Inflation or deflation? cyclical versus secular forces

What is the issue?

Government’s and monetary authorities around the world are flooding the markets with liquidity. Massive fiscal stimuli are about to be implemented in major economies such as the U.S., the UK and China. In normal market conditions the combination of these two factors would be considered hugely inflationary. Yet, as shown by the following chart the market is pricing in an unprecedented period of low inflation. The current spread between 10 year treasuries and 10 year TIPS suggests an annual inflation rate of 0.15%.

What is going on here?

First off, it is important to recognise that these prices are not entirely fundamental. A recent trend which seems to have gone somewhat unnoticed in the equity market is the massive shift by foreign central banks out of US securities with any hint of credit risk and into treasuries. This started in 2007 as foreign demand for US corporate bonds collapsed. Most recently the shift has come out of agency securities into treasuries, particularly by China and Russia. Brad Setser from the Council on Foreign Relations calculates that since the end of September, central bank holdings of treasuries are up by over $210bn, while holdings of agencies are down by around $130bn.

So we can be reasonably sure that some part of the current Treasury-TIPS pricing conundrum is explained by foreign central bank asset allocation decisions. Without this, implied ten year inflation would not probably look quite as low as it does.

Nevertheless, the Treasury market is huge, and these foreign central bank flows are not sufficient to explain all of the recent bull market in Government bonds. Many other supposedly “rational” market participants have also loaded up on treasuries (and not on TIPS). So unless we assume this is all just panic, it is fair to infer that the wider market expects very low inflation to be a reality that will continue for some time.

Cyclical and secular forces are working in opposite directions

My approach to the problem is to think about it from both a cyclical and a secular perspective. I think this is important because there are very different forces at work here.

From cyclical view – i.e. the next 12-18 months – deflation seems very likely. This period is clearly going to be characterised by a considerable deleveraging and credit contraction. Moreover, saving rates in the UK and the U.S. are likely to rise back to the levels of the early 1990s as consumers are unable to obtain credit and become more risk averse. With such macro trends it is very difficult to imagine the price level going up.

The only argument against this is that unprecedentedly low level of nominal interest rates will drive consumers to spend more. Yet, as most of the historical evidence shows (Japan, 1930s etc) what matters most is the level of real interest rates, which in an environment of falling prices will remain substantially positive.

Therefore, from a purely cyclical perspective, I expect the outcome for the price level (at least in the U.S. and the UK) to be at least as bad as where consensus seems to be.

However, my secular view is very different. Here I can see a number of important forces working in the opposite direction. I would highlight four in particular:

1) Money supply growth could expand rapidly if/when recovery begins
Thus far the expansion of central bank balance sheets and leverage ratios has merely served to offset the decline within private sector financial institutions. Looking at broad measures of money supply such as M3/M4 growth suggests money supply growth has been flat to negative. But once financial institutions’ balance sheets have been repaired credit creation will start again. From a monetary perspective this will be inflationary unless the central banks can very rapidly shrink their own balance sheets.

2) Capital scarcity means many surviving industries will have pricing power if/when recovery begins
In many cyclical industries this recession will cause much capacity to be removed from the market. This has already started to happen in some industries (e.g. insurance, asset management, retailing) and will soon spread to more late cycle industries (e.g. industrials). We should not expect this capacity to be brought back quickly once demand starts to tick up again because banks will be much less willing to make capital available than before. If they do, it will likely be more expensive. Therefore many surviving industries are likely to become more oligopolistic in terms of pricing, a situation conducive to demand driven inflation.

3) Government fiscal stimuli will accentuate capital scarcity
While the planned Government fiscal stimuli may be good for employment, they will likely have the usual “crowding out” effect on private investment. As capital is diverted to (unproductive?) Government spending, the availability of capital for private sector will be further reduced. This will serve to accentuate 2) above.

4) China is unlikely to continue exporting deflation
We should not forget that the recent benign period of low inflation has been partly a result of the Chinese (and other EM countries) policy of export led growth. They have kept their real exchange rate artificially low in order to promote exports and investment at the expense of consumption. This led to deflation of many manufactured products. It also led to a global savings glut which kept long term interest rates artificially low. This benign set of macro forces is very unlikely to return. If China attempts to return to its export-led growth strategy it will find that foreign demand is no longer there for its exports (a global paradox of thrift). On the other hand, if China attempts to shift to a policy of domestic consumption driven growth, this will necessitate real exchange rate appreciation, and hence higher export prices. It will also entail a low level of saving, implying lower demand for treasuries and higher long term interest rates.

These four forces lead me to conclude that we are likely to enter a period where inflation and long term interest rates are significantly higher than they have been over the past cycle. Indeed I would not be surprised if there is a long-term bear market in Government bonds, much like that which was experienced in the 1960s-70s.

