Kong’s nouveau riche and the “enthusiasm of the sale” of Hong Kong’s retail bankers. I have already called for examinations on financial markets/products for buyers and well as sellers of financial products. Although this idea has not been imposed, I think the regulator is heading in this stringent direction. It has already demanded that retail/general banking and wealth management services be physically separated at bank branches. This will be a nightmare for small retail banks with their tiny branches. The solution for many could be to rent space next to their branches, which will be a boon for retail shop values. However, this assumes that mass-market wealth management services remains profitable. All sorts of selling restrictions will be imposed by the HKMA, practically making it impossible for this business to be at all profitable. One such restriction will be a cooling off period, whereby a customer can walk away from buying something after a certain period of contemplation. As the price of most products change daily, a lot of borderline trades will not be carried through to actual fee income.

And the HKMA is not just stopping at the sale of investment products to retail investors. Bank balance sheets are also coming under scrutiny. The HKMA has had to deal with several bank run incidents in the past (particularly in the early and late 1990s), but these were mainly aimed at foreign-owned, small banks. Last year’s run on Bank of East Asia struck right at the heart of the local financial system because BEA proudly boasts that it is the largest, independent, Chinese bank in Hong Kong (Hang Seng Bank is owned by those Scottish bankers headquartered in London, so they don’t count). The result of the run on BEA was the guaranteeing of all customer deposits in Hong Kong by the government. Previously, there was a cap on the amount insured, and the fund covering the liability was being paid for by the banks (via lower deposit rates for their customers). The guarantee is expected to be lifted when global financial markets calm down. At that point, the benefit of the guarantee to small banks will be removed and the possibility of disruption could ensue as depositors assess whether they should keep their cash in a small bank that’s paying higher rates, but with no protection. Increasing the old cap to HK$300-500k will not change the dynamics of the deposit market.

So far, there have been no bank failures in Hong Kong (compared with 25 in the US already this year – same as for all of 2008), and there are not likely to be any either. But the HKMA is not taking any chances. The government has been keeping its reserves in place just in case. This explains why the budget giveaways were conservative – to say the least. It also explains why the Aggregate Balance (a proxy for bank HK$ liquidity) continues to rise, as the HKMA attempts to keep the HK$ within its trading range. Banks are basically hording liquidity (at the HKMA’s request). The HKMA’s stress test requests in recent months include: how many days would a bank’s liquidity ratio remain above the minimum requirement of 25% if half of the bank’s deposits were withdrawn in a single day. The answer, universally, has been: not very long. Of course the HKMA is the lender of last resort and is supposed to help out in a situation as drastic as a 50% withdrawal of deposits at a bank. Major shareholders would also have a say. Although these stop-gaps were not included in the stress-test, it is a given that all parties would come to the rescue. However, the HKMA is not taking any chances, and is coming down hard on local banks right now, demanding that liquidity be kept high in case of trouble.

When a regulator starts dictating a market to the extent that the HKMA is currently doing, profitability will come under pressure. I’ve said for many years that banking is a mugs game: how do you balance the social responsibilities of being a custodian of an economies’ liquidity and the desire of shareholders to see higher returns on their equity? This quandary will remain unanswered in the current set up (but it is clear that local banks shareholders are paying a high price for the social good), while calls for the regulatory regime be modified from the current arrangement (where various bodies oversee respective corporates) to a system where a single regulator oversees all systemic risks in the financial markets sounds just as ambiguous as the current arrangements. Until a decision on this is made, regulators will be freezing decisions and, therefore, potentially stalling/inhibiting both the profitability of financial institutions and therefore the recovery of the overall economy.

What does this mean for the short term direction of the market? Not much, because, although local banks are flush with cash, the recent uptick to 100 billion shares traded each day has been funded by mainland banks (although talk of a stabilization of economic conditions has fuelled the flows into Hong Kong equities). These sentiments will probably hold this week, allowing the Coppock Indicator to confirm its turn.

#1 Investment Weekly – Three strategies (L.M.ST)

This newsletter’s model portfolio cannot be classified as available for sale or trading, because the intention of the portfolio is to produce a return on investments using a long-only buy and hold strategy. For some investors this is a boring approach to investing – they would much rather day trade or look to take advantage of momentum trends. Here are the performances of these three strategies (Long, Momentum and Very Short Term – L.M.ST) using the Hang Seng Index, for your consideration, and advice on which one will perform the best when the light turns green.

It may have slipped my mind at the time, but here’s a graphic illustration of why I believe the stockmarket’s traffic light changed to amber two weeks ago. The HS Index’s monthly Coppock Indicator has turned upwards for the first time since the current bear market began. The indicator assumes the stock market absorbs all the bad news of a bear market 11-14 months after the event trigger. In order to confirm the uptrend, the HS Index needs to close the month above 15,200.
HS Index Coppock Indicator

The indicator doesn’t turn very often, and usually, when it does it continues to do so for a long while. Unfortunately, the indicator has not been tested in the dire global economic conditions of the present. Hence the need for caution about the status of the traffic lights at this time. For a long term investor, leaving the first bounce on the table doesn’t hurt overall returns, but it does take a large degree of will-power to resist.

