You could feel the despair around the dealing room and in the voices of clients who still remembered my phone number. You can tell everyone wants a rally; even bears want a rally for the greater good of the financial system.
You could feel the despair around the dealing room and in the voices of clients who still remembered my phone number. You can tell everyone wants a rally; even bears want a rally for the greater good of the financial system.
But this is now the stiffest of psychological and balance sheet tests. You will never face a stiffer test of your conviction or balance sheet. This is a once-in-a-generation test, while also a once-in-a-generation opportunity to buy the highest quality assets from forced sellers at extremely low valuations.
The great investor John Templeton, a pioneer of contrarian value investing, said: “The time to invest is at the point of maximum pessimism.” I wonder if he would be turning in his grave at the opportunities in front of us today. Clearly, the market map paints a picture of “maximum pessimism”.
I know we all want the instant gratification of a big relief rally. We had a taste of that earlier in the week and it was a very pleasant moment. I stand by my view that a huge relief rally is pending, but the real opportunities the equity market is presenting us are investing opportunities, not short-term trading opportunities.
However, with the unprecedented volatility it is almost impossible not to be sucked into chronic short-termism and over-trading. Aren’t we all waking up to see what the Dow has done? Aren’t we all looking at LIBOR and TED spreads to see if there are any signs of the credit freeze thawing? Aren’t we all just looking for anything that’s a short-term positive!
But if we are going to be this obsessed with the short-term, we may as well spend the day at the casino betting on black or red. Actually, I have never been back to a casino since I had the largest bet of my life playing roulette. I put the bet on red and the damn ball landed on “green zero”. The house won my money and I didn’t even have the satisfaction of being completely wrong! At least in the equity market you can be completely wrong.
So you can be a gambler or an investor. Yet right now, being a gambler/speculator or investor in the equity market, I think the odds of making money are stacked in your favour because we have reached the point of maximum pessimism. The world has given up on possibility of co-ordinated and unprecedented central bank and government response to this crisis ever being able to ease the credit freeze.
However, I think that is an irrational conclusion to come to. It’s just not rational to believe that banks will never deal with each other again. Why would they not deal with each other when the counterparty now is a government? I think we are all hoping to see an instant thawing of credit markets but the more likely event is a gradual thawing of credit markets. I am in no way saying credit markets will recover to anything near what they were, but they will slowly thaw and as the equity market realises the credit markets are back open for selective business, a genuine relief rally will ensue.
As the credit thaw starts, the first issuers to be able to transact will be those with impeccable balance sheets and cashflows. This will all be about AA rated and above companies (and individuals) having access to funding. It will be another example of the strong getting stronger and being able to take advantage of the distress in all asset classes.
This is going to be quite interesting. When the world realises the credit markets are starting to thaw a notch, the reaction in equity markets will be a rally in “risk”. We saw earlier in the week the dress rehearsal for a relief rally. That failed attempt at a relief rally was absolutely led by the highest-risk stocks and I don’t doubt that when the genuine, sustained relief rally comes it will also be led by the highest risk stocks.
And that’s great for anyone who wants a quick trade in risk, it may well prove a very rewarding quick trade, but the fundamental investing decision is to buy the highest-quality, longest-duration companies you can because they are the true beneficiaries of the credit markets starting to thaw for the highest quality issuers.
The strong will get fundamentally stronger, both absolutely and relatively, so to my way of thinking I must be buying the strong, and only the strong, to form a genuine investing perspective during this period of maximum pessimism.
While the temptation is to buy risk, and that will work for a trade, the real value will be added over the medium term via buying quality, absolute quality. Why do I say that? Because I think we are going back to a much simpler world. We are going back to basics after a decade of excess.
We are going back to much more conservative loan-to-value ratios, debt-to-equity ratios, interest cover ratios and balance sheets. Credit standards are going to increase dramatically as are accounting standards, while regulatory oversight will also increase dramatically. Global growth will slow to far more subdued growth rates as the multiplier effect of significantly less leverage in the world filters through. These developments will significantly favour the highest quality (strongest) companies over just about everything else over the next five years.
