A mid-week note to start 3Q2010

I feel almost apologetic that the market practically has had its wheels fall off after my double dip post on Monday. My protégé smsed me and said maybe I should write about more optimistic scenarios and the market may turn positive. Often have we heard about markets overshooting on the upside and downside. I believe the sell down in 2008 was a classic case of overshooting on the downside on the back of “end of the world” pessimism. While the sell down in 2008 was spectacular, the rebound in 2009 was nothing short of a big bang. The question that lingers in one’s mind is…Did it overshoot on the upside. I believe the answer is maybe. As we all know, the world is a big place, global markets are not equal in terms of status and valuations, this is the reason why my answer was maybe.

When the tide rose in 2009, every market rose in tandem and almost every investor became a genius (including me). But if we look at the earnings expectations, I would have to say that the expectations have been a little too optimistic for some markets. The S&P reaching 19 times p/e at its 2010 peak was excessive considering economic growth was still tepid. While the Shanghai composite traded at a mere 20 odd times when China was reclaiming double digit growth numbers. How I would classify this current correction as a normalization of valuations for the markets that have overshot on the upside. As for Shanghai Composite trading at 15 times p/e, that is just a bargain. The worries over a slowdown and its property bubble bursting is keeping valuations in check but I believe for those brave souls out there, they should be buying some CSI 300 or any A shares ETFs because returns will be great down the road.

In simple words, 2009 was the biggest 1 year rebound in stock markets ever and many stock indices doubled during the period. Remember, these all happened before the earnings recovered in any way. Investors realized that they had been overly pessimistic and sold down stocks to a level which should only be touched when the world was coming to an end. No one can be blamed for that besides the media who wrote about the crisis as if it was really financial Armageddon and the world we know was coming to an end. When the world did not come to an end and rationality came back home, investors started to price stocks more rationally. As the markets picked up, so did sentiment and this pushed prices to levels where it was a little stretched and now we are paying the price.

According to PIMCO’s New Normal thesis, investors should get ready for lower growth in developed countries and emerging market will start to play a bigger role in world markets. They also mentioned that investors have to stop having the expectations of double digit returns from bonds or equities in this new normal environment. Investment assets are not expected to perform as strongly as the "old normal" over the past 20 years and in the "new normal" investment returns are going to pale in comparison to the past.

Never in PIMCO’s dreams was the market going to rally like what it did in 2009 and it was practically an egg in their faces. But I would like to add, they may not have gotten the timing correctly, it does not mean that they are wrong. Eventually their new normal will arrive and investor expectations have to adjust to the new growth path. They were too early on their call on the sub-prime crisis, but at least they were well positioned for it by the time it happened.

I do believe that the credit crisis of 2007-08 stemmed from the fact that we have built the world we live in on credit. Credit is a part of all of our lives. It is commercialization that has led us to rely so much on credit and living on credit became a norm. Credit cards lure us with their attractive promotions, interest free installment payments, Kris flyer miles etc, convincing us that by using them is more than just out of convenience but also the benefits are bountiful. Credit is used in buying luxury items like houses, Panerai watches, sports automobiles etc. It allows us to buy things which we cannot afford at the current moment but we wish to believe we will eventually make enough to do so. For the past 30 years, credit has been utilized from individuals to corporates to governments and the multiplier effect has been one that the world has never seen before. The creation of securitization has exacerbated the problem by allowing financial institutions to sell the debt back to the very people who are taking on the debt. What irony!

The credit crisis of 2007-08 represents the wake up call that we have so desperately needed but never want to hear from. As credit is withdrawn from the system, “deleveraging process” is what it is called, corporates, individuals and governments are all suffering from their past over indulgences. From a sub-prime and mortgage crisis (individuals), it evolved into a banking crisis (corporates) and now moving to the advanced stage…a sovereign crisis (governments). The credit crisis is not over, it is just evolving and moving like a contagion from the smaller players to the larger ones. We are probably at the more advanced stages of the deleveraging process but it is a stage which could drag on for a long time. Credit expansion is not expected to come back with a bang any time soon (with the exception of China) and sovereign risks are rising as less peripheral countries like Spain and the UK are getting dragged into the picture.

Many would say a sovereign crisis like this is possibly a once in a generation event, in Nassim Taleb's words a "Black Swan" event. From a personal point of view, I do not think the Euro zone's crisis is the trigger for the "Black Swan" event. No doubt these Euro zone problems will not be going away any time soon but they will not lead to a world wide crash. Do not listen or take heed in what the press are writing about; how the Euro zone is going to split up, the end of the Euro is nigh, Germany to leave the Euro zone, PIIGS going to be kicked out of Euro zone etc. First let me say, the Euro will never disappear and the Eurozone will not break up. To top things off, assertions of Germany leaving the Euro zone is just preposterous. The Germans are better off with the lower Euro, they are going to be exporting a serious amount of BMWs and Porsches. There is also no chance the Germans will take the risk of incurring the wrath of its largest trading partners by abandoning them during their time of need. Germany is afterall the largest exporter of goods within the Euro zone and the last thing they want is to make their largest customers angry. So logically, all those debates in the media on the breaking up of the Euro zone is just silly.

There is without a shadow of a doubt that the troubles of the US is significantly higher than that of the Euro zone nations. There will always be arguments that the USD is the reserve currency of the world and that it can never be replaced. I would like to remind readers that no one believed that Rome would fall too. I do not think it would be wise for the world be complacent and believe that the US will always be the leader and with their ability to print more money, they will not fall into the same trap as the Euro zone countries. All I can say is, it is only natural that no one stays in a leadership position forever. Just like Roger Federer, Lin Dan, Michael Schumacher etc, they may be the best of all time at present, but their no. 1 position will one day be usurped by others. It is great to be on top, but enjoy the moment because it will not last forever.

Best,

SVI