Monthly Archives: March 2009

27th March Dealing with extraordinary complexity

I have read a huge amount in the last few days about the sets of announcement we have seen this week. Monday’s news of the huge repurchasing scheme has been amplified by US Treasury Secretary Geithner’s testimony to Congress today, in which he started to spell out a refashioned financial services sector. The full text of his speech can be found here http://blogs.wsj.com/economics/2009/03/26/3889/

I definitely think this is worth reading, although it is light on detail at this stage (I haven’t been able to find the 61 page supporting Bill, which has been passed to Congress yet).

One sentence in particular leapt out at me;

“Our system is wrapped today in extraordinary complexity, but beneath all that, financial systems serve an essential and basic function.”

I couldn’t agree with this more, but if you read on a central pillar of the proposed solution is to create a mega-regulator, which will have far-reaching powers in dealing with perceived systemic risk. While it wouldn’t be fair to criticise this move, without seeing the detail behind it, it strikes me as odd that the solution for extraordinary complexity would be to create an even more complex system on top of the existing one; almost as odd, one could argue, as solving a crisis caused by excessive liquidity with increased liquidity.

I will do my best in the next week to try and forget the total failure of regulators all over the World in averting the Credit Crisis and read the detail of Geithner’s plan with as open a mind as I can.

After all at face value the market has reacted extremely positively to all this news, with major equity indices posting roughly 8% gains so far this week. Of course if you scratch beneath the surface of these market moves, there are still significant signs of weakness. Volume has been high on the falls, whilst declining on the rises. Volatility is still extreme and short interest (short positions taken up by traders against stocks) on the New York Stock Exchange has reached levels last seen when Lehman failed. Even so the strength of this rally should not be taken lightly (but as an aside I still intend to short the Dow at 8,000 – make of that what you will!).

I will leave you with one of the more interesting pieces I have read in the last few days http://www.marketwatch.com/news/story/tim-geithner-has-gone-toxic/story.aspx?guid=%7B259097F3%2D62E6%2D4089%2D9E47%2D87A11493B59F%7D. As the writer says, this week could well turn out to be the making of Geithner and that this might be the most surprising event of 18 months of shocks. While I am still sceptical about this, I think having an open mind for the next week or so wouldn’t be a bad thing. With the G20 meeting and the next US Payrolls number occurring next week, we should have an excellent opportunity to plan what to do over the course of April and the vastly important earnings season.

25th March Two bond auctions struggle

Something very worrying has happened today for US and UK quantitative easers. Bond auctions on both sides of the Atlantic failed. In the UK this was the first time in 7 years this had happened.

This gives a clear signal that international investors’ appetite for their debt is waning. This has far reaching implications for stocks, Sterling, the Dollar and the wider economies in both countries. Watch very closely for further signs of weakness in these auctions in coming months. If investors refuse to buy US and UK Government debt, then both countries are going to face serious problems in implementing their stimulus packages.

25th March The beginning of a new financial World; Retrospective taxation; Signs of weakness in the rally

Tim Geithner, the US Treasury Secretary, visits New York today to meet with 200 top executives from the financial industry. Not much detail has been released about the agenda for discussions, other than a radical overhaul of the management of the financial system is planned.

We have heard some comments from Ben Bernanke about the need to change rules relating to capital requirements and management http://www.theaustralian.news.com.au/business/story/0,28124,25219357-36418,00.html, so policy makers must have some plans in mind. There has also been some talk of Goldman Sachs giving back all bailout money they have received http://www.boston.com/business/articles/2009/03/25/goldman_sachs_looks_to_repay_tarp_money/.

Given that the G20 meeting is only around the corner we should not underestimate the likely significance or timing of today’s meeting. Although it is far too early to draw any conclusions yet, we might well be about to witness the first step towards the reorganisation of the manner in which capital is deployed and exploited around the World.

I will keep a keen eye for any information which filters out.

Retrospective taxation

I wrote, somewhat joyously, about the bill which sailed through Congress last week, proposing a 90% tax on bonuses paid to executives of failed financial institutions. Over the course of Friday and the weekend, it became clear this bill was going to run into difficulty in the Senate. Then a headline was released from the Whitehouse “Obama advisers note populist tone, urge restraint”, which was picked up by the majority of news providers.

