Wednesday 19th November 2008

The Message from Financial Sectors Relative to Broader Indices - Fullermoney has long regarded a country's financial sector as a lead indicator for its overall stock market. There is logic to this contention, and we maintain that what is good for financial shares is usually good for the economy, and vice versa.

Among many resources in the expanding Subscriber's Chart Library is an extensive "Relative Charts" section, highlighting some of the key comparisons. Subscribers can also customise their own relative charts, comparing any two instruments of interest, selected from many thousands. These can also be stored in Personal Portfolios, where they update automatically, for review as required. Please note: relative charts that you create need to be saved as Presets; they cannot be saved as individual charts as you may have done with those in the Relative chart section.

Charts for financial sectors relative to broader indices have been in the Library for over a year. They should help us to assess upside potential relative to downside risk for global stock markets. For instance, this 10-year chart of the S&P 500 Banks Index divided by the S&P 500 Index, shows banks deteriorating in the late 1990s, prior to the bear market commencing in 2000. We also see the recovery in the S&P 500 Banks Index commencing during the base building process for the broader index. While the Banks Index relative peaked in the second half of 2002, it mostly ranged sideways thereafter, before weakening significantly from February 2007.

Looking at this 5-year chart for additional detail, the ratio improved following rescues in July, but has retraced some of these gains more recently. A bullish signal for Wall Street would be a sustained break above the September high. Conversely, a new low would be consistent with an ongoing bear market. To avoid distortions due to takeovers or bankruptcies, we should also look at other financial relatives, such as this chart of the S&P 500 Diversified Financials divided by the S&P 500 Index. It has resumed its decline recently, indicating that Wall Street still has risks to the downside.

What about relative comparisons for other stock markets?

This item continues in the Subscriber's Area.

Silver Linings and Lessons Learned - My thanks to a subscriber for this highly educative additional report from the venerable Jeremy Grantham of GMO. I had meant to post it earlier, before family events previously mentioned took me away from the office for a while. No less valuable today, it is posted in the Subscriber's Area but here are two brief samples:

The Gold Lining

Topping off all of the offsetting virtues of this ugly last year is the arrival of cheap assets. All too easily we forget that you can compound wealth rapidly only by having cheap assets. For those with a long horizon, it is always better to have assets fall in price so that the compounding returns are higher. For an unparalleled 20 years, global equities, especially U.S. equities, have been overpriced. Now, finally, they are cheap and likely to get cheaper. Likely, I believe, to set up a once-in-a-lifetime investing opportunity (or maybe twice in a long career).

Finally, a Single Piece of Advice for the Government

I have never been a fan of the hysteria that has surfaced on all sides in recent years at a hint of recession, and the panic to throw public money at the economy. Mild recessions have several long-term advantages discussed in earlier Letters, but in recent years we seem to have lost interest in the long term.

However, this time it's different. This is the Real McCoy crisis, and we must welcome all the stimulus we can get. It is easy, though, to end up employing people to build mildly useful parks or, in the Japanese style, nearly useless bridges to nowhere. Government stimulus can have a decent (even high) return in the long run. It absolutely doesn't have to be a series of boondoggles. Let me suggest that the magic word this time is not "plastics" but "alternatives." Massive spending on energy and, better yet, energy savings will create jobs, stimulate the economy, produce a good long-term economic return, reduce dependence on depleting Middle Eastern oil, curtail carbon dioxide emissions, and set, for once, a real example for other countries. From the simplest - better insulation and more efficient machines - through the new alternatives - solar, wind power, and second generation biomass - to the potentially massive investments in new nuclear plants and efficient energy transmission, this could be in total a long range bonanza for the U.S. in economic and broader respects. Such a program could offset the risks of a Japanese-style drawn-out recession. It would be potentially an epoch-defining change, and one of which, like the Marshall Plan, future generations might be proud.

My view - I commend Jeremy Grantham's letter to all subscribers. The section you may not have seen yet commences on page 9.