Conclusion: implications for equity portfolios

The key issues for portfolio construction are: a) should we try to play this theme at all?; b) timing

a) This is really a question about whether or not to take an explicit macro view. In macro terms, the bias in favour of structurally higher inflation and long-term interest rates is quite bullish. It implies that we are going to avoid the Japan style debt-deflation scenario, and that there will be a recovery. However, some people would argue that the Government bond market is merely pricing in two possible outcomes – debt deflation and even lower long-term interest rates versus the recovery/inflation scenario. I would argue that economic history favours the latter scenario – the U.S. economy is very flexible and resilient and has historically managed to find its way back onto the growth path. But I may be being too optimistic.

b) Timing is difficult. It is probably too early to start gearing up for a period of structurally higher inflation given the risk of a low level equilibrium trap and/or a major policy blunder. But I do think the markets will price this is in really quickly. If and when our central case becomes an economic recovery, it would make sense to start positioning portfolios for structurally higher inflation and long-term interest rates.

Scarcity of capital, and what it means for industry

The current financial crisis has made capital, one of the key factors of production, a much scarcer resource. As long at this continues, it is likely to fundamentally alter the structure of many industries.

Scarcity of capital erects both a new entry barrier and a new exit barrier. This has implications for pricing power and industry consolidation.

There are three important factors that will determine which industries are most affected: 1) how much capital they need to operate; 2) the length of the capex/payback cycle; 3) the type of market structure.

A key question for investors is whether capital scarcity should be expected to subsist into the next cycle. If so, many market structures are likely to become substantially less competitive. This could present some interesting investment opportunities.


Scarcity of capital: what does it mean for industry?
Capital is now scarce. Banks are de-leveraging globally, and will surely continue to do so at least until the end of 2009. New debt financing will therefore be very difficult for companies who want or need it. Other sources of capital such as equity are also likely to remain scarce, or at least be very expensive, except for companies with highly rated shares. Furthermore, even once the deleveraging process it is over, it is questionable whether capital will ever be as freely available as it has been previously.

Capital scarcity has two important consequences for market structures:

1) A significant barrier to entry has been erected. While capital always becomes scarcer in economic downturns, it is increasingly becoming apparent that capital is going to be much scarcer now than it has been in past downturns.

The main consequence of this new barrier to entry is increased pricing power. The inability of competitors to enter markets should render the existing players very well geared to any upturn in economic activity.

2) The other side of the coin is that barriers to exit have also been raised. The inability to raise capital means that exit prices for uncompetitive or unprofitable assets are extremely low. There are few buyers. Moreover any buyers that do exist know that they have huge leverage over price.

The main consequence of this new exit barrier is increased industry consolidation. I would expect in many industries that the smaller, capital-starved operators will either end up going bust or being absorbed by competitors who still have a balance sheet. Of course this happens in any cycle, but it is likely to be more severe this time around.


Scarcity of capital: which industries are likely to be most affected?
I think there are three factors that will be particularly important in determining the scale and speed with which particular industries are affected.

1) The level of capital consumption in the industry. For example sectors that require lots of capital to operate successfully will surely run into problems first. We have already seen the banks affected, and now it is spreading to other financial balance-sheet businesses like asset managers and insurance.

2) The length of the payback period. For example, business models that require a continual inflow of capital for a (sometimes speculative) pay-off in the future are surely likely to suffer. Obvious examples here are biotech and tech. Venture capital generally is also likely to be affected. We could also see companies with very long capex cycles affected, perhaps leading to underinvestment, with implications for pricing in later years.

3) The market structure of the industry. Businesses that operate in markets characterised by “monopolistic competition” could see a significant change in terms of pricing power (assuming they survive). This is because monopolistic competition tends to ensure that pricing is reasonably competitive – despite the name, monopolistic competition is actually much closer to perfect competition (many buyers and sellers, limited level of non-price competition, low barriers to entry). However, if capital remains scarce, then the threat of entry is no longer a factor controlling pricing. It is therefore possible that many companies operating in industries previously considered to be very competitive may have a surprising amount of pricing power in the next cycle (examples of monopolistic competition include retailing, financial services, restaurants etc.).


Scarcity of capital: a visual interpretation
The following diagram illustrates my understanding of this process. Over time, I would expect more and more industries to be affected by the scarcity of capital. In the first stage, it is the balance-sheet business models that are most immediately affected. By this I mean companies that need huge amounts of capital to generate a decent return on equity – i.e. financials. In the second stage, it affects industries with long pay-back periods or long capex cycles. Finally, in the third stage it starts to even industries previously considered very competitive simply because there is little or no possible of entry. At the present time I would suggest we are about half way through stage 1.




Some additional thoughts and conclusions

This is only one of many possible outcomes
I am not arguing that the above is certain to happen. Indeed we may never make it much beyond stage 1. It all depends on whether capital remains scarce. Indeed, once capital returns we could expect the process to reverse itself. However, as long as capital does remain scarce, the process will continue, with more and more industries affected.

