Sunday, November 11, 2007

A potentially deadly "cocktail" for a recession

The recent focus has once again shifted onto the sub-prime mortgage loan crisis in the USA, with the markets there suffering their worst one-week drop since August 2007. I had watched with alarm as a seemingly deadly mix of sub-prime woes, a falling US dollar and high oil prices combined to create one of the most potentially devastating mix of problems for the US economy moving forward. Let’s take a look in turn at each of these events and their probably impact on the economy in the months to come.

Sub-Prime Mortgage Loan Crisis – Unless one has been living under a rock for the last 6 months, the sub-prime mortgage problem should now be a familiar mention among investors and pundits. The result of over-leveraging for people in the USA with poor credit histories, and being overly lax on credit policies, this problem has ballooned into a major crisis of confidence in renowned banks all over the world. Packaged debt instruments called “collateralized debt obligations (CDO)” are losing their value almost on a daily basis and forcing financial institutions such as Citigroup, Morgan Stanley, Merril Lynch and UBS to make massive write-downs. The indirect effect this has had on the credit markets is that it is now not easy to get a home loan anymore, as credit policies have been tightened in the USD as a result of the sub-prime fallout. On a macro scale, the property market there is taking a hit as foreclosures hit a record high on falling home prices. On a more micro-level, consumers have been hit hard with “negative equity”, which is what happens when the value of what you own (in loans) is higher than the value of the underlying asset (i.e. the property they hold in this case). The crisis will have two effects which I can forsee in the coming months: There will be a major slump in the property market as foreclosures get under way, and more and more people will restrict spending (lowered consumption) as their mortgage loans eat up more and more of their savings. This is the perfect recipe for an economic slowdown, which has been predicted by the Federal Reserve’s Mr. Ben Bernanke.

Weakening US Dollar – The US dollar has weakened considerably in the past few months, dropping from 1:1.55 SGD to the current 1:1.439 SGD (as at the time of writing). This is most probably a result of the huge US budget deficit and is further exacerbated by the Federal Reserve’s interest rate cuts to 4.5% (25 basis-points on October 30, 2007). The US dollar is now at a ten-year low against the Singapore dollar and at an all-time low against the Euro, which has led some pundits to remark that perhaps the US dollar will soon cease to become an international currency for exchange ! The positive part is that this makes US exports cheaper to other countries but I feel that the weakening dollar may signal more economic problems within the USA which have yet to surface.

High Oil Prices – Oil prices have been on a rally of late, touching US$98.62 per barrel (an all-time high) for light sweet crude just a few days back but now settling around US$95 per barrel. The reasons for this are manifold: supply concerns, unrest in the Middle East (again !) as well as the falling US dollar are all contributing to the steady rise in oil price. This, in turn, will have an effect on the costs and subsequently profits for many companies which use petroleum or petroleum-based products as their raw material for manufacturing. The effects are probably not apparent now but investors should take note of oil price’s impact on the costs for the companies they own, as many companies’ gross margins (e.g. in the furniture industry) may be squeezed by this development. For the man on the street, higher oil prices also mean that pump prices at petrol stations have hit a high and this makes it more expensive to top up fuel for vehicles now.

The above is just a very brief discussion on the three factors which I think possess the deadly “cocktail” to propel the US economy into a recession, unless strong and immediate measures are undertaken by the relevant authorities to address the situation. How this will pan out for the outlook for Singapore companies is uncertain, but the effects of the sub-prime crisis have already taken a toll on the three local banks which have been forced to make provisions for their CDO-related assets. I will be closely watching the effects of these 3 events and will give readers an update again in the coming months, as well as my personal views and analysis.

Note: I added a link under "Research Links" on the right-hand sidebar for the Public Insight program, which I recently discovered to be airing reviews on Singapore-listed companies. They are into their third season episode 1 right now and all previous episodes (including one on Ezra Holdings Limited) can be viewed from the links within the website.

8 comments:

fishman said...