Today, we still see evidence of further global deleveraging, which is alarming because all of us are affected in one way or another. At such times we need to remember that cheap assets are the essential ingredients for sustainable bull markets. Fullermoney's challenge and quest is to identify the better opportunities in a timely fashion.

Jeremy Grantham's point regarding alternative energy, ideally leading to a significant degree of self-sufficiency, could not be more important. Another silver lining for this crisis is the window of opportunity granted, in which to prevent a much bigger catastrophe in terms of energy prices and shortages. Success in this endeavour will require good governance, another resource that is too often in short supply.

This item continues in the Subscriber's Area.

Another China Bailout? 800 Billion Yuan Stabilization Fund Being Reviewed - This item from EEO may interest readers who invest in China. Here is the opening:

An anonymous policy recommendation calling for an RMB 600-800 billion fund to buy up mainland stocks in the event of a market crash has made its way onto the desk of top banking officials.

The report, which included three pages of discussion and a two-page list of target shares, was first sent using an anonymous internal email account to a mailing list at the Research Center of International Finance (RCIF), under the Chinese Academy of Social Sciences, on October 30. It was later submitted to top banking officials as policy advice, the EO learned.

It suggested the government use such a fund to unconditionally buy shares in 50 heavyweight firms listed on the Shenzhen and Shanghai exchanges if the Shanghai index hit 1,500 points.

The RCIF's director Yu Yongding confirmed the authenticity of the report. According to a researcher at the Center, the report was well received by the financial industry, and the Center had so far received much feedback. Banking officials had long considered establishing such a fund, he added.

My view - This would not be the first time a government has considered investing in its stock market. It makes financial sense if valuations are depressed, and the government can also take profits on an incremental basis during the next bull trend, to help prevent bubbles from forming. Additionally, the mere mention of possible intervention can stabilise the market as we have seen in China recently.



Additional Commentary by Eoin Treacy

Iron Ore Supply Demand Update: the Race for Cut Backs - Thanks to a subscriber for this interesting report by Alan Heap and Alex Tonks for Citigroup covering the iron-ore market. The full report is posted in the Subscriber's Area but here is a section on forecast prices for the coming year:

Iron Ore to Settle -20%
We maintain our current forecasts for a -20% fall in JFY2009 iron ore contracts. We believe trough cycle pricing outcome would be unlikely in this round of negotiations as:

The cost curve is steep with high cost Indian and Chinese production providing a buffer (price elastic production). This can already be seen with domestic Chinese iron ore production has lost market share this year and Indian exports have slowed. However further curtailments will be required.

~80% of new production growth is controlled by the majors. The majors are at the bottom of the cost curve and may use price weakness to drive out high cost players. Yet if price are excessive then a lack of incentive for expansions will see a dramatic change in mine supply outlook.

If Chinese steel production growth recovers more rapidly than we expected then the projected surpluses will not eventuate and prices could recover. A return to recent growth rates of around 20% would be sufficient to push the market back into deficit.

Contract prices are less volatile than spot and never achieved the highs of the spot market, and will be unlikely to reach the lows as has been the case in other markets where spot sales and contracts are use in parallel (e.g. thermal coal). We would expect some relief in the spot market as inventories are worked off and freight rates pick up. However the iron ore market will remain under pressure in the outer years and we have trough pricing achieved by 2012.

My view - The illiquid iron-ore market has been much slower to react to the slowing global economy than the share prices of the major producers. As long as a global recession is being considered, no one expects these companies to continue to be able to charge the high prices for iron-ore they have gained in the last few years.

Collapsing prices for many commodities have led investors to question the supercycle hypothesis with good reason. The demand destruction taking place will take time to rebuild and a synchronised global economic expansion is probably needed to improve sentiment towards this sector.