Are these changes in market structure permanent or transitory?
This is absolutely crucial for valuation. If capital is to remain scarce for the next cycle then many industries will be radically altered – they will move from being reasonably competitive to being more oligopolistic.

On the other hand, if capital returns as soon as the up-cycle starts again then many of the changes will be merely transitory. For example, insurance or asset management will revert to the monopolistic competition model, implying that any earnings or cash flow benefits will be temporary.

Lack of capital + lack of capacity = cartel
There is a possibility in some extreme cases of industries becoming almost cartelised in terms of pricing. If capital remains scarce and, importantly, there is also under capacity, then we should expect the incumbents to exercise their new found pricing power. They will not compete, they will collude. This could present some interesting investment opportunities for investors.

Which sectors could go this way? One possibility is banking – e.g Lloyds/HBOS’s should have huge pricing power in the mortgage market when/if the market turns up again.

What will be the attitude of the regulators?
It might be objected that market concentration and the exercise of pricing power will simply be blocked by regulators. This should definitely be a consideration. However, I also expect that the Government will turn a blind eye to many of these competition issues in favour of promoting employment and the survival of big companies and industries.

The Curse of the Benchmark

So Xstrata shares have fallen below £6, down from a peak of just under £45 barely 5 months ago. Having been wrong for so long on commodities (or rather seen the bubble carry on going) I do at least derive some satisfaction from having got something right in this market, even if some my firm’s funds have been burnt badly with the recent commodities blow up.

What I find most interesting about this recent price action is not so much the speed of the collapse but the size of it. With the Xstrata shares at less than £6, one has to ask the question, how could the bubble possibly have gone on for so long? Unless the market is currently seriously mispricing the shares (which is certainly a possibility which I’m currently investigating), it defies comprehension that people could have genuinely believed the shares were undervalued at £45.

Another interesting question is whether or not I was actually correct to be bearish. And here it depends entirely on your timeframe. When I interviewed for my current job back in June 2006 (it feels like a lifetime ago now!), one of the arguments I made was that the current commodities boom was an investment fad, based on a false extrapolation of Chinese growth rates out into perpetuity. For sure I was not denying that China was going to carry on growing. Rather I was suggesting that it would become more efficient in its use of inputs and that supply would respond to the growing demand. After all, over the very long run (past 250 years), commodity prices have not risen at all in real terms, so why should we suddenly expect this to change?

While this now appears to have been the correct position to take, if a little early, the fact remains that had I actually been in a position to implement my belief within a portfolio, the results career-wise would have surely been catastrophic. Lets imagine a parallel universe where, upon joining the firm, I was immediately given a high profile portfolio to run. The previous manager had been massively bullish mining and commodities. Performance was fantastic and the clients were all happy.

So I immediately sell down all the mining and commodity related positions, only to see, to my horror, that Xstrata – the previous manager’s biggest overweight position - more than double in value again! Performance falls apart and clients start leave. Then toward the end of 2007 the CIO (who is also a commodities bull) gives me a stern warning that such underperformance will not be tolerated for much longer. But being a value investor I argue my case and stick to my guns. Finally mid way through 2008, management have had enough and I get the boot. Assets under management have collapsed due to poor performance, so my services are no longer required. Of course the next week the collapse begins, but it is too late.

This is what I call “the curse of the benchmark”. You can be absolutely right about something fundamentally, but if you are too early then the benchmark will kill you. I really dislike this side of professional fund management. I do not think that a fund manager should be obliged to hold stocks that he or she thinks are overvalued just because they make up a big chunk of the benchmark. If I would not buy something with my own money then I should not buy it for my investors. Thankfully for me this is only a hypothetical story, but for many it has no doubt been a reality.

Emerging markets: economic policy for the next cycle

At the original Bretton Woods conference in 1947, one of Keynes' proposals for the new financial architecture was for an adjustment mechanism that would penalise persistent creditor nations. Keynes was acutely aware of the problem that emerges when one set of countries run huge surpluses. This is the problem of adjustment - at turning points in the cycle, adjustment is always mandatory for debtor nations but optional for creditor nations. It is this basic fact that renders any free international financial system inherently political. When the debtor nations are small and lacking systemic influence, they typically find themselves at the mercy of the big boys (e.g. Asian financial crisis, Mexico 1994, Latin America 1982 etc.). When the debtor nation is large and systemically indispensible (i.e. the US now), adjustment can be delayed for a long time. But it must occur eventually, and given recent newsflow and datapoints it would seem a good bet that this adjustment will now happen over the next 1-2 years.

