Posts Tagged ‘1987’

Should value investors be ‘bullish’ in a bear market?

Tuesday, July 15th, 2008

Some of you may have subscribed to value-oriented stock research newsletter. One thing you may notice is that as the market enters deeper into the bear market, the number of “Buy” recommendation increases. From that perspective, these value-oriented stock research are ‘bullish.’

Before we comment on the wisdom of their recommendations, we will have to explain the philosophy of value-oriented stock research. As we explained to one of our reader’s comment in Confidence back? Beware of bear market rally,

… for long-term value investors, they follow the ?bottom-up? approach. That is, they (i.e. the value investor) invest in businesses based mainly on its individual merits (i.e. is it a good solid long-term safe businesses whose stock price is undervalued? Bear Stearns is definitely ruled out in this case) and not worry about the macroeconomic big picture, the business cycle, e.t.c. … In that sense, such value investors are neither ?bullish? or ?bearish.? Rather, they have a neutral view on the business cycle and other macroeconomic big-picture.

Here, we see a potential trap for the unwary value investor. Back in February last year, as we explained in What to avoid at the peak of the business cycle?,

One of the common mistakes that novice investors often make is to extrapolate the past earnings of cyclical stocks into the indefinite future during the turning points of the business cycle. Since the stock market always anticipates the future earnings of companies, cyclical companies will look ?cheap? (i.e. low P/E ratio) during the peak of the boom.

During the turning point of the business cycle, the P/E ratios of good quality companies in a bear market may look very enticingly cheap. But as we explained in Why accumulating stocks on the ?cheap? can be deadly to your wealth?, during such a time,

… a falling average P/E ratio does not imply that stocks in general are cheap. Yes, with careful and judicious stock picking skills, you may be able to find really cheap stocks. But do not let falling average P/E ratio fool you.

Low P/E plus the “Buy” recommendations from the value-oriented stock research may make buying stocks of good quality companies look like astute contrarian moves.

But this is where the Achilles? heel of value-oriented stock research lies. Because they hold a neutral view on the macroeconomic big picture and business cycle, they can severely underestimate the effects of a protracted downturn in the earnings of businesses. This news article, Bottom-up analysts ignore the big picture, sums it well:

“You have got a set of numbers that assumes some sort of recovery,” Macquarie’s equity strategist, Tanya Branwhite, said when releasing the report. “Unfortunately, that’s premised on the cycle we have seen in the last five to 10 years. What is facing the economy at the moment is nothing like we have seen in the last five to 10 years.”

One value-oriented stock research (which we will not name) believes that this current bear market will be like any other ‘typical’ bear market in the past- the downturn will last only 12 to 18 months. In other words, their position is that this coming recession will only be a V-shape or U-shape recession (see What type of recession is coming?). If they are wrong about that (i.e. the coming recession is an L-shape one), then their current “Buy” recommendation will be very wrong.

To illustrate this point, we will give you two examples.

After the stock market crash of 1987, the world economy did not fall into a Depression as initially feared. By 1989, stock markets had more or less recovered. If you bought into the market after the crash, you would have profited greatly.

But what if you bought into the market after the stock market crash of 1929 (see The Great Crash of 1929)? Or you bought Japanese stocks just after the bursting of the bubble in the late 1980s? The outcome will be completely different if you had done so.

In short, not all bear market purchase will turn out to be astute if the timing is way too early.

Liquidity?Global Markets Face `Severe Correction,’ Faber Says

Tuesday, January 16th, 2007

Marc Faber, the legendary contrarian, predicted the 1987 stock market crash, had this to say. He singled out emerging markets for a correction, especially Russia, followed by China (see China is tightening liquidity) and India. In that correction, all asset markets will be affected.

What is the rationale behind Faber?s prediction?

First, we have to understand the concept of ?liquidity.? What is ?liquidity?? There are other meanings for the word ?liquidity?, but for the purpose of this article, we will stick to the quick and dirty definition of ?liquidity? being ?money? in the financial system. Now, how do we define what is the ?money? in liquidity? Traditionally, ?money? is just what it is?cash and deposits. But today, with the advances in finance, ?money? is no longer as easily and clearly defined as before. As a result, money substitutes are becoming proxies for money and playing a much more important role in global liquidity than before. Examples of money substitutes include credit (e.g. mortgage-backed securities) and derivatives.

Now, what has liquidity got to do with the asset markets?

As you may have noticed, stock markets around the world are in record high territories. What is driving the stock markets is liquidity?the sheer weight of money and money substitutes chasing after a limited supply of assets (bonds, stocks, art, etc), resulting in skyrocketing prices. Therefore, any crunch in liquidity will result in collapsing asset prices.

How is it possible for liquidity to be crunched?

The problem with liquidity is that most of the ?money? in it is made up of money substitutes, most notably derivatives. Today?s modern financial system is such that when the central bank ?creates? money, money substitutes get spawned multiple times. The outcome is a pyramid of ?money,? with hard cash at the apex and derivatives at the bottom. The financial assets between the apex and bottom include cash deposits (spawned and multiplied from hard cash through the fractional reserve banking system) and credit (e.g. securitised debt). In such a liquidity pyramid, the values of financial assets at the lower part of the pyramid are derived from and backed up by the financial assets above it. Since much more of global liquidity are composed of ?money? in the lower part of the pyramid, any contraction in the upper parts of the pyramid will result in a multiplied contraction in the lower parts. If the liquidity contraction is severe enough, asset prices will fall precipitously, which in turn may trigger even more contraction in liquidity. This is called a ?market crash.?

Thus, as long as the central bank can influence the increase in liquidity into the financial system, asset prices will rise. If for whatever reason, liquidity contract severely enough, asset prices will collapse.

The question is, are we now ripe for a contraction in liquidity?