In short the view was expressed that the politics of mob mentality shouldn’t govern policy. Taking retrospective action is apparently a dangerous path to follow.

While I agree that initiatives born of anger cannot be healthy, I couldn’t disagree more about the so called risks of retrospective action, in this one instance. (To be clear I am not advocating a generalist approach towards retrospective action).

I had lunch with a friend the week before last and we were talking about Fred Godwin’s pension. I advocated a move to take this from him. My friend argued the point about the risks associated with such a move. My counter argument went something like this

“The current crisis has been caused by exceptionally greedy, intelligent people, who created a system so complex and sophisticated that it was nigh-on impossible to regulate or govern effectively. The legal, political and regulatory systems are slow-moving and were not able to keep up with the pace of change in the financial sector. One could even argue they were obsolete in dealing with the associated challenges of financial innovation. For a society to function successfully there needs to be appropriate checks and balances. Given the absence of decent oversight and the concentration of financial power, it is not surprising that the banking system became so corrupted it collapsed.

While we now have an almighty economic mess to contend with, one of our highest priorities has to be to ensure that this does not happen again. As a civilization we have suffered financial crises before. However each time, self-interest has worked its way back into the system and caused the next crisis. While macro-measures are definitely required, I believe micro-changes are also needed in the form of a new set of personal principles and values of financial executives. Given that these people have historically shown themselves to be completely incapable of such enlightenment, we need to consider what policy actions can be taken to encourage them to change their personal behaviour.

The threat of retrospective taxation strikes me as the perfect manner in which to do this.

After all, why would bankers pay themselves bonuses, based on excessively risky transactions, if they were liable to lose all of their gains?

I think the worst outcome for us all from the Credit Crisis, would be for the banking sector to be left with the long-term impression that they are too important to fail and will be bailed and compensated out no matter what happens or what they do. Had the banks actually been allowed to fail the argument over executive bonuses would have been irrelevant as surely none would have been paid.”

We must remember that these people act exclusively in their own interests. While I would love to live in a World where this were not the case, I am afraid we have to deal with reality. For the benefit of all, the long term interests of financial executives need to be more directly aligned with the interests of society. By removing the incentive for taking on excessive risk, I am sure we will be much closer to achieving this goal.

Signs of weakness in equities

I have been keeping a close eye on volume in equity markets. Volume has been notably higher on the down days than the up days. While the significance of Monday’s announcement cannot be underestimated, earnings’ season is around the corner. I am still convinced that the earnings’ outlook will be critical for the medium term health of stocks. Alcoa announces on April 7th, starting earnings’ season.

If you managed to catch this move I would consider taking profits or reducing exposure at this stage. We have a raft of economic data in the next 10 days, culminating in the US jobs’ report next Friday.

At the moment I am planning to short stocks if the Dow hits 8,000 or the end of next week, in anticipation of a dire set of earnings and a substantially reduced outlook, but I am going to give this some more thought before doing anything.

23rd March Contradictory messages in the Public-Private Investment Programme

Details were released today of the Fed’s latest plan to shore up the beleaguered balance sheets of banks. Below is the link to the official release of the plan

http://www.ustreas.gov/press/releases/tg65.htm

It is fairly heavy going, but I would definitely advise you read through it and understand the examples that have been provided of how the scheme will work. I have spent some time over lunch doing that and an immediate contradiction leapt out at me.

I wrote about the liquidity versus solvency argument and to my mind this plan only further muddies the water. The most important/contradictory paragraphs are at the start of the document;

The Challenge of Legacy Assets: Despite these efforts, the financial system is still working against economic recovery. One major reason is the problem of “legacy assets” – both real estate loans held directly on the books of banks (“legacy loans”) and securities backed by loan portfolios (“legacy securities”). These assets create uncertainty around the balance sheets of these financial institutions, compromising their ability to raise capital and their willingness to increase lending.