So what? Why does this matter for emerging markets? It seems almost certain now that the US is going start saving considerably more. Over the past cycle the excess savings stemmed from emerging markets, which were in turn lent out to the US to finance the leveraged boom. Emerging markets were essentially following an export-led growth model: keep exchange rates down, prioritise investment over consumption, promote exports. This is fine so long as there is demand for your exports. Unfortunately in the new world of a thrifty US consumer, there is going to be no marginal buyer for these exports. Therefore, if emerging markets try to adopt the same export led growth strategy as they have over the past cycle, we risk drifitng into a low-level equilibrium. We would have a global paradoox of thrift - increasing savings in both the US and emerging markets, but lower overall demand for goods. Clearly this would be a disaster.

History has shown that the best way out of these situations is for the creditor nation to embark on domestic fiscal expansion in order to stimulate domestic demand - see Martin Wolf's recent article on this point. I am increasingly coming round to the view that this could be the single most important macroeconomic challenge over the next cycle. If emerging market policy makers can get it right, then we could revert to the 3-4% global economic growth rates of the past. But if they try to follow the policies of the past cycle then I fear we could be in for a seriously pro-longed slump. The world has changed, and policy needs to change with it. In this regard, China's stimulus package is very encouraging, but there will need to be a lot more where that came from.

Investment versus consumption

I am becoming rather worried about investment spending. Yesterday, one of my colleagues returned from a meeting with his investment trust board in which the finance director of a UK utility and a board member of a major bank told him that credit is essentially not being advanced to anyone, regardless of their perceived creditworthiness. The finance director said that companies were now basically being run for cash, which is then being hoarded to protect against any refinancing risk.

If this is true - and to be fair I have heard conflicting reports from other sources suggesting that credit is still available to some companies - then it does not bode well for any kind of discretionary corporate spending, whether it be expansionary capex, advertising and marketing or R&D. As is well known, investment spending is the most volatile component of GDP. Just take a look a the following chart, which shows investment spending in the UK economy over the past 50 years.

Admittedly the last two quarters of data (Q1 and Q2 2008) were negative, but only marginally so. We are a long, long way away from the -10% to -20% seen in past recessions. With the credit market still bunged up and managements terrified of a recession, it seems pretty unlikely that we wont see at least a few quarters of -10%. Of course with the recent sell off in everything exposed to corporate end markets it may be that the shares are already pricing in this outcome, even though consensus estimates clearly are not. However against this stocks do still seem to go down on the profit warnings, as Cookson showed today.

The other thing to remember is that, for all the bearishness on the consumer, consumption expenditure is much less volatile than investment. Over the past 50 years, the reported number has never been worse than -4% y-oy. Of course within this there will be a large variation - electrical goods will be a lot worse than clothing, which will be a lot worse than food etc. Nevertheless, I can't help but feel a little more positive on the consumer, at least on a relative basis - big downgrades have already been put through, interest rates are coming down etc., - while none of this has really begun yet for the industials.

Bretton Woods 2 - the end of an era?

With the worst of the current financial crisis apparently past, now is perhaps a good time to reflect on what was and what was not correctly anticipated beforehand. For my own part, there is no escaping the fact that my record has been pretty mixed. Looking back over some of the past posts on this blog and recalling my own views at the time, it seems that I was very much correct in my skepticism of the "de-coupling" thesis, and particularly of those investors who were bearish on equities generally but bullish on China, India, mining etc. However, the events of the past couple of months have shown my bullish (relative to consensus) views on equities to have been spectacularly wrong. So the natural question to ask is how did I manage to get half so right and half so wrong? (Or was it just luck!?).

First off, it is important to recognise that crises are always so much clearer with hindsight. What started with some property related write-downs at US banks had escalated, despite numerous policy interventions, into a global banking crisis, and now what looks like a recession in the real economy too. The following diagram shows my understanding of how the financial system worked prior to the beginning of the crisis in summer 2007.




This is not particularly ground-breaking - indeed, many observers no doubt had a similar view of how the system operated. What is interesting however, is that fact that many commentators (although by no means all) expected the crisis to emanate from the emerging markets, rather than directly inside the western financial system. There was much analysis of the build up of Chinese reserves, whether this was a good thing or a bad thing, what would happen to the dollar and interest rates if they started diversifying etc. etc. When the crisis did hit, I think many people (especially equity investors) failed initially to understand its significance because they were looking for it elsewhere.

For my own part I was certainly guilty of this. When you look at the above diagram, it is so blindingly obvious that the breakdown of the process of credit creation should put a serious spanner in the works. It is not hard to see that a de-levering puts the whole cycle of flows into reverse (switch all the arrows round and then think about the consequences!). I had correctly understood that de-coupling was a myth, but I had not correctly anticipated the extent to which the de-levering itself would drive down all equity prices. I simply looked at valuations and said - "well, clearly mining and commodities are overvalued, but the rest of the market is pricing in a recession anyway and therefore doesn't look too expensive".

