While we are probably yet to enter a bear phase for equities, it is going to be very difficult to make money trading stocks By LIM SAY BOON
THE YEAR 2008 is shaping up as the Perfect Storm. And probably few investors and bankers/brokers alike are prepared for what lies ahead - a US recession, uncertainties in emerging market economies and extreme volatility in global stock markets.
Indeed, all manner of hitherto bullish and tightly correlated risk trades - equities, commodities, high yielding currencies, and hedge funds - are likely to be severely shaken in coming months. The easy money from going long in all manner of risk assets is gone.
Over the past year and a half in this column, we have gone from outright bullish in 2006 and early 2007 to cautious by the middle of last year and increasingly gloomy since then. And while we are probably yet to enter a bear phase for equities, it is going to be very difficult to make money trading stocks in 2008.
The nightmare scenario is that the markets break key supports in 1Q2008 - triggering 'capitulation' - before rebounding in 2H2008. But before the rebound, it will severely test the patience of traders and investors with low conviction alike - prompting many to cut losses and possibly whipsawing them with volatility through the year.
For the past six months, we have been warning of the need for more disciplined strategies to cope with more difficult market conditions ahead. Those 'difficult market conditions' are here.
Standard Chartered Global Research has called a US recession in all but the most technical of definitions. That is, we have cut our 2008 growth expectations for the US from 1.4 per cent to only 0.5 per cent.
Fear and panic
And while there is a still a chance that the US might narrowly avert two consecutive quarters of negative growth, this really won't matter - it will just be a matter of semantics. To the markets, this will look, feel and smell like a recession.
The fear and panic is spreading.
In coming weeks and months, market attention will revolve around the deepening crisis in the US housing market - indeed, the 'doomsayers-come-lately' will suddenly wake up to the rapidly weakening UK housing market and the affordability crisis in the Australian housing market.
And suddenly, the talk will turn to a 'global housing bubble/crisis'. Certainly, with an inventory overhang of more than 10 months, the US housing market will give headline writers an endless stream of bear market material for the rest of 2008 and possibly well into 2009.
With that, US sub-prime mortgage defaults, which are already running in the region of 18-19 per cent, will accelerate upwards.
Mortgage backed securities will take an even more awful hammering in coming months - with the possibility of more ugly news of financial institutions facing balance sheet crises.
Markets will panic on talk of the Federal Reserve being unable to contain a worsening credit crunch as banks de-leverage. Indeed, there will even be comparisons between the US today and Japan of more than a decade ago - talk of a liquidity trap within which the financial system and economy just refuses to respond to interest rate cuts.
And some will even point to inflationary pressures in the emerging markets and rising headline inflation in almost all markets as harbingers of impending stagflation - wedging central bankers between the conflicting pressures of recession (requiring rate cuts) and inflation (requiring rate hikes).
Emerging market economies will not be spared the gloom. Rising inflation and interest rates in developing economies - most prominently China - will overshadow interest in their robust economic growth rates.
Indeed, analysts are also likely to start questioning whether the China-led era of global disinflation is over. And whether China itself faces a prices crisis over rising labour costs, food shortages, and an environmental crunch.
While there are reasons for legitimate concern in almost all the above, at some point, they will totally eclipse consideration of equally legitimate countervailing bullish factors.
At that point, the markets will see capitulation - sellers overwhelming buyers. Irrational bearishness will take over, possibly setting the markets for a rebound on oversold conditions.
At this point, it is worth remembering that equities are still reasonably valued in price to earnings terms. Indeed, the PE averages for the US and European markets are both at the bottom end of their respective past 10-year ranges.
Even within emerging markets, notwithstanding the notorious PE ratios of the Shanghai Composite, there is still value to be had.
The MSCI China, for example, offers better value at a forward PE of around 20 times - high by current international standards but offset by robust expected earnings growth of some 22 per cent.
The emerging market PE average of around 15-16 times forward earnings is still mid-cycle rather than the sort of valuations suggestive of 'end game'.
And there is the yield gap in both the US and Europe in favour of equities earnings yields over long-term bond yields.
In a similar vein, while prime lending rates are rising and running around 8 per cent in China, it is worth remembering that China's listed industrials are looking at returns on equity averaging around 16 per cent.
Also bear in mind that liquidity injections and rate cuts - especially of the magnitude that we are likely to see this year - can have very powerful effects on asset prices. There will be lags between the rate cuts that we have already seen in the US and the ones yet to come and their impact on the economy and the financial markets.
As in 1998, when Fed funds rate cuts pumped liquidity into the growth theme of the time, there is still a reasonable expectation that the cuts we have seen and are likely to see this year (and we are expecting at least another 100 basis points to come off this year, with the possibility of more if the economy or financial market does not respond) will pump liquidity into the growth story of 2008 - emerging markets.
But until then, it will be a stomach-churning ride.
Given the very tight correlations between equities, commodities and high yielding currencies (see chart - we have used the Australian dollar/US dollar as a proxy for high yielding/commodity currencies), there will be few places for directional-long trades to hide.
Indeed, if you overlaid any of the major hedge fund indices, the result would have looked pretty much the same.
The hedge fund universe has been running a 0.8 to 0.85 correlation coefficient to equities in recent years. So they too will take a nasty knock when risk appetites drop.
This is the year for finance professionals to have difficult but honest conversations with clients. Rather than attempting to time the corrections and rebounds, they should have the professionalism to take clients through the winning logic of the long-term buy (quality) and hold strategy.
They may be mocked by smart-mouthed traders who think they can do better punting the tops and bottoms.
But my riposte is that for every short-term winning trade in the market there is by definition a losing trade.
Add to that transaction costs and trading is by definition, system-wide, a net negative game.
This is the year for difficult conversations about complex issues such as diversification and the 'efficient frontier' - about how diversified portfolios, over time, generate better returns at lower volatility for higher risk-adjusted returns.
Satellite positions
But outside those core holdings - that clients should recognise as the 'stuff' of long-term wealth building - they can also have satellite positions. And for satellite positions, in such turbulent times, investors might want to consider alternatives to the directional bet on the whole equities or even commodities market.
That is, even when faced with corrections in global markets, investors could look at structured products as tailored solutions.
If, for example, they are taking profits off their emerging market positions in the face of a possible global market correction but still believe in emerging market outperformance, they could put the profits they take off the outright long positions into a relative outperformance note against one or several of the developed markets. They could also do relative outperformance structures between countries and sectors - say, Singapore banks versus S&P500 banks.
Investors could also buy portfolio protection through participation in the upside of equities volatility through a structured note - buying, say, the S&P500 volatility index VIX as a hedge against sharp drops in risk appetites and spikes in volatility.
And while commodity prices could broadly soften against a slowing global economy, investors could still look at specific sectors.
An example is food commodities such as wheat, corn and soyabeans as a play on rising food inflation and the catch-up of real food prices which are still around a 50-year low.
The opportunities are only limited by the willingness of professionals and investors alike to consider alternatives.
Lim Say Boon is chief investment strategist for Standard Chartered Bank, Group Wealth Management
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