Investors Go For "Mo"?
Is momentum the way to go in the current market?
"De-coupling" is now investment orthodoxy. Equity is the new debt; emerging markets are "safe havens."
De-coupling assumes strong corporate earnings and healthy balance sheets. De-couplers assume that the credit crunch is a "financial" crisis that does not imperil the "real" economy. There are reasons to be skeptical about the new investment mantra.
In developed economies, the financial sector is a large portion of the equity market. In the US, the financial sector accounts for around 20% of the market value of the S&P 500 and around 30% of the index's 2006 combined earnings. In Great Britain, the financial sector makes up around 10% of GDP and contributed around 30% of overall GDP growth in recent years. Financial institution profits are unlikely to achieve the stellar heights of recent years for a while. Analyst forecasts for a quick recovery in investment banking profits are optimistic. Recent sources of strong earnings – securitization, structured credit, leveraged finance – remain moribund. Strong trading revenues (a result of high volatility), strong mergers and acquisitions fees and emerging market activity will need to remain at high levels to keep earnings respectable.
The US real estate sector – a substantial portion of the equity market directly and indirectly – faces difficulties. Residential housing markets in other countries – Great Britain, Ireland and Spain – look vulnerable. Commercial real estate is now being affected by the credit problems and the profit outlook is unclear.
Non-financial corporation profits, for example, American companies, have remained buoyant. Corporate profits as a share of economic output in the US in 2006 were at a record 40%. National accounts data from the US Bureau of Economic Analysis suggests that profit growth is slower. A similar gap between the reported and national account figures was evident in the late 1990s due to creative accounting.
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Earnings growth has slowed in recent times. Slower growth in the global economy will further affect earnings. Borrowing against the increased value of property and financial assets has fueled US consumption in recent years. Falling real estate values will affect consumer spending. The "consumer discretionary" sector (carmakers, consumer durables, retailers) faces a less promising earnings outlooks.
The "financialization" of earnings and balance sheets of non-financial institutions is underestimated. General Electric's (GE) financial services earnings are 1/3 of total pre-tax earnings. Financial services are now a significant source of earnings for companies from different industries and countries; e.g. Ford (F), General Motors (GM), John Deere, Caterpillar (CAT), Pitney Bowes (PBI), Sony (SNE), Honda (HMC). A major component is vendor financing to help increase sales. Financial earnings are vulnerable to higher defaults and also higher costs of funding.
Andrew Smithers (writing in the Financial Times) used National Accounts data to question whether corporate balance sheets are really "in good shape." He identified increased use of mark-to-market accounting, a rise in financial, non-tangible assets and increased leverage (including off-balance sheet borrowings) as major factors distorting reported financial performance. The problems are likely to become evident when asset prices fall.
There is also the financialization of equity markets – share buybacks (many companies have been paying out more than their earnings in dividends and share repurchases), mergers and acquisitions and private equity bids. This depends on the availability of low cost debt. Private equity activity has slowed as funding becomes less available and more expensive.
Emerging market equities, especially the Shanghai and Mumbai markets, have decoupled. Bizarrely, they "de-couple" only if the US markets fall but "re-couple" if the US market goes up!
Increases are driven by substantial short-term capital flows fleeing developed markets and the US dollar. The assumption is that valuations and earning growth are sustainable. Some prices in India and China are reminiscent of the surreal valuations of the dot.com and (earlier) Japanese equity bubbles. The quality and performance of recent initial public offerings have been variable and, in some cases, poor.
Earnings quality is questionable. Earnings growth has increasingly been driven by investment income – stock market and property speculation. In a strong market, this accentuates earnings as higher investment earnings feed increasing share prices in a virtuous cycle. In a falling market, this works in reverse, accelerating losses.
Returns on capital investment are variable. Chinese state funded businesses with access to cheap funds are not earning investment returns anywhere near the cost of capital. Many projects are predicated on high, continued economic growth well into the future.
De-coupling assumes that emerging market will not be significantly affected by a US slowdown.
Emerging markets fortunes generally are tied to the vagaries of globalized trade. Exports account for one-third of Chinese economic growth and 10% of GDP. India is dependent on export growth. Russian and Brazilian growth depends on commodity demand and high commodity prices. 80% of Asian intra-regional trade is driven by demand for outside Asia. A slowdown in the USA and Europe will affect growth.
Europe has the added problem of a weak US dollar. EADS (Airbus' parent) recently complained that the strong Euro placed the firm's viability in question - the plane maker's chief executive used the phrase "life-threatening."
Belief that domestic consumption can take over from exports as the growth engine in emerging markets is untested. Any Xie (writing in the South China Morning Post) speculated recently that "In China, people make money to, well, make money. Happiness comes primarily from counting the money, not spending it." The total number of the mythical middle class consumers in emerging markets that obsesses Western analysts is probably exaggerated.
India and China also face infrastructure constraints. Shortages of educated and skilled workers are forcing up labor costs rapidly. Essential infrastructure gaps like transport and power in India will take years to correct. Inflation from imports (energy and commodity costs) and rising domestic costs is driving local currency interest rates up. In China, concern about speculative bubbles driven by debt has led the central bank to both increase interest rates but also limit lending. This may choke off growth. A widening interest rate differential against the US dollar also causes currency appreciation attracting capital flows whilst reducing local currency earnings of exporters.
There are feedback loops. Corporate earning growth in developed countries assumes an increased contribution from sales to rapidly growing emerging markets, just look at the Boeing (BA) and Airbus projections. Any slowdown in emerging markets will in turn hit corporate earning in the USA, Europe and elsewhere. The "flat world" actually folds back on itself in an origami moment.
There are also other "risks" in emerging markets – political risk, trade wars, problems of corruption, health and safety issues in products, environmental degradation etc. All this isn't "front of mind" at the moment.
China's Shanghai market is down about 20% off its recent highs. The Indian market recently recorded an intra-day move of around 14 % (8% down followed by 6% up) when regulations regarding foreign investment were mooted. Such volatility is de-stabilizing.
Tellingly, savvy and well connected investors from Singapore, the Government of Singapore Investment Corporation or "GSIC," and Temasek Holdings, a government-controlled investment fund, are steadily divesting from China and switching to other assets, including distressed bank stocks in Europe and the US. What do they know?
For the moment, most investors are going for "mo" - momentum. They are relying on Will Roger's advice: "Don't gamble; take all your savings and buy some good stock and hold it 'till it goes up, then sell it. If it don't go up, don't buy it. "
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