But my valuation argument has been shown to be largely irrelevant as many company valuations have gone careering through trough multiples anyway. Stocks that I thought could not go any lower have indeed continued to go lower. In fact, the cheapness of equity markets really depends on your time-frame. My valuation assumptions had been based on data for the past 15 or so years. What I should have realised was that the scale of the structural changes under way presented a serious risk to these assumptions. On longer-term valuation metrics, equities did not look quite as cheap. After the recent falls they do now look cheap, although (somewhat worryingly) they have in the pas fallen even lower.

Reflections on banking (I) - maybe George Soros was right

One of George Soros’s most interesting contributions to finance and social theory is the idea of reflexivity. It is not an idea that originated with him, but he has done a lot over the years (often to the sneers and jeers of the academic community) to popularise its importance in determining social outcomes. Its basic premise is that in many social situations the theories and beliefs of the participants affect the situation itself. As defined on Wikipedia:

“...[R]eflexivity is considered to occur when the observations or actions of observers in the social system affect the very situations they are observing, or theory being formulated is disseminated to and affects the behaviour of the individuals or systems the theory is meant to be objectively modelling. Thus for example an anthropologist living in an isolated village may affect the village and the behaviour of its citizens that he or she is studying. The observations are not independent of the participation of the observer.”

In his book, “The Alchemy of Finance”, Soros used numerous episodes from recent financial history to support the idea. For example, one of his long standing criticisms of the fundamental analysis of equity investments was that in many cases the share price was not independent of the fundamentals. Clearly, for fundamental analysis to work this cannot be the case - for fundamental analysis holds that (over time at least) the fundamentals will determine the share price.

Soros used as one of his examples the conglomerate boom over the late 1960s. Over this period, there was a bubble in many conglomerate mega-cap stocks in the US. The false belief (or “prevailing bias” as Soros called it) was that the diversification and scale offered by these companies meant they deserved a valuation premium over their smaller more focussed peers. The reality, as Soros argued, was that this very belief was determining the outcome. As more and more investors started believing in this false argument, the valuations of the mega-cap stocks – “the nifty fifty” as they were known at the time – were bid up to substantial premiums. The companies' then took advantage of their highly valued equity to acquire more and more of their smaller (lowly valued) peers. It didn’t matter if the deals were not earnings or cash flow accretive because the market would revalue the acquired earnings to that of the acquiring company. Thus, in this way, the share price served to determine the fundamentals.

What is interesting is that the fate of bank shares over the past 18 months has been largely determined by a similar process. One can attempt to undertake fundamental analysis of these companies - what do they have on their balance sheet? what is the net worth? size of write-downs? etc etc. However the reality seems to have been that the share prices themselves have been determining the fundamentals.

The problem with the banks has been their exposure to the wholesale markets - short term funding from money markets. Their business model consists (consisted is probably more accurate) of taking short term funding from these markets in order to finance long term assets. They have to be able to roll over these liabilities because most of their assets are not particularly liquid. Moreover in most cases the leverage was very considerable - often greater than twenty times. The value of the equity portion therefore depends on the position of the short term liabilities relative to the long term assets. Unfortunately for the banks, no matter what their managements' say, the share price acts as an indicator of the value of the assets relative to the liabilities. As the share prices fall (to reflect the fall in the value of the banks' assets), potential funding sources take it as an indicator that the bank is likely to fail. This makes it harder and harder for the bank to roll over its short term liabilities.

As Lehman Brothers discovered this process inevitably leads to insolvency. Beyond a certain point it does not actually matter what the value of the assets really is. Once market participants observe that the share price is cratering, they will take note and run for the hills. Funding dries up and the bank is insolvent.

Of course we will never know if Lehman was actually bust - i.e. if it had been possible to organise an orderly sale of all the company's assets at fair market values, would the proceeds have covered the liabilities? It is possible the answer was yes, but it does not really matter. The point is that the business model itself was bust.

I suggested to colleague that perhaps the short selling ban on financials imposed by the SEC was perhaps not such a bad idea. No doubt many hedge funds saw what was happening and realised that they could force the process along by shorting the equity even further. He made the good point that actually the problem lies with the lack of regulation. Because the regulators have no idea what the big market positions are, they are totally in the dark when they try to assess the systemic fallout of a big financial bankruptcy. If they had known who was exposed to what, they would never have allowed Lehman Brothers to go under.

The end of the world as we know it? Or the greatest buying opportunity in a generation?

The last couple of months have been truly hectic, such that I now feel glad just to have made it to the weekend.

Observing what is going on within the financial sector has led me to conclude that it is almost certainly the end of the world as we know it as far as banking is concerned. By all accounts the problems within banks are now starting to spill over into the real economy, with business is some parts of the economy pretty much grinding to a halt. The authorities now seem to really "get it", as was clear by the Brown and Darling plan announced earlier in the week. It is only a matter of time before the US goes down the same route. Perhaps something will come out of the G7 convention this weekend. Indeed one has to hope it does, for this is truly the first global financial crisis, the one that all the academic books warned of, the one that the current national system of regulation would not be able to deal with. Some sort of global coordinated response on a scale larger than seen so far is probably going to be necessary.