  • Origins of the Problem: The challenge posed by these legacy assets began with an initial shock due to the bursting of the housing bubble in 2007, which generated losses for investors and banks. Losses were compounded by the lax underwriting standards that had been used by some lenders and by the proliferation of complex securitization products, some of whose risks were not fully understood. The resulting need by investors and banks to reduce risk triggered a wide-scale deleveraging in these markets and led to fire sales. As prices declined, many traditional investors exited these markets, causing declines in market liquidity.
  • Creation of a Negative Economic Cycle: As a result, a negative cycle has developed where declining asset prices have triggered further deleveraging, which has in turn led to further price declines. The excessive discounts embedded in some legacy asset prices are now straining the capital of U.S. financial institutions, limiting their ability to lend and increasing the cost of credit throughout the financial system. The lack of clarity about the value of these legacy assets has also made it difficult for some financial institutions to raise new private capital on their own.”

Am I missing something? Surely these paragraphs describe an insolvent system; one which has run out of money because of serious structural inadequacies. The process of deleveraging, which has been occurring, is because the banks lent so far beyond their means, that the underlying true value of their balance sheets became miniscule to the point of irrelevance in comparison to the derivative “assets” they held. The “legacy assets” create uncertainty on the balance sheets of financial institutions, because they were founded on thin air and huge bonuses were paid to their originators and resellers.

Despite the complexity of this issue, we mustn’t lose sight of this last point. The people who created these “assets” are now largely long gone with their hordes of cash; a point I shall no doubt return to a lot.

Sticking with the main topic of discussion, there is little doubt that the “real” economy is in the midst of a severe liquidity crisis, caused by the Credit Contraction. It is arguable whether or not this will be a good thing in the long run, but what I fear most is that the measures being taken are only going to server to prolong the pain.

If you continue to read the US Treasury release, you will see how the proposed Public-Private Investment Program will work. In very brief summary private investors will be required to put up 6% of the value of the “distressed assets” they purchase. The rest of the money will come from the TARP, the FDIC and the US Treasury.

Applying very simple analysis to this formula, the US Treasury believes the true value of the “legacy assets” is 6% of their face value. Given these “assets” are largely made of pools of loans this gives as clear an indictment of the banking system as any we have seen. Even referring to “assets”, while factually accurate, sticks in the throat.

In the final paragraph of the three I selected the point is made that “excessive discounts… are now straining the capital of U.S. financial institutions”. This raises another very serious question, namely are the discounts “excessive”?

Given the scale of this latest set of measures the Fed had better hope they are.

If the discounts in fact prove to be valid then the US Treasury is taking on hideous exposure to worthless junk. If the private investors, who are required only to stump up 6% make claims against the Federal Insurance provided to underwrite the “legacy assets” then US taxpayers are going to be faced with an incredibly large bill. On top of all the other bills they have picked up in the last 18 months, there is going to come a point when repayment is going to pose some serious problems.

I think I will continue to short the US$ for the rest of the year, at the very least. While the immediate reaction to this plan has been overwhelmingly positive, I believe the true implications of it will settle in over the coming weeks and we are likely to return to the downtrend of the Greenback.

20th March The US finally gets tough on failed financial executives

Last night’s overwhelming vote in Congress, which saw the quick passage of a bill designed to tax recipients of bonuses from bailed-out banks 90% of their ill-gotten gains, is exactly the type of move I have been hoping to see. Although I have been advocating extreme retroactive action against the greedy bankers, who created the financial mess, I also recognise the inherent risks. However deciding to levy punitive taxes is an extremely intelligent solution. It is legal and there is precedent for it. After all who is really going to challenge a Government’s ability to set taxation levels, especially after they have been voted on?

The tax will be applied to those executives who have an annual family income greater than $250,000. Other Governments will surely follow the lead of the US and enact similar laws. I would dearly love to see Fred Godwin have his pension taxed heavily.

Rewarding failure is one of the key structural flaws in the financial system. Resolving this issue has been a major sticking point and has stopped the debate about the restructuring of the financial sector from moving on. In many ways there are more serious issues which need to be addressed to resolve the iniquitous practices of the banking industry, but the matter of executive pay has caused the most public outrage.

We need to see what comes next, but if other Governments follow up with similar actions then I will take this as a fairly bullish signal for the long term.

18th March Another staggering move by the Fed and first thoughts on Nike

I feel I missed a bit of a trick today. In an environment of competitive devaluation, in which central banks around the World are racing each other to see who can devalue their currency the quickest, today’s announcement by the Fed that they too were going to start Quantitative Easing was not that much of a surprise. What was truly shocking is the scale of their measures.