Hi Musicwhiz,

For value investors, such "gloomy" tidings might not be so bad after all. Think of it as Great Stock Pre-Sale? Issue is in identifying great companies that can weather the storm. Hai too bad I'm short of cash. Don't think got chance to take put in the coming sale again!

Have a great sunday!
fishman

musicwhiz said...

Hi fishman,

Thanks for dropping by so early. Yes, you are right in that pessimism produces prices which are advantageous to the value investor; however, one must also take a close look at the company to see if the factors I mentioned affect its operations and profitability. One cannot turn a blind eye to economic events and assume they do not affect the companies we own.

Haha, well you can start building up your "war chest" so that you can make use of opportunities in a market correction or crash. Good luck !

Regards, Musicwhiz

Anonymous said...

Good write up!

The points you mention are 3/5 suggested warning signs to a stock market crash too. I read bout that some months back. Another indicator is consumer spending in the US. Are people spending?

What would your personal strategy be now? Liquidate funds that have been doing well (profit take)? Move funds to defensive stocks like singpost?

There is no one perfect strategy (depending how you look at it, liquidating where cash is king could be good), but interested to discuss investor's strategies at the moment. Bond yields have been falling in the US, suggesting people are taking money out of stocks and into bonds, seen as a 'safer heaven'.

--charlesming

Anonymous said...

MW,

Nice piece. Not sure if you have visited the Wallstraits where I posted on Friday night b4 the market opened that the US indices has just gone into a correction, ie., the uptrend is broken.

The US market has gone into a correction on Thursday, when the leading stocks broke down on huge selling volume. Leading stocks like Google, Baidu, Dry Ships, Diana Shipping all came down hard.

The leading US index, Nasdaq, sliced thro' its 50day moving day average on huge volume, signifying institution selling.

Unless Singapore market can decouple from US market, this might be a time to be prudent on investments on Singapore stocks. It might be prudent to go back in cash. I have just gone back into cash today.

This is not a buy or sell recommendation. Just to let you know that market trend has changed in the US.

Market trend reversals are most difficult to catch for the layman investors. Unfortunately, our investing public has been brainwashed that it is not possible to time the market.

The US market dropped much more on Friday night.

This is part of the discipline of the CANSLIM model I have talked about before.

I hope if my posting can help some people take some money off the table or at the very least, avoid serious losses, that would be worth it.

Regards,
MM

musicwhiz said...

Hi charlesming,

I think people in the USA (those affected by the sub-prime mortgage crunch) would be more wary of spending wantonly, especially when they are hard pressed to keep up with mortgage payments. The extent of this problem is not known though until a survey is conducted on consumers' spending habits, and it will take some time to permeate throughout USA as this is only the beginning.

My personal strategy is to stay vested throughout the turbulence, as I do not think my companies will be affected by the current troubles; or even if they are, I already have a margin of safety to prevent me from large losses. But I know some people's strategy involves parking some money in bonds or treasury bills. To each his own, and there is no right or wrong.

Regards, Musicwhiz

musicwhiz said...

Hello MM,

That's a good write-up on Wallstraits, and I must applaud you for your intelligent insights and analysis to determine the change in market trend, as I am usually very bad at such things !

The decision to be in 100% cash though, is a personal one and I do not fully agree with it. I would prefer to stay vested through the "turbulence" as my margin of safety should prevent any serious losses. I also maintain an opportunity fund as recommended by Dennis Ng to be ready to capture good opportunities to buy cheap when the market corrects severely or crashes.

Yes, I have heard of the CANSLIM model which incorporates FA and TA. However, I am still more comfortable with the focused (value) investing techniques.

Regards, Musicwhiz

Anonymous said...

Yes.. if got margin of safety. Some people happen to buy at high prices. ie, more downside risks than upside hence more risky than in your case. Diff strategy for diff things :P

--charlesming

musicwhiz said...

Hi charlesming,

Yes, margin of safety is the buffer which value investors require in order to make an investment. This prevents large losses and limits the damage should our analysis be wrong.

Regards, Musicwhiz