“From a value investing perspective, the sharp falls are opportunities to invest at very attractive prices. The major banks offer excellent examples. Interim results show continued strength, yet at a point on Tuesday, CBA was trading at $43.50, offering investors a grossed up dividend yield of 9.9%. We believe that we will get more opportunities in coming months…”

Maybe we should wait for the release of “The Big Short 2″ on internet book portals in 2013 to explain the recent collapse of equity markets around the world. However, by then we may have missed out on some wonderful investment opportunities which are being presented in the current mayhem. So let’s have a look at what is actually happening in the world today and see if there are any connections that we can piece together.

At the outset let’s pose a confronting question – Is there any connection between the outbreak of coordinated attacks by youths in the United Kingdom and the coordinated attacks on equity markets around the world? We would suggest that there is, in a perverse and disturbing sense.

Over in the equity markets of the world there appears to have been a similar coordinated attack. The equity market itself has very weak defences because it is characterised by excessive leverage and its flows are dominated by withdrawable funds and not by permanent or committed long term capital. Even more disturbing is the proliferation of derivatives, exotic Exchange Traded Funds (ETFs) and shadow trading activities. These trading products are promoted by investment banks and supported by stock exchanges. Indeed it is likely that in coming weeks the ASX will reveal that it has achieved stunning growth in revenue from clearing derivative trades as opposed to tepid growth in fees from stock trades.

An attack on the equity market is in a sense self-fulfilling. With the recent GFC so fresh in people’s memories, there is a real temptation for many people to head for the exits at the first sign of trouble. The psychology of the market is now so fragile that shorting attacks have every chance of being successful; and the more investor scepticism rises, the more successful the strategy will be.

It has been our view in recent months that world growth was stalling (again) and that equity market upside was limited. Active funds invariably have some commercial relationships with the large investment banks of the world. Indeed it is a universal fact that investment banks themselves have massive proprietary trading desks that are constantly active across markets. While they are proffering their public views on market directions, simultaneously they employ covert and biased views of value in the hunt for trading profits.

While there was a rational liquidity argument for speculative rallies from the quantitative easing campaigns of central banks, it soon became apparent that there was little possibility of a sustainable market recovery in the short term. Investment banks and their associated broking houses have continued to recommend stock purchases to their clients right up until recent weeks. They continued to do this despite a rapidly deteriorating outlook in Europe and slowing growth in the US. In Australia, the investment bank economists unanimously forecast interest rate increases in early June given the strength of the Australian economy! None of them (apparently) looked outside of Australia to the growing mess of international economies. Only one commercial bank economist (Bill Evans from Westpac) questioned the logic of the majority of economists. The question is – Why did so many economists get it so wrong?

Having exhausted the rhetoric to their clients of the potentially strong equity price performance due to world growth, the investment banks came to the realisation that their serious clients (the institutions) were becoming increasingly sceptical. What a beautiful trading position to be in when your clients are telling you that your forecasts are rubbish. Even better when your investment bank peers are hearing the same stuff; proprietary trading desks sniffing blood probably started devising their short trading strategies.

Having numbed the general market with “pie in the sky” price and stock indices targets, the settings were perfect for a massive attack on sentiment. Thus, we suspect that the large trading books of the investment banks and their related parties went to the short side. Indeed it now seems obvious that the Australian market was a prime candidate for an equity and currency attack. The reason for this is because our market is dominated by major resource companies and banks. The Australian institutions are “full to the gills” with these stocks and are not natural buyers other than meeting index flows. Thus, price falls are unlikely to be countered by equivalent buying and less so when the bank bill futures are forecasting interest rate increases.

To understand why the Australian market can easily be destabilised and cause massive gyrations of stock prices, remember that:

1. We continue to offer investment leverage through margin loans;
2. We have shadow trading products such as CFDs and options;
3. We have withdraw-able equity trust funds where managers are meeting redemptions when they should be buying;
4. We have index funds that lend stock to hedge