From what I have read the Fed is going to print another $1.15trillion (yes, that’s right TRILLION) and purchase $300billion of treasuries and $750billion of mortgage related debt. Taking into account all the bailouts, the TARP, the tax rebate and the lending schemes, by the end of this year the Fed will have created roughly $3.5trillion since the start of 2008. We are now so far into unknown fiscal and monetary territory that it is hard to remember what “known” economics looked like.

The only comparable precedent for this type of policy was the Japanese one in the early 1990s. We all know how that ended.

What is most worrying about today’s move is the reaction it is likely to provoke in other central banks. How aggressively will the Bank of Japan attempt to suppress the rise of the Yen in an attempt to prop up manufacturers? Will the Reserve Bank of Australia decide their currency has fallen too far and they need to act to bolster miners? How on Earth will the Chinese react to this, given their vast reserves of Dollar denominated assets?

The immediate market reaction was extreme.

Looking first at the US$, this got smacked. It fell between 3% and 5% against the major currencies. I think it fair to say that the “Dollar as a safe haven” view is now in peril. If I am right, then trading Dollar weakness could be an excellent wheeze for the rest of the year. This strategy will be completely dependent on the reaction of other central banks. If they follow suit and we see a collective attempt at financial hara-kiri, then the falls in the Greenback might not be so pronounced. However if there is actually a central banker who still believes in the value of his or her national currency to the extent of actually defending it, then there will likely be excellent profits to be made in that pairing. US$/Norwegian Krone is one pairing I am going to keep a close eye on.

Moving onto the equity market, stocks rallied hard on huge volume. I expect this is on the expectation that the Fed move will underpin the housing market in the short term. Recovery in the housing market has to be a precondition for economic recovery. Given the rally we have seen developing in the last 9 days the likelihood is this is going to continue until the Dow hits at least 8,000 or Earnings Season begins. In spite of Bernanke’s belief the recession will begin to end in 2009, I expect downcast and downgraded outlooks will be the norm. Remember earnings strength or weakness will dictate the longevity of stock market moves.

The next asset class to see major moves was bonds. Yields had their highest daily fall in 50 years. The fact the Fed is buying $300billion naturally caused this collapse, but it remains to be seen whether this is the start of a trend. I mentioned the “safe haven” argument earlier. One surprise this year for me has been the appetite of global investors for American Government Debt. Perceived wisdom holds that the US Treasury is too big to fail. Of course there is a lot of strength to this argument, but surely the credit-worthiness of the US has to have been affected by the monetary policy of the Fed. While a default isn’t likely to be on the horizon, how long are investors going to be prepared to pay a premium for US Treasuries?

Finally we saw rallies across the board for commodities. I have been meaning to write about oil in the last couple of weeks as it has been exhibiting some pretty bullish indicators. Today’s rally has almost certainly been strengthened by likely Dollar weakness. Again commodities are likely to offer some attractive trading opportunities for the rest of the year. Keep a special eye on gold. This has always been the ultimate flight to safety and its prospects have surely improved greatly now.

Nike

Nike announced their results after the bell tonight. They beat analyst estimates by a whopping 20c a share. This was an excellent performance. The cost cutting measures they have enacted have meant they have maintained their cash pile of $2.6billion. Given the strength of their brand, their ability to generate free cash flow, the strength of their balance sheet and their dominance in their field this looks like an excellent stock to be in for duration of the current crisis. I will be watching for a pullback and then take the opportunity to buy some stock to hold for the long term.

16th March The full extent of the AIG mess is announced and last autumn starts to make sense

Of all the bailouts there have been, last autumn’s of AIG was one of the most controversial. At the time the scale of the $85billion rescue seemed incomprehensible. Last night a lot of the questions were answered about why the Fed and US Government felt it necessary to act in the way they did.

Quite simply an AIG bankruptcy would have ended the financial system.

