Has the equity markets gone ahead of the fundamental economy?

Let’s start with some basic premises; the equity market is always a forward looking, future predicting indicator of where the fundamental economy will be in the future. The question is; is it 3 months forward looking or 6 months forward looking? Globalism means that capital flow moves faster in an out of asset classes and amongst different countries, liquidity and flight monies has become close friends because the world has become smaller with the help of IT. Correlations are higher because capital flow moves faster and the lag time between the impacts to different financial markets have narrowed.

 

Correlation and the contagion effect are kissing cousins; notice how quick equity markets all over the world responded in unison like an orchestra; all collapsing to a low in early March 2009!

 

Since then till now, all the equity markets have rebounded significantly with Shanghai, Hongkong and Singapore leading the back; 100%, 63% and 70% respectively. The western countries also rebounded but in a much lesser extent, the U.S., Australia and Japan have rebounded in the 38% to 43% range.

 

In hindsight, when we look backwards, it is always 20/20…….we have perfect vision.

 

The gloom and doom sentiment took a firm foothold, gathered pace into Q4, 2008 and culminated in Q1, 2009, the equity markets affirmed the gloom and doom by going into an oversold position and hitting a low in March 2009.

 

Are the equity markets reflecting the state of affairs as it is? In reality, do equity markets reflect the current state of the economy or does it reflect the future state of the economy? We believe the equity markets in the last decade no longer is a leading indicator of the economy but in reality is the current indicator or the confirmation of the current state of the economy both on the fundamental aspect as well as the sentiment aspect.

 

In the last decade, a handful of the leading banks in the world have developed comprehensive analytical models to predict sentiment besides, the traditional fundamental analysis and technical analysis, why? This is because within the last decade, sentiment has proven to be a power driver of trends in financial markets from as short as 2 months to as long as a year. Therefore, it is an important factor in understanding the movements in the financial marketplace. It also largely narrows the gap between sentiment/expectations and fundamental/reality, so much so that one can plausibly conclude that the equity markets are a reflection of the current state of the economy. Backward testing of the last ten years of both the economic cycles and the financial markets substantiate this view.

 

Where are we today? Sentiment and liquidity were the clear drivers of the financial markets from March 2009 till about July 2009. And then, maybe March could have been an oversold situation and the rebound could have been a normalizing effect. Then came corporate earnings results and slightly better economic indicators which has driven the markets the rest of the way till now. Then again, the equity markets have been trading sideways the past month……….not sure what to do or where to go next?????

 

Corporate earnings are now being criticized as not being reflective of the state of the health of the economy because forecasts have been reduced to such a dramatic low that any ounce of earnings would outperform forecasts.

 

The financial markets moved strongly in August when economic data showed that manufacturing and production had increased, housing appears to be stabilizing and unemployment still rising. However, stronger manufacturing and production data was not in response to strong consumer demand. In fact, consumer demand or consumption is still very anemic and with rising unemployment hitting near 10%, no American is exactly motivated to spend money if anything at all.

 

The improved manufacturing and production numbers was because of inventory re-stocking, companies are rebuilding their inventories in anticipation of consumer demand later in the year. 

 

Therefore, the improved economic data may not be sustainable which is why the financial markets are languishing and trading sideways because there is simply not enough convincing data, views or arguments to support why the financial markets should continue to move upwards.

 

I beg to defer. Everyone is looking at unemployment figures, housing figures, consumption and earnings; I would like to suggest that we look at CAPEX. Capital expenditure or Capex is when companies use either their retained earnings or raise capital from the capital or debt markets and reinvests in the company. When companies have more confidence in the economy, they will begin reinvesting in the businesses to diversify, to expand and to grow. 

 

Capex is the absolute clearest indicator that the economy is on track to recovery and growth. Right now, we are seeing the first evidence of capex turning the corner. Australia is clearly leading the world with Capex and the economy is showing it in better GDP numbers, employment numbers, stronger currency, better productivity and subdued inflation. Other countries include Hongkong, Malaysia, China, India, Brazil, Taiwan and Singapore.

 

Singapore is different! Sounds like a familiar phrase, but it is true. Capex by Singapore companies has not happened but why did the equity market rebound by more than 70% compared to other equity markets. The answer is because the Singapore Government has done such an excellent job marketing Singapore that capital flows are coming into Singapore in two big waves: - the first is foreign companies setting up offices or factories in Singapore, this is capex. It does not matter that it is imported capex, it is still capex, it creates jobs, boosts GDP growth, and promotes consumption; the second, many individual foreigners are migrating to Singapore to make Singapore their home, to work, to do business and to raise their families. These individuals bring capital to buy property and invest in our stock market, this is capex at work. These two reasons alone are strong enough to ensure the recovery in Singapore. Of course, like all other major equity markets in the world, the Singapore equity market has been trading sideways for the post month, an affirmation of the uncertainty of the times. We’re all waiting for Singapore Inc. to start turning the wheels of capex.

 

The time to be brave is now; it is time to invest monies in the equity markets and get ahead of the capex cycle. When the capex cycle comes which we believe it will in the next quarter or two, the equity markets will respond aggressively and we may actually see equity indexes doubling from its current levels.

 

Of course, we must always respect risk and risk adjusted rate of return. Higher potential returns comes with higher risk, there is no escaping this relationship. Granted, as Asians we are more familiar with the risks associated with Asian countries and Asian equities. However, it is also important not to discount the U.S., and Europe, though, they are behind the curve right now, they will eventually catch up and these mature countries do have a lower risk adjusted rate of return which is important to balance the overall risk in one’s asset portfolio. 

We also acknowledge that Asia including China and India are and will be the growth areas of the world for the next 10 years…………this is a FACT. Latin America and Eastern Europe are also great opportunities; however, we do not know enough of these emerging countries to manage risk.

 

The rule of thumb is to invest in companies with solid business models, strong management, good cashflow and low gearing. We are here to make sensible returns and not to chase after the 100% returns and end up risking our hard earned savings or wealth. The truth is that we already possess wealth, so the objective is to preserve the wealth and to grow it prudently and sensibly through time, most importantly, to be able to sleep peacefully at night.

 

Why is Warren Buffet so successful in his investing? He always invests early in the economic cycle buying into companies when everyone is afraid to do so and then taking principal back when the cycle runs up and letting his profits ride. However, the average investor will pile on more monies into the financial marketplace and chase the dream. When a down cycle comes again, Warren Buffet is usually cashed up because he had taken back his principal earlier during the up cycle and now he is in the position to use his cash to buy back into the marketplace. On the other hand, most average investors are stuck and have no cash. One other great advantage he has that most of us do not, is that when he buys into a company, he takes a significant equity stake and therefore, has the inside track on everything that goes on in the company including influencing the fate of the company. This is risk management and it helps him reduce the probability of loss and improves the probability of profits.

 

In conclusion, it is time to increase our asset allocation to Asia bias including China and some in the U.S. and Europe.

 

 

Warmest Regards,

 

 

Andrew Dekguang Jhou Chew