Saturday, 13 August 2011

Crisis and asset price behaviour

The previous post was squeezed in-between trades (to have a standing record of my thoughts-in-motion). I spared myself a rather longish exposition on history and behaviour. Now that the gyrations have played out (somewhat; and I have unwound my panic trades), I have time for a breather.

The US debt downgrade was greeted with knee-jerk reactions followed by various voices crying hoarse, expressing solidarity in Uncle Sam’s debt. The Risk switch snapped from ‘On’ to ‘Off’ and capital duly forsake equities, fleeing into US Treasuries, Gold and CHF (Swiss Franc). The flight into Gold was understandable, given its current-flavour-of-the-season status as a safe-haven. The CHF and US Treasuries' behaviour were queer, to say the least. 

Crisis moments in history always provide good food for the curious brain.

1987 stock market crash
The 1987 stock market crash triggered a bout of risk-aversion. Panicking investors pulled out of equities to seek refuge in Treasury bonds. Gold was sold. The prevailing rationale for dumping the latter centred around two basic arguments. 1) A depression would likely follow the crash, in which case inflation would be a non-event. As Gold was seen as a hedge against inflation, it wouldn’t be in demand, 2) Gold was being sold to meet margin calls on other asset classes that were being pounded in the battering.

Equities – DOWN, Gold – DOWN, Treasury Bonds – UP

Gulf War
The onset of the Gulf War triggered a rise in crude oil prices (which was reasonable, considering the battleground was atop mountains of oil). The US$ weakened as investors fretted about likely future budget deficits caused by Gulf War spending. Equities and US Treasuries sold off; on the rationale that war-induced inflation would hurt the economy. As inflation is stocks and bonds’ nemesis, both sold off. It is pertinent to note that US 10-year Treasuries were yielding 8.75% and the Fed had much leeway in slashing interest rates, if needed. Another quirk was the behaviour of the Japanese Yen (JPY). Even though Japan was more dependent on Middle East oil than USA and was still coming to terms with the fallouts of the Nikkei bubble, investors embraced the JPY!

Equities – DOWN, Gold – UP, Treasury Bonds – DOWN

Internet bubble
The dot-com bubble that popped in 2000 was chiefly led by technology and internet stocks that were heralded as the game-changers of the 21st century. When the bubble eventually popped, investors swapped equities for bonds. 2000 turned out to be a good year for bonds that were up about 13%. The tech wrecks dragged down equities, with the S&P500 ending the year -10%. Minus the tech jocks, the S&P ended the year marginally positive, indicative of the ring-fenced tech space power outage.

The crash, once again, prompted fears of an economic slowdown. Overlapped on US’ fiscal situation (budget surpluses, which minimized the need for debt financing), this created a happy situation for bonds. Bonds were in vogue as people positioned themselves for a slowdown. Gold had a good year too.

This might seem a bit odd. If inflation was a big concern, Gold’s rally would seem rational, given that it was seen as an inflation hedge. However, this should have caused bonds to sell-off. But as both gold and bonds rallied, did this point to an anomaly? An irrationality? Some caution is called for before forming an opinion on supposed irrationality. Because, sometimes, people see Gold as an inflation hedge and at other times, they perceive it as a safe-haven. In this event, Gold was christened as a safe-haven buy. When perceptions change is difficult to predict and is one of the many things that make a market practitioner’s job interestingly challenging.

Equities – DOWN, Gold – UP, Treasury Bonds – UP

These events highlight divergences in investor behaviour at various points in history. The illustration is useful for more than its behavioural value. It highlights the pitfalls of betting blindly on past patterns repeating in the future. Firstly, crisis events have no clear pattern repetition. While events rhyme, each event is unique in character and the test is one of right interpretation. Secondly - and yet - it hurts to not peer into history to learn the lessons of past folly.

Gauging prevailing investor psychology (the Hypothesis) at various points in time is probably the toughest and the most important aspect of an investment practitioner’s job. It is akin to a doctor checking a patient’s pulse as the first stage of a diagnosis. In 1987 the Hypothesis was an era of economic growth slowdown where inflation was not expected to be much of a concern. In the aftermath of the Gulf War, the Hypothesis was a period of economic growth slack where inflation was the chief concern. Post the 2000 bubble, the Hypothesis was a period of growth slack but where inflation was not a priority concern. Recession was posited in the first and the third instances, while stagflation was the prognosis in the second. The common thread in all three was the repetitive passing out of equities. Paradoxically, even though equity sell-offs have often triggered fear, usually they are reactive to broader rumblings elsewhere in the economy.