After fighting a rearguard action, the board of AIG announced the major recipients of the state aid last night. Financial institutions included;

  • - Goldman Sachs $12.9billion
  • - Merrill Lynch $6.8billion
  • - Bank of America $5.2billion
  • - Citigroup $2.3billion
  • - Wachovia $1.5billion
  • - Societe General $12billion
  • - Deutsche Bank $12billion
  • - Barclays $8.5billion
  • - UBS $5billion

The rest was distributed amongst lesser financial institutions, corporations, US States and municipalities

What is most interesting about this bailout is the amount that was paid to non-US banks. I wonder how easily this bailout would have passed had US taxpayers known the level of subsidy they were being asked to pay to foreign financial institutions. Given this occurred 2 months before the election, this issue could have been far more divisive than it proved to be at the time.

We must remember that whilst AIG was being bailed out, Lehman was allowed to fail. During this period the latter was the bigger story, but could it be that US policy makers had decided to underwrite the global financial system with US taxpayer money come what may?

In time we will learn more, but I think I understand more now about the decision to let Lehman go. At the time I thought it was madness and threatened to unravel the Fed’s strategy. US officials had followed an exceptional, interventionist policy since Bear Stearns was rescued and fused with JP Morgan. Their determination to support the financial system was crystal clear in every policy they implemented. The failure of Lehman seemed to be diametrically opposed to this strategy.

The views at the time held that the failure of Lehman would carry huge counter-party risk, given the sheer volume of open positions the bank had with other financial institutions, and would destroy fragile confidence.

It is apparent now that US policy makers decided to underwrite the counter-party risks of Lehman, by bailing out AIG and pumping billions of Dollars into banks all over the World. They recognised the extent of the problems and that these endemic to the whole system. Any solution had to be a panacea, or risked being ineffective. Given the global nature of the crisis, nationalistic politics could have undermined any attempt to repair the system, especially in a Presidential election year.

After all why would average US voters give approval to the bailout of foreign banks with their money? The answer is they almost certainly wouldn’t have and would have expressed their distaste at the prospect of such action at the ballot box. I am not suggesting that this was a conspiracy to benefit or thwart either candidate, but had public opinion become a serious factor in policy-making it would have proven to be very difficult to implement any action, yet alone those radical steps we saw in the autumn.

Even so, there was a major flaw with this plan (if it indeed was the plan). The failure of Lehman also threatened to shatter investor confidence.

Hindsight is of course a wonderful tool for analysis, but I wouldn’t be at all surprised to learn in the coming years that Paulson and Bernanke underestimated the risks to confidence as they believed the TARP (the $700billion rescue package, authorised by Congress) would pass unhindered and this would shore up investor sentiment.

Of course the TARP failed the first vote and this signaled the rout in global equity markets.

It is arguable whether any of the bailouts will have mattered in the long run, given the extent of the problems besetting the Global Economy now, but last night’s AIG announcement helps shed light on how critical decisions were made.

14th March Liquidity versus solvency; the dilemma of quantitative easing

So much has been written in the last few weeks about quantitative easing that it is quite difficult to write about a view that has not already been covered. Quantitative easing is the process, whereby a central bank increases the money supply, by the creation of new money and then engaging commercial transactions with financial institutions. In the UK this means the Bank of England is going to purchase up to £150billion of paper “assets” from British banks to provide them with enough working capital, primarily with the intention that they start lending again.

Under the terms of this buyback scheme, it is expected that the banks will repurchase these “assets”, once the market recovers, thereby alleviating the Public Purse of their burden.

All this sounds great in principle and to be fair the measures the Bank of England has started to take in enacting this strategy have been well received by the market so far. The first 3 sets of bond sales this week went well giving a clear sign the investors still believe in the credit-worthiness of our beautiful, sceptered Isle. That is for the time being at least…

I was sent an interesting article earlier in the week, which summed up the debate that is raging in the States about whether the Credit Crisis is a liquidity crisis or a solvency crisis.

http://www.huffingtonpost.com/2009/03/10/howd-we-get-here-romer-di_n_173426.html

The relevance that this argument has for the likely success or failure of the quantitative easing strategy cannot be underestimated.

In summary if the Credit Crisis is one of liquidity then this equates to a huge cash flow problem. The economy is fundamentally sound and the current problems will be solved through the huge cash bailouts we have witnessed in the last year. Our goal should be to return to the path we were on and all will be well.