Unfortunately (or fortunately!?) for the banks, I think this is most likely to mean a complete sea-change. Now that the authorities are aware of the risks posed to the real economy they will not stop until the problem goes away, even if it means complete nationalisation, firing of all directors and senior management and replacement with regulatory bureaucrats. If the banks don't start lending to each again on their own then I think this will be what happens.

Yet when I look at stock market valuations, I cannot avoid the conclusion that this could well prove to be the greatest buying opportunity in a generation - much like 1933 or the early 1980s. Long term valuation metrics would certainly suggest so. For example, the Graham-Dodd 5yr p/e for the European market is currently at 11.7, only slightly above its historical trough of 9.8, and well below the average of 18.6. Admittedly, using 10 year data would probably be less favourable but the conclusion still holds. The US market looks less cheap on this measure, although still well below its long run average. Tobin's q - a measure of market value of assets versus their replacement cost - currently stands at 0.5 for the US market, versus its 50 year trough of 0.4

Before this week, the FTSE 100 was trading on a 2009 p/e of around 10X. So after this week's dramatic move, it will be down to around 8X. For sure the "e" for 2009 is wrong (too high), but even correcting by 30-40% still leaves the market looking far from expensive.

The sector I focus on (media) has some pretty resilient companies trading at what looks like absurd valuations. For example all the advertising agencies are on huge discounts to their historical valuations - 50% off trough multiples. Perhaps the long term future is not as bright as it was in the past, but these business services companies are not going to disappear, and neither are companies going to stop advertising. Earnings will almost certainly fall next year, but this is more than priced into the shares already.

Opportunities are being thrown up in other sectors too. The recent move down has been driven heavily by industrials and mining, sectors that had previously been holding up OK. Some defence and engineering companies such as Cobham and Meggitt are on multi-year valuation lows. These business have many highly defensive and long-term revenue streams. Within financials asset managers (Legg Mason, Ashmore) also look exceptionally cheap. Despite what markets are doing, people are not going to stop needing their assets managed.

All of this leads me to conclude that now is actually a fantastic entry point for any unleveraged investor with a reasonable time horizon (i.e. more than 2 years). Indeed, this is actually a natural part of the credit cycle. Despite all the media hype surrounding this crisis, it is actually following all the normal stages of a credit cycle (all be it on a slightly grander cycle). What we are witnessing now is a great de-leveraging, as all the excesses of the past few years are unwound causing asset prices to fall. With money markets not really functioning, the equity market is currently the only liquid market. This means it is suffering particularly badly as leveraged market participants facing margin calls or debt maturities become forced sellers. It is natural in such an environment for unleveraged market participants to enter the market, pick up a lot of bargains, and in the process restore the market to fair value.

Inflation: will history repeat?

I had previously thought that all the current hoo-ha about inflation was misplaced on the grounds that bond markets weren't pricing it - presumably if inflation were such a severe problem then the 10 year US treasury market, one of the most efficient in the world, would be reflecting this with higher yields? Since that is not the case, we must be worrying about something just because we like to worry.

Unfortunately, history does not really support this argument. Looking back to the 1960s, the 10 year US Treasury was certainly not pricing in the coming period of inflation. In fact, it was not until inflation really started to kick in the later 1960s and 1970s that the market really responded by marking down treasuries.

...so much for that argument then (and probably best to avoid treasuries!)

The elephant and the blind men.

The Buddha reportedly once told a story about a bunch of blind men gathered together by a raja to examine an elephant.

"When the blind men had felt the elephant, the raja went to each of them and said to each, 'Well, blind man, have you seen the elephant? Tell me, what sort of thing is an elephant?'

They assert the elephant is like a pot (head), winnowing basket (ear), ploughshare (tusk), plough (trunk), granary (body), pillar (foot), mortar (back), pestle (tail), or brush (tip of the tail).

The men come to blows, which delights the raja. The raja says:

O how they cling and wrangle, some who claim

For preacher and monk the honored name!

For, quarreling, each to his view they cling.

Such folk see only one side of a thing.

Of course the point of this story is that what one sees depends entirely on one's perspective. The current situation in the markets appears to also resemble something of a bunch of blind men arguing with each other. So who are these blind men?

First we have the "Chindis". These are the rather emotional types who believe that China is the only thing that matters for the markets now. Haven't you heard? Its 15% growth rates forever now. All the money is in China, all the building work, all the infrastructure, all the future wealth, all the growth. This the place to be man. This is where it is at! Unfortunately the Chindis fail to see all the glaring problems staring them in the face such as: 1) Despite the high growth rates, China, and the rest of the BRIC and emerging markets for that matter, is still a massively geared play on the OECD. To see this, one doesn't need to look any further than the consumption data, which clearly shows that domestic consumption is still a relatively small portion of GDP (compared to the OECD). 2) Much of their growth is still dependent on exports, something which the official data do not really pick up due to the prevalence of exporting and re-exporting along the value chain. Therefore, if you believe the OECD economies are going to slow (as many of the Chindis I know do), it almost inconceivable that China can continue to grow at its current pace.