A slightly more exciting strategy is to trade momentum. The chart below shows the performance of the HS Index (using the Tracker Fund) based on signals provided by candlestick movements.
Tracker Fund vs candlestick returns (rebased to 100)

There were 27 (buy:sell) trading signals during the past two years, which, for a buy:hold portfolio, would be considered excessive trading. Using the candlestick technique resulted in nine wrong trades, which is a 33% strike rate. Compare that with this newsletter’s 114 trades in eight years, with a loss of 18 (including current positions), and the difference is clear – half the loss rate.

As you can see, the strategy is not particularly useful during raging bull markets, but it has its merits during downturns, as it can produce outstanding returns by trading the bounces (such as the current one). There are usually six technical rebounds during bear markets, and the index is currently enjoying its fifth. The candlestick indicator signaled a sell on April 8, so it has missed the 6% upside since then. But that’s the point of momentum trading; the signals for when to exit are not very strong.
Mid-point change in daily high-low of HS Index (%)

Judging by the swings of the chart above, anyone that day trades stocks must be slightly mad and quite reckless, in my opinion. This is particularly true if you decided to trade the hottest stock in town right now, CITIC Pacific. Here’s what happened to the price last Tuesday. It gapped up 3.8% at the open to HK$11.02, in heavy volume, which continued through the session, leaving 91 million shares traded for the day (~6% of free float). The weighted traded price was HK$11.803, with an intra-day price movement of 19.7%. Now that the stock exchange has got rid of the auction period, day-end price manipulation is now conducted in the open, with the bid-ask for CITIC at HK$12.12-12.14, but the official closing price was HK$12.38. The close was 2.1% higher than the bid and 4.9% above the weighted traded price. All that movement would have been welcomed by traders, but analysts are at a complete loss about how to value the company following the sacking of the two founders of the company, and the installation of the CITIC Group’s president. Target prices for CITIC are as wild as the share price movement, with CLSA giving a HK$9.60 tag, while Macquarie’s analyst must have missed something with a HK$3.75 price target. By the way, no one has a price target above the current price. Why? The analysts don’t know how to value guanxi. I remember when I covered CITIC Pacific as an analyst: I could never properly value the “connections potential” of the company. However, I think it’s fair to say that this intangible increased significantly with the removal of Larry Yung and Henry Fan. Amazingly, the potential overhang of these (still) major shareholders has not had a major impact on the share price, which has risen 40% so far this month. At 17x forward earnings and no dividend, the model portfolio will give more time to its investment in CITIC before deciding when to offload the stock, no doubt at a loss.
HS Index bull/bear phases using month ends – 1987-present

In summary, it would appear that there is room for optimism about the prospects for Hong Kong equities from a long term perspective, while the momentum play currently being ridden by momos will likely hit a ceiling at the Index’s neckline and first fan line resistance at 16,200. The last time the index managed eight weeks of successive gains was after the announcement of CEPA in April-June of 2003. This was achieved despite rising local unemployment – which peaked at 8.7% in July. Confirmation of a downturn in the rate was announced in October (six months after the stock market bottomed). The index has just completed its sixth straight weekly gain (despite rising unemployment) in heavier volume. Intraday volatility is likely to remain (reassurance for those living on day trades), as there are plenty of uncertainties ahead (stress test results, quarterly results, plain-vanilla corporate defaults, CDS related bankruptcies etc).

For the three investment approaches (L.M.ST), I only have return data for the long term and momentum versions (although recently retired Richard Bernstein agrees: if day traders make any money it’s mostly due to luck). The former method, using this newsletter’s buy and hold strategy, has generated a 65% return (with dividends) in eight years, while the candlestick momentum method has produced a 35% gain in two years. The difference in the returns is the higher risk involved in momentum trading (33% loss rate vs 15% for the long term). If I have to make a suggestion, it would be: ride the current momentum if you have a position (i.e. sell in May and go away), but switch your mind-set to a long term strategy during the next downturn (i.e. the sixth and, usually, final down wave), because the momentum trade will only match the Index’s return from here on in. Although Index returns are going to be in the triple digits, it’s during bull runs that most gains can be achieved by buying and holding on.

#1 Investment Weekly – Let’s get sentimental

A name-sake of mine at Portales Partners was quoted by Reuters as saying that the changes in mark-to-market rules announced by FASB last week would not have a significant impact on bank profits. This could be right and it could be wrong – because we do not know how banks/auditors are valuing/classifying their investments. However, the changes will have a major impact on sentiment. Above and beyond what impact the changes will have on bank profitability, it shows that elected leaders/regulators are listening. Fortunately, the politicians are listening to the longs, rather than those lazy shorts (who will now have a lot more investigating to do).

Critics of the FASB changes say that investor sentiment will be undermined by reducing transparency, but I didn’t notice this concern as HSBC’s share price rose 16% last week. They also note that the political pressure used to get the changes was a dangerous development. They fail to realize that in the current climate popularist politicians have felt empowered to act because of the failings of the previous free-market system. Politicians are much more adept at gauging sentiment, because they, being human, better understand that the mental state of the market is just as important as the fundamentals.