However if the Credit Crisis is actually one of solvency, or insolvency to be more accurate, then this is a lot more problematic. Insolvency indicates failed business models and working practices. An insolvent company is one, which usually deserves to fail. Hosing it with money does not solve its structural problems, but rather serves merely to delay their outcome. Insolvent companies should be allowed to die off to make way for the new, improved business model.

The strategy of quantitative easing is clearly designed to solve a liquidity crisis, but even then there could be problems with it.

Despite the protestations of Eddie George at the Bank of England, the creation of “new” money has to be at the heart of the quantitative easing strategy. Although not physically printing new money, the Bank has in effect done the digital equivalent. At the click of several buttons in the coming months, as much as £150billion is going to be created.

To most people this increase in the money supply has the potential to increase inflation and undermine the credibility (or even viability!) of our beleaguered Pound. The Quantitative Easers (is that the term?), however, will tell us that this is not the case. They believe that the clever repurchasing scheme they have lined up will mean that by the time we might expect to feel the inflationary pressures of the £150billion these will be negated. They assume that the banks will have returned the money to the Bank of England when buying the “assets” back. This will mean that the £150billion has been removed from the money supply and there will be no problem….

Unless I am missing something there are several major risks with this plan and they all depend on the outcome of the liquidity versus solvency debate.

If the Credit Crisis turns out to be one of solvency, as I believe it will, then we are likely to see more large scale banking failures. While HSBC might give us some cause for optimism for some banks if their rights issue passes off successfully this week, RBS, Lloyds and Barclays (despite their “positive” announcement of a profitable first two months of the year today) will still pose substantial threats. Given these latter three are likely to be the main beneficiaries of quantitative easing, how much faith should we have in their viability and future ability to purchase the “assets” back? �

If we have learnt nothing else from the last 18 months it is the incredible ability of bankers to look after their own interests. Whether paying themselves undeserved bonuses or withholding lending facilities from companies or homeowners, not to mention creating this mess in the first place, their behaviour has been shameful. Why does the Bank of England believe they will repurchase the “assets” when “the time is right”?!�

Purely from a practical point of view, for the quantitative easing strategy to work it requires that a large portion of the riskier (for that read rubbish) “assets” are taken off the banks’ balance sheets by the BoE. I find it highly unlikely that the banks will be inclined to honour the second set of transactions to repurchase these if they do indeed turn out to be junk-grade.

Whatever the case, if the Bank of England is unable to sell the “assets” they buy back to the banks then the money supply will have expanded and quantitative easing will not prove to be inflation-neutral.

10th March An earnings’ scenario

On a day when we saw the broadest rally in equity markets around the World on huge volume, I spent some time giving consideration to the earnings outlook.

I tried to look at comparative earnings potential in the UK and US, but struggled to find the data for the FTSE. If anyone can point me in the direction of a chart of historical earnings for the FTSE 100 & 250, I would be grateful.

Irrespective of this, sticking with the US and, more specifically, the S&P 500 we can start to get a picture of how low markets might go. Admittedly the huge volume today and broad base of the move up could be the catalyst for a rally, but I do not believe we have hit the bottom of this crisis yet.

An interesting table I found captured the earnings performance of the S&P 500 since 1960. An extract is below, but the full table can be found at http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/spearn.htm.

Year

Earnings Yield

Dividend Yield

S&P 500

Earnings

Dividends

P/E Ratio

2006

6.18%

1.77%

1418.3

$87.72

$25.05

16.17

2007

5.62%

1.89%

1468.36

$82.54

$27.73

17.79

2008

7.24%

3.11%

903.25

$65.39

$28.05

13.81

This table is apparently drawn from Bloomberg and is dated January 31st 2009, so I think we can rely on this for the purposes of the examples below.

I have highlighted the column “Earnings” in red. I added the column “P/E Ratio” in blue.

This shows us two clear developing trends:

  1. Earnings are falling, reflecting the contraction in economic activity
  2. P/E ratios are declining, reflecting the multiple the market is prepared to pay for earnings. Remember P/E ratios rise and decline in line with market optimism and pessimism

So how can this help us look for a floor in the market?