Then we have the "Commis". These are the mining and commodity analysts and traders. These blind men are touching a similar part of the elephant to the Chindis although their knowledge base is more specific. Apparently the managements of Rio Tinto, Xstrata and BhpBilliton are saying that demand for commodities is really strong, and a lot of it is coming from China and India. Wow! Now there is some really conclusive evidence for you. Its got to be "stronger for longer" if the managements of the mining companies say so. The most patently ridiculous aspect of this argument is the idea that what these managements are saying has any bearing at all on what is going to happen in the future. Everyone knows that China is still growing, so obviously these managements are going to be bullish. Unfortunately, as with the Chindis, the Commis fail to see the extent to which their thesis collapses if and when the OECD slows down - the potential for downgrades at the mining companies (which, by the way, are at all time highs and are the main reason the UK market is where it is today, or at least before this week) is so much larger than anything else, that it is this sector that is likely to lead the market down if and when we do enter a bear market.

Next we have the "junkies". These are the blind men who operate in the credit market, or at least used to until they all got fired. These guys are the most bearish of anyone. Jesus! Where have you been man!? Don't you know that the credit market is CLOSED!? Game over man, game over. At a party some weeks ago, I randomly met a risk manager at a major bank who was responsible for the leveraged loan, ABS and sub-prime desks. He very much epitomised this category of blind man. Since he worked all day in the credit market, he seemed to take the view that the credit market must be correctly pricing the real economic risks, and that therefore the equity market was vastly overpriced. Of course it did not occur to him that perhaps it might be the equity market that was correctly pricing the risks, while the credit market that he knew so well was not actually a very good indicator given all the forced selling and general lack of liquidity. The Buddha would be laughing in his grave. To be fair to the poor chap, he was willing to put his money where his mouth was by betting me that the FTSE would be down at least 40% by the end of the next year.

And finally, as always, there are the contrarians. These are the guys who want to buy the bank stocks. In my last post I stated my reasons why I would not get involved in this area yet, although I must say that the contrarians are increasingly counting a large number of investors that I highly respect such as Anthony Bolton and Bill Miller.

The point of all this is not for me to try and say who is right (I haven't got a clue) but rather to point out some of the inconsistencies between people who hold one or other view. The most glaring example is of the course the Chindi-Junkie cross-breed, those who think that stock markets are going to fall heavily but that China is still going to hold up and that therefore we should all be loading up on everything with exposure to China. Perhaps I will be wrong, but I find this outcome highly unlikely, for it would an entail an even more bizarre shift in the construction of the index, with mining, capital goods and industrials taking up an even larger share of the index. I guess to some extent it depends on your time frame. The commis and Chindis will be OK provided they are astute enough to get out in time, but that will probably prove difficult, especially given how wedded many of them are to their thesis.

Banks and mining shares - a mug's game.

I continue to be amazed at the number of work hours spent (wasted!?) trying to call the bottom (top) of bank (mining) shares. Every morning meeting seems to be taken up with discussion and yet nothing ever seems to be decided on or resolved.

What is my view? To put it bluntly, I do not have one. If I were a fund manager I would neutralise both sectors and with my own money I would own neither. Here's why.

For the banks, the argument is pretty simple. There are far too many unknown variables involved when trying to value bank shares - how much further US housing has to fall, how much crap they have on the balance sheets, how bad is the current "crisis" really going to be, when will managements be changed etc. On some valuation metrics, such as dividend yields, banks, especially those in the UK, look exceptionally cheap. But against this, the future earning power of the banks is clearly far off what it has been in past years, where earnings were driven (inflated?) by new products and trading gains that are now history. I wouldn't be surprised if banks don't recover their 2007 level of profitability for another 2-3 years. In this case dividends will be cut and returns will be mediocre. It is possible that the economy will rebound, but this is not something I would want to bet on - there are other cyclical companies also on depressed valuations with the same or more upside and much less downside.

I continue to be astounded by the extent to which people manage to delude themselves with the mining and commodity boom. In our last morning meeting, the European CIO, who is a fervent "Chindia" commodity and mining bull, was banging on about how he thinks the FTSE index is heading for another 30% fall (i.e. 20% below the trough in January). What I find so odd about this argumentation is how one could believe we are about to enter a protracted bear market, while also being bullish on mining and commodities. It seems blindingly obvious to me that there is almost no possible way the index could fall 30% without this being led primarily by the sectors that are back up at their all time highs (i.e. mining). Let's remember that the recovery in the index from its January trough to where it is today was mainly driven by these "secular growth" industries. The cyclical media stocks that I look at are still on trough valuations. Now I haven't actually done the maths on this yet, but for the index to fall 30% and for mining to significantly outperform would entail cyclical names falling right through their trough valuations, while the mining and commodity related sectors accounting for an even larger share of the overall pie. How likely is that?