A ‘barmy’ world?
A quick look at US’ financial situation in 1987 compared to today. Compared to 1987, US national debt has risen 6-fold while GDP has increased about 3-fold. US national debt is now nearly 100% of GDP versus 50% in 1987. Back in 1987, US 10-year Treasury yielded 9.5% and inflation (CPI) was 4.5%, implying a real return of +5%. For investors flooding into US Treasuries in 1987, this was a tempting prospect. Cut to 2011, US 10-year Treasury yields 2.5% (and trending lower) while inflation (CPI) is 3.5%, for a real return of -1%.

Yet, capital flooded US Treasuries. The CHF is bid even as real rates on it are negative.

Even as European peripheral weaklings spar with bankruptcy and US scrambles to extend its honeymoon period with borrowed capital, corporate financial health seems to be healthier than in 2008. Net debt/EBITDAs, in general, are lower than in the crisis, interest-rates are at multi-decade lows and valuations seem reasonable. Yet, bidders are rare.

The world looks thus: Negative real-rates trade seems to be well and truly pumping. An asset that has never had a recorded account of throwing out cash, which is painstakingly (and expensively) dug out of the earth only to be stored in vaults (at an expense), is bid up enthusiastically. While businesses that are healthier now than in the recent past (and throw out real cash) are ignored.

Will Alice come out of Wonderland?

Saturday, 6 August 2011


So S&P downgraded the US one notch to AA+ with a ‘negative’ outlook. Given the downgrade, escalation in the debt limit and promised spending cuts spread over the next decade; one would be forgiven for thinking Treasuries would have sold off with money flowing into safe-haven favourites (CHF, JPY, Gold..). Treasuries rallied reacting to this news, showing that in times of duress, psychology trumps everything else as investors pile into an asset class for its perceived safety value. Never mind if the expected return is not commensurate with the risk assumed. Actually, few think in terms of 'return' when it is apocalypse time. Treasury rally in the face of a downgrade also indicates that few probably believe in the rating agencies' opinions. With the Swiss bank slashing rates to curb the CHF's rise and the BoJ intervening to prevent a rise in the JPY, the world resembles the stage in the 1930s when everyone scampered to be the first to hit the currency bottom in a bid to boost exports. 

Given the above, it looks likely that Monday market open will be greeted with $ weakening, more Treasury buying, and money flow into Gold, the ultimate (perceived) safe-haven. Disclosure: Long yellow metal.

Stepping back a bit and looking at the globe as a developed/emerging markets matrix, one observes:

1) The developed world struggling with solvency and liquidity issues, with politics upstaging economics by a huge margin. The politics trade is a tricky one, giving few asset classes or trading themes time to take shape. Growth continues to be anaemic while inflation seems just a corner away from ambush. The devil is on leash for now but for how much longer? The path of least resistance seems to be a period of stolid economic growth amidst a backdrop of low-to-moderate inflation. Stagflation = +1.

2) The emerging world is grappling with a central banker's ultimate nemesis; above-target inflation and below-trend (and slowing) economic growth. The path of least resistance here too, like the developed world, seems to be a period of stagflation. Stagflation = +2.

Lessons from history are a little dodgy here. The (anti-inflationary) Gold Standard was still in vogue in the 30s, so inflation wasn't an issue for economies till they defected or were forced to defect from the Gold Standard. Economic growth took a knock collectively but inflation did not pose as much a threat as a collective issue as it does now.

Given this central hypothesis of stagflation, hard-asset plays and businesses with annuity characteristics with some degree of freedom to raise prices without a corresponding increase in cost, are themes worthy of consideration. In a period of anaemic growth, investors have historically not been loath to paying a premium for sustainable growth, explaining lofty valuations of some of the consumer plays like Nestle, Colgate, Gillette, P&G. As long as the central hypothesis holds, these consumer plays will continue to blink on investor radars, high valuations notwithstanding. Another theme is companies with strong balance sheets and low dividend-payout ratios. Cigarettes, toll-roads, water/waste-water treatment, sections of the natural gas value chain, battery makers...The fixed-income asset class provides some interesting plays, given the high interest rate environment, by way of NCDs that offer an attractive risk-reward in senior pieces of the capital structure.

The Phoenix bursts into flames before perishing, followed by a rise-from-the ashes moment. Though the flames aren’t visible yet, a burning smell wafts into my nostrils.