The equation is quite simple, but there is likely to be a great deal of variance dependent on our view on how low earnings can go. We also need to make our best efforts at estimating how low P/E ratios will fall, but in this case history can help us.

Starting with historical P/E ratios at times of crisis, at the depths of the 1930′s bear market, P/Es fell to 4.1, whereas during the collapse in equities in the 1970′s they bottomed out at 7.3. I believe that the difference in the two levels can be explained by two factors. First the 1930′s crash was much more severe than that of the 1970′s. Second I am a firm believer that demographic changes apply upwards pressure to P/Es, insofar as increased life expectancy naturally means that investment horizons grow longer, but more of this another day!

Taking into account these factors I think a reasonable P/E to apply to a market bottom would be the 8-10 range. This takes into account and places a greater weight on the severity of our situation, but also factors in the demographic pressure.

Forecasting earnings in the current climate is far more difficult. I have seen some extremely credible commentary recently that earnings could fall as low as $50. This represents a 23% decline on the previous year. Let’s face it; this is definitely not in the realms of fantasy.

So if we apply the range of P/Es to the prospect of $50 earnings this points to the S&P settling somewhere between 400 and 500.

Tonight it closed at 719, meaning we could see as much as a 30% decline from here, if not in the near future.

If earnings do fall as low as $50, then this gives a P/E of 14.38, which feels wildly optimistic, given the uncertainty in the market place.

Of course we need to remember that there is a wall of money sitting on the sidelines, thanks to all the liquidity measures taken by Governments and Central Banks all over the World and we haven’t had a decent bear rally since last March.

If today is the beginning of a move up, I believe it will be short-lived, especially if earnings confound next month.

This all said yesterday’s blog convinced me to go long the Nikkei! I traded with a very small position with tight stops. While it is nice to have caught today’s move, I recognise this is lucky and have moved my stops up to guarantee a small profit. If things take off from here, I will obviously do better, but I am certainly not intending to put more into the market just yet. With the year-end just around the corner I intend to err on the side of caution.

9th March The selling continues, but when might it stop?

March has been dreadful for shareholders all over the World. As markets have failed there is now talk of an “Obama Bear Market” given the 20% fall in US equities since he took office. While this is unfair, the juxtaposition of equity markets versus his record high opinion poll scores is a position which will have to correct itself before much longer.

Either we will see a substantial recovery in share prices or the American populace will start to turn on the Democrats. If the former occurs then such a rally is likely to be short-lived, whereas if the latter happens too quickly then the prospects of a prolonged Depression increase significantly. We all have a lot riding on Obama’s stimulus plan, but the fact it has been so poorly received does not bode well. The Global Economy is in such a poor state that a radical overhaul is an absolute necessity, combined with strong, visionary leadership to see it implemented and embedded. While Obama is not responsible for creating the morass, he was extremely keen to take on the job of sorting it out. What was that about being careful what you wish for?!

Looking at market movements in the last 10 days, several notable factors are worth considering.

First the 8,000 level of the Dow failed dramatically. As of writing the Dow is now down at about 6,500.The pace of selling in the last 10 days has been intense, bordering on the level of panic. Trying to gauge the market from a technical perspective is extremely tough in these conditions. The market psyche is so emotionally fragile that seeing anything other than further down moves is difficult. The prevailing wisdom holds that we are well on the way to Dow 5,000, S&P500 600 and FTSE100 3000.

Second volume has been extremely high during this phase of selling. Any slight moves up have been quickly battered into submission. We saw another bearish one-day reversal today, where stocks started the day up only to finish substantially lower.

Third the tone of commentary on Bloomberg, CNBC and other media outlets has darkened significantly. During 2008 the majority of the “talking heads” giving their view of the market foresaw recovery beginning “within 6 months”. Now you will be hard pressed to find anyone talking of recovery before the second half of 2010. Optimism is in short supply.

Now this is the point I usually start talking about the possibility of an impending rally. While the factors above could be seen as bullish (when applying the “low equity prices + negative sentiment = time to buy” equation), I think it is worth now focusing on earnings.

At the moment it is impossible to gauge two critical aspects of company earnings – what they will be and what multiple the market will settle on applying to them. The macro-economic data all shows that global economic activity has fallen off a cliff. The World Bank predicts that the Global Economy will contract for the first time since the Second World War. The last round of earnings was pretty terrible. The next round (starting at the end of this month) is likely to be much worse.

