Akash Prakash: A time of confusion

It still seems that early to mid-2009 is when equities will conclusively bottom.

Current market conditions are quite extraordinary, to put it politely. I have never seen such fear, panic and confusion all at the same time. One has seen bear markets before but the sheer pace and velocity of this plunge has been breathtaking.

One is also caught between two conflicting instincts. On the one hand, given the extent of damage and fear around, every contrarian instinct one possesses is shouting out to buy. Everyone has heard about buying when there is blood on the streets and fear all-pervasive. How can things get any worse? Also, are we not supposed to be buying when governments finally give up and actively intervene to shore up the financial system? Isn’t a large financial institution going bust the indicator everyone was looking for? All indicators of fear and capitulation are flashing green. For anyone believing in mean reversion, your first instinct will be to buy and buy aggressively now.

However, one continues to remain hesitant, and it is important to understand why.

 

First of all, this is new and uncharted territory for everyone participating in today’s markets. None of us has ever seen a credit contraction and deleveraging cycle of this magnitude. As we have never seen this beast before, one tends to be more cautious in facing it. When the mean itself is unclear, playing regression to the mean is a little difficult. We have lived through two decades of global credit expansion, and are not used to credit being simply unavailable. 
 

There is a clear sense that this crisis has now spiralled out of control and become global in nature. It is also very difficult for anyone to dimension just how bad things can get. Never before has someone like GE found it difficult to access short-term funding markets. The credit freeze has to have forced all companies to reassess business, and consumers are running scared. We are most likely about to enter a very serious economic downturn, and most investors still do not seem prepared. This will be a consumer-driven recession and far worse then anything most current investors have seen. Analysts still expect earnings to grow in 2009, when they will probably fall 20 per cent. We have still to print even one negative quarter of GDP growth in the US, yet already 760,000 jobs have been lost and earnings are down 30 per cent (entirely due to financials).While we have seen the mother of all credit collapses, we are still in the very early stages of the consumer credit deterioration associated with an economic downturn. In prior recessions in the US, 60-65 per cent of the market and corporate profits decline tended to occur during the recession itself — could this still be ahead of us? It is only now in the past month or so that the US economic data has turned decidedly negative. If the recession is only now beginning then we may have a lot more downside ahead. Valuations are also not yet cheap enough on a cyclically adjusted basis, with longer-term earnings-based measures not yet in value territory. 
 

While most probably all the actions undertaken by the Fed and other authorities globally will work eventually in unlocking financial markets, the consequences of these measure not working is extremely dire. We have no choice but to assume that the Fed and Paulson will be effective(what choice do we have?), but the story may not end with the troubled asset relief programme (TARP) plan. We could see a lot more measures needed and many unintended consequences, for truthfully, the authorities are making decisions on the fly. With such adverse repercussions to a negative outcome, one must be conscious of tail risk(a small probability of a very negative event actually happening). Given what happened to Lehman and AIG etc, investors can be forgiven for being more focused on tail risk than normal. 
 

One is also very uncertain about the endgame in terms of how the attitude of banks, regulations, investors etc towards emerging markets (EMs) will play out post this deleveraging cycle. Will investors still be interested in playing EMs, when the US itself is becoming cheap? How will flows eventually play out? How will investors’ attitude towards risk assets change? 
 

Even from an Indian context, while the commodity bust is going in our favour, and we have probably seen the peak in the monetary tightening cycle, earnings risk is still all-pervasive and the weakness in governance a serious overhang. We run large fiscal and current account deficits and have very limited room for fiscal manoeuvre. A country which needs FDI desperately to fund its current account, cannot afford to have a repeat of Singur or Posco. This is also our first credit cycle with significant retail leverage.

It probably makes sense to wait for some normality to return to the credit markets before one can become more aggressive. This may be one time when, given all the uncertainty, it may be worth giving up some of the upside in return for safety. Even after we see some unlocking of the credit markets, equities will still give us enough time to participate. To track the credit unlocking, one will need to see the TED spread, LIBOR and corporate spreads normalise.

We will see of course trading bounces, and given the panic, one should appear very soon, but it still seems that early-mid 2009 is when equities will conclusively bottom. I think investors should control their contrarian instincts, and recognise the lack of clarity in the environment and possibility of extreme outcomes. Capital preservation still seems to trump the need to aggressively position oneself for capital gains in the immediate short term.