However, we also know that demand for bulk commodities will not disappear. The need for infrastructure development is as strong now as it was a year ago; cash to pay for it is now the problem. Countries with current account surpluses, such as China, have the money to fund their development projects. Increasingly, the solutions being mooted to combat growing unemployment are centring on big infrastructure projects in many countries. It has long been identified that the USA is badly in need of an infrastructure overhaul and the incumbent administration has made positive noises about taking on this challenge.

This section continues in the Subscriber's Area.

Astaire Research: The India Report - Thanks to Deepak Lalwani for his ever interesting report which this week leads with commentary on India's falling inflation. The full report is posted in the Subscriber's Area but here is a section:

YoY wholesale inflation fell sharply to 8.98% for the year to 1 November, after touching a peak of 12.91% in early August This is the lowest reading in five months, helped by strong agricultural output lowering food prices, the prices of metals and fuel falling and the slowing economy experiencing a drop in demand. The annual inflation rate was 3.35% during the corresponding period a year ago. The wholesale price index is more closely watched than the consumer price index, which is published monthly, because it covers more items and is published weekly. We expect the inflation rate to fall sharply from January because of the high base effect and we see the rate at around 5% by March 2009.

The downward trend in inflation is a great relief to policymakers at a time when consumer demand needs to be increased to stimulate economic growth, especially ahead of general elections. The falling inflation rate gives some room for the RBI to further reduce interest rates by 150-200bp by end January 2009, after cutting it aggressively by 150bp in October and November.

My view - Indian policy makers will indeed be happy to see that the rate of inflation is falling because it allows them greater leeway to act in support of the economy. Inflation is always going to be a worry for a country where a vast rural population has voting power. The government has to be seen to do something about rising prices as they directly impact the poor in society most quickly. This was part of the reason for India's aggressive raising of rates last year.

This section continues in the Subscriber's Area.

Email of the day (1) - on a lecture given in India titled Global Imbalance - An imminent Dollar Crisis:

"This lecture from India could be worth your time listening to."

My comment - Thank you for this interesting lecture (57mins) by M.R Venkatesh. It covers, among a range of topics, the imbalances evident in the global economy from an Indian perspective.

Email of the day (2) - on a New Zealand tracker:

"I was wondering whether there was an investment vehicle which gives exposure to New Zealand in general, rather than just individual shares in its 50 index?"

My comment - From searching on Bloomberg, it appears that New Zealand tracker funds are a rare entity. Most of the funds I found offer exposure to the currency rather than the equity market.

I added the Fisher New Zealand Growth Fund listed in New Zealand and in New Zealand Dollars to the Chart Library. It invests in small growth stocks but has performed more or less in line with the NZSE 50 over the last year. According to Bloomberg it has a front-end load of 1%, management fee of 0.85% and performance fee of 10%.

If subscribers know of any more suitable funds please let us know and we will be happy to add them to the Chart Library.

Congratulations to the All Blacks following their narrow victory over Munster last night. It was a thrilling spectacle and tight game right up until the end. Although it wasn't to be our night, I think any supporter watching the game will have gone away proud of their team.

Today's interesting charts - The Chart Library has a large number of fixed income prices and yields which may be of interest to subscribers.

US Treasuries - surging upwards to test the September highs near 124 and a downward dynamic is needed to check momentum beyond a brief pause.

This section continues in the Subscriber's Area.

Email of the day (3, 4, 5 & 6) - on additions to the Chart Library:

"Could you please add Jupiter Financial Opportunities Fund to the library? The manager Phillip Gibbs is first rate and has managed only 3% decline over the last year massively outperforming the sector. He has the majority of his money currently in bonds and is sitting on 27% cash. Once he feels the time is right a lot of this is going to equities and the fund will get a great lift."

And

"Would you please add the following emerging market corporate bonds to the library M&G Emerging Market bond, Threadneedle Emerging Market bond."

And

"Could you please add the Invesco Leveraged High Yield Investment Trust to the library?"

And

"Would you please add Unicorn UK Income A Fund to the library?"

My comment - Thank you all for these interesting suggestions which have now been added to the Chart Library.

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