Ultimately it will be the earnings’ power of corporations that will pull us out of the mess we are in. Once it is clear what companies are earning in the most difficult environment in three generations, the market will then decide how to value these. I think I am right in saying that at the bottom of the 1932 bear market P/E ratios were down to 4. Under some scenarios, if we repeat this pattern today, this could see equities in the US and UK fall a further 60% from the point they are at now!!!

I am going to take some time tomorrow to do some calculations to support this point, but for now the point is it is impossible to call a bottom until we get some earnings visibility. This can only come at the year end.

Of course the temptation is there to buy stocks or trade indices with prices as “low” as they are. I might even be tempted myself, but if I am I will certainly not commit too much. I want to build a long term strategy and this is not the environment to do that in.

2nd March Citi, AIG, HSBC and another rout in equities

Today’s sea of red on global equity markets was entirely predictable. I meant to write over the weekend, that this was likely to be a bad week for stocks.

On Friday we heard that the US Government was essentially taking as much as 36% of Citi Group in yet another bailout of this decimated financial institution. There was a lot of anger over the weekend from shareholders, who were faced with yet more wealth destruction. For the general market this was far more troubling as it was yet another sign that the various bailouts have failed to avert this latest crisis.

All the recent talk of nationalisation of US banks seemed to be coming to fruition, in spite of numerous denials from the Obama Administration. Remember that Citi Group was once the World’s largest financial institution. On Friday its share price closed at $1.50 down from $55.70 in December 2006. It won’t be long before commentators start talking about the 1% club of shareholders of financials, who have seen their holdings collapse in value. It was only eight years ago that this happened during the bursting of the dotcom bubble, but the difference now is we are witnessing the final humbling of a much more established component of the economy.

I was going to make the point that Friday’s payrolls report was likely to add further pressure to stocks, but then rumours started to swirl about the extent of AIG’s losses and this point seemed a bit redundant.

When it came, AIG’s announcement was staggering. In the fourth quarter of last year, they lost $61.66 billion, the largest loss in corporate history ever. The news that AIG was to receive another $30 billion from the TARP, taking their support to $70billion, seems like small change in comparison. They additionally were allowed to cancel dividends owed to the Government, which is as good as another cash injection.

In both the cases of AIG and Citi Group, this is the 3rd time the US Government has stepped in to try and save them. Will there be 4th attempts? You certainly couldn’t rule it out, but surely by this point full nationalisation will be the only course of action.

As an aside I read an interesting article in the weekend FT making the case for nationalisation, which is certainly worth a read http://www.ft.com/cms/s/0/5dc48bf8-06a0-11de-ab0f-000077b07658.html?referrer_id=yahoofinance&ft_ref=yahoo1&segid=03058

Meanwhile in the UK, HSBC announced a £12.95 billion rights issue at a 50% discount to Friday’s close. Yes that’s right, 50% or 254p. Friday’s close was 491.5p.

The hammering the stock has taken today, as a result of this action, is not a surprise. While the outlook for existing HSBC shareholders is pretty poor in the near future, part of me does think it serves you right if you were too heavily invested into this company. All the talk about how immune HSBC was to the Credit Crisis was always rubbish. The Credit Crisis represents systemic failure so all participants are bound to be adversely affected by it.

However in the meantime this rights issue could give us all some cause for hope. Last autumn, HBOS’ failed rights issue signaled much worse to come in the banking sector and was reflective of the woes afflicting that company and others in similar positions.

While HSBC was always likely to take a near term hit, this is nowhere near as dire as has happened to their peers. If the rights issue is a success and the full $12.95 billion is taken up, this will surely be a clear signal of confidence slowly starting to return to the financial sector. The fact that this will be a private placement, without governmental support, strengthens this view.

Of course it remains to be seen how the market responds to this action, but we should all watch it quite closely. If successful, then HSBC’s future relative to its competitors will surely look bright and existing shareholders might even see their losses reverse into profits. While such a turn of events is unlikely in the short-term, if you have a long enough investment horizon then this might well turn out to be an excellent strategy.