The reality is that the correction in cyclical names has already happened, such that they are now effectively pricing a recession. The downside is therefore limited to probably 10-20% in a really dire scenario - i.e. the actual realised fall in earnings, offset somewhat by multiple expansion. The real risk to the index comes from a slowdown in Asia and the collapse of the "decoupling" myth. This would lead to huge downgrades in everything related to the Chindia thesis. And nor would it take much for this to happen - a couple of weak data points out of China and that could be the end of it.

However it should also be appreciated that in a recovery scenario the mining and commodity sectors could easily become the next tech bubble. If the FED succeeds in turning around the macro situation then the next asset bubble is likely to be driven by a falling dollar, which would favour anything priced in dollars.

Therefore, the best course of action is to just ignore banks and mining shares. No need to take a view. Let the big boys waste their time debating it. I continue to focus my attention on value stocks with good franchises and sustainable business models, usually within the beaten up cyclical sectors (TNS, Prosieben, Wolseley to name a few).

Cyclicality versus secularity

Which of the current trends that can be observed in the stock market are "cyclical" and which are "secular"? The more I think about it the more I am convinced that the answer to this question is what will ultimately determine who are the winners and who are the losers in the current market environment.

Since the summer of 2007 there has been a remarkable rotation of value within the stock market (if value as defined by stock prices). Sectors perceived as being as being cyclical have sold off considerably, to the point that many are now already assuming a recession. This is true among retailers, consumer media, advertising, housebuilders etc., all of which are trading on trough multiples. Sure, if the actual macro situation turns out to be truly terrible then perhaps these sectors will sell off more. But we could easily have already had a recession, with the recovery and bounce soon to follow.

Meanwhile, other sectors, such as industrials, mining, commodities and emerging markets (to some extent) are back at all time highs. Why is this? The only explanation, as far as I can tell, is that the expectations are that these sectors are now is a secular up-cycle, immune to a downturn in the western economies. This seems to me a rather bullish belief and I would certainly not be overweight these sectors. Either the economy goes down further and these sectors suffer more than those that have already sold off (as expectations are revised downwards), or the economy recovers, and those cyclical sectors that have already sold off have a greater re-rating.

It is very strange in the current market how much of an obsession there seems to be with macro, and whether or not there will be severe US downturn. This might partly explain why those sectors perceived as structural solid growers have outperformed so much. Yet I find it odd how many fund managers I work with continue to look for "defensiveness", somehow convincing themselves that the market must not have already priced in all the macro data. If something is in the press every minute of every day, if all your colleagues are talking about it and fretting about it, then that should surely be a sign that it is time to move on and get ahead of the curve. I therefore believe that now is the time to be aggressive, not defensive. Don't get involved in the defensive/secular stories, but rather look for the beaten up cyclicals with the most upside in a recovery scenario. That's where the alpha is in today's market...

Volatility and contrarianism

So volatility is back. The most interesting aspect of it is the extent to which it has affected my colleagues' temperaments. Where they were normally quite fundamental and balanced in their approach, now they have become very short termist and somewhat deterministic. I find it rather amusing actually. One fund manager I work with, and I actually have a lot of respect for, has now taken to storming around the office announcing the "R" word at every opportunity. "It is no longer a case of if but when and how bad". "What is the downside?". "How defensive is the stock?"

While I do not have a problem with doing macro, or having a macro view, I cannot help but think that the sudden change of view of my colleagues towards outright bearishness is little reactive and one-sided. There seems to be an assumption that the market is somehow mispriced. It is almost like there is a belief that the only way is down, as the shift out of cyclicals into defensives continues indefinitely. Yet I do not see any reason to make this assumption. Sure the macro outlook is not very good and no doubt there is a high chance that the US economy will experience some sort of recession this year (www.intrade.com recently put the odds at around 70%). But the market has already priced in at least a mild recession. So unless you believe it is going to be really bad, I do not see much reason to disagree with what the market is currently pricing.

The other issue is methodological. I recently had an interesting discussion with the aforementioned fund manager, one who is usually very contrarian, in which I challenged his macro view by suggesting that it wasn't contrarian enough. He responded by saying that one cannot be contrarian on the economy. Now this is where I disagree. For me the key issue in times such as these is to avoid the perils of deterministic thinking. To my mind, this fund manager has simply taken his view on the economy and applied a 100% probability to it. All he is really interested in is the downside that stocks have. There is no mention of the upside at all. But what happens if we don't have a recession? What happens if this another false positive? What happens under that 30% chance of a recovery and turnaround? I believe that the contrarian approach in the current market is to focus on both outcomes. Therefore I am trying to find stocks that have some defensive qualities but also have the ability to outperform in a recovery. Only then can one be sure to take on positive expected value trades.