I also think the demise of the marginal hedge fund and marginal prime broker will permanently affect the price of “risk” assets, particularly equities. You could argue “risk” premiums, or at least relative risk premiums between smaller capitalisation (higher beta) equities and larger capitalisation stocks (lower beta) have been mispriced for the past five years due to the unprecedented access to leverage in the hedge fund industry and margin lending industry.
That extreme leverage is now gone forever and I see that relative risk premium spread between higher-risk and lower-risk equities continuing to widen in favour of lower risk stocks over the medium term. So while higher-risk stocks and pure market beta will lead any genuine relief rally, the real opportunity is in taking advantage in that rally in risk and rotating to the highest-quality, longest-duration portfolio you can.
Right now, duration and quality is on sale. In fact, it’s a forced fire sale in duration and quality. However, duration and quality is so rarely on sale and we must, must use this period to increase our exposure to long-duration, ultra-high-quality companies. That is why I am trying to do so many “doomsday valuations” on major Australian companies.
I stand by my view that Australian banks have seen their absolute and relative lows. They again tested those “doomsday valuation” lows yesterday, but they held well and major banks outperformed the broader market. If I am right and the major banks have made a bottom, then all we need now is for the major resource stocks to make a bottom and the relief rally will be on. I think resources are trying to make a major bottom and it was very interesting to watch the trading of BHP in London last night.
BHP plc has consistently followed our weak lead lately and likewise opened down 11%. However, it twice rallied back to positive territory last night, which is strange after a very bad day in Australia. However it only capitulated again when the Dow fell 400 points in intraday trading. Maybe the pommy bargain hunters have arrived in BHP?
I reckon Rio’s backflip – a decision to extend its asset divestment timetable and less bullish remarks on China, which pulled the stock down 16% on Thursday – will mark the bottom of the sector, just as its Alcan acquisition marked the top of both the commodity price cycle and the cheap credit cycle. Interestingly, commodity prices fell again last night but commodity equities in the US led the market.
There is also one chart I have open in front of me every day. I keep the four-year chart of the ASX200 in front of me to remind me of the fact we are trading 2800 points off our highs. This chart simply reminds me there is no point being bearish. What value is added being cautious AFTER a 2800-point correction? What value is added in being “defensive” AFTER a 2800-point correction? What is the point of being bearish with equity risk premiums at record levels?
This is the peak of fear and the peak of volatility. This is the peak of “bipolar” trading in equity markets. The Dow isn’t going to have 1000-point intraday swings for the next few years; that will most likely only last a few more weeks at the most.
Volatility is clearly peaking and on that basis I remain of the view that we are at the bottom of the Australian equity market and a rally to fair value of around 4800 is pending over the next few months.
That’s a 20% rally and it could easily happen as investors realise the credit markets are thawing a notch while nobody seems to have noticed oil is below $70 a barrel, which is a huge positive for the world. The Reserve Bank will cut interest rates again by a minimum of 50 basis points next month, while the Federal Government’s stimulus package will also start kicking in. I can see more positive catalysts than negative catalysts in the short and medium term.
Yes, we face huge global macro-economic headwinds, but the pending rally is more about moving back from the systemic failure of the financial system to pricing in global recession.
While it sounds ridiculous, the difference in ASX200 pricing in my view is about 20% for the two scenarios. Don’t give up at the bottom, this is a once-in-a-generation opportunity in quality and duration. Listen to John Templeton; we are at the point of maximum pessimism.
Charlie Aitken, a director of Southern Cross Equities, may have interests in any of the stocks mentioned.
This article first appeared on Eureka Report
Smart Company is a sister publication to The Mandarin, catering to Australia’s entrepreneurs, small and medium business owners and business managers.