The state of mind of Hong Kong bankers is slightly more relaxed now that that they have finished reporting their results for 2008, but they should not let their guard down just yet. On average, as expected coming from such a high base, net profit declined 60% as bankers kitchen-sinked their exotic investments. Will they come to rue their actions if IAS adopts the FASB changes? Probably – because the extent of the write-downs meant that loan provisioning looked a little on the light side. This will come back to bite the sector in 2009. None of the 10 banks reported a loss (although Bank of East Asia came pretty darn close), suggesting that the HKMA is happy with the small band of listed bank stocks (in the last major financial shock in 1998 three banks (Union, HKCB and Ka Wah) reported losses, managements were replaced and the banks were promptly sold – got the drift Mr. G?).

Last year’s Hong Kong bank sector performance has been slightly distorted because another two banks were de-listed in the last 12 months. However, as they were middling sort of players, most of the comparisons with 2007 are still valid. Although one would have expected a marked slowdown in loan growth in the later part of 2008, the listed banks still reported an 8.6% increase in loans during the year compared with the 10.2% increase at half time. This was achieved despite a forewarning increase in non-performing loans from 0.6% at mid-year to 1.0% by year end. A major distortion appears when comparing loan provisions to net interest income (NII) because Wing Lung and CITIC Ka Wah aggressively cleaned up their balance sheets in 2007 in preparation for their sales. Excluding the two, loan provisions as a percentage of net interest income was 17% in 2008, compared with 19% in 2007. This suggests that banks were 1) underproviding or 2) producing higher higher NII.

Local bank sector performance

It would appear that NII was in fact a good source of income in 2008, despite the disruption to the economy. NII rose 5.4% for the sector, with loan growth providing the main propulsion, because margins were basically flat at 1.92% (vs 1.93% in 2007). Fee income was decimated, dropping 21% because of investment write-downs and lower brokerage and investment product sales. However, as local banks are basically plain vanilla lenders, the drop in fees was not particularly devastating, with operating income falling only 4% (which, coming from a high base, was a credible performance). The problem arose with expenses, which were not reined in at all. First half expenses were 18% higher, but were still +14% for the full year. Part of the reason was because bonuses for the bumper year of 2007 were split (as a retention strategy). The industry has seen some head count cutting, but it has been done slowly. With revenue falling 4% and expenses up 14%, operating leverage for the sector was negative for the first time since 2005. Only ICBC (Asia) produced positive operating leverage. Naturally, return on equity for the sector fell to 8.1% from the unsustainably high 16% of 2007. Despite the weak profit performance and increase in loans, the sector’s Capital Adequacy Ratio was steady at 14.2%. CAR was boosted by sub-debt issuance and even a share issue.

The share placement was between BEA and Bank of China (HK) (HK$8.60 – 2388.HK). At the time, the placement was seen as an endorsement of Hong Kong’s banking system and BEA’s China connections, as well as a vote of confidence in the owners of BEA, the Li family. However, it now turns out that the deal was struck with an undertaking that, at some point in the future, Bank of China (HK) would be the next local bank stock to be de-listed from the market. So, although BoC (HK) officials received little in the way of bonuses because the bank had to take a HK$2 billion write-down on the BEA stake, their share options should be safe. I predicted in 2007 that Bank of China would bid for its local branch, thus removing the confusing situation of having two Bank of Chinas listed here. It was therefore no surprise to me to hear that Bank of China has publicly committed to increasing its 66% stake in BoC(HK). For a long term investor, this pledge is a red rag to a bull, and, with the sale proceeds from last week, I am adding a bank to this newsletter’s model portfolio for the first time in years. BoC(HK)’s 7% dividend yield is relatively solid, and downside on the stock must be limited to at or below book value of HK$8.20 because of the parent’s support. Bank of China (HK) would be one of the largest beneficiaries of changes in mark to market rules. And, as IAS will be thinking about a complete review of their “outdated” (their words not mine) accounting standards in the next six months, this positive will also provide support for it and the overall market.

As turnover jumped last week I got the same feeling that I experienced when China announced the through-train scheme in mid-2007. It was a sense of disbelief that market sentiment can change direction so quickly, along with the regret that I sold too early (in fact the index is only up 3% since I sold, and most of the Index’s gain was due to HSBC’s 16% post-rights rally). The fundamentals have not altered much: unemployment is rising everywhere, demand is weak, the de-leveraging continues. There has been some restocking, which is giving the impression that economic activity has bounced off the lows of late last year, but it is not likely to be sustained. Technically, the HS Index is flying well above its Ichimoko cloud; it’s at the top end of its Bollinger band; with an RSI of 60+. Interestingly, the index broke above the second long term fan line after failing to break it the week before, while the index looks to have formed a double bottom.

HS Index indicators, fans, bands and bottoms

But overseas indicators are not so clear. The VIX is still elevated above 40, US equity short positions have increased to US$16.2 billion (the highest level since September last year), credit markets tightened, but again the reaction to FASB (like the Geithner toxic asset plan) was muted. It’s still a mixed picture, which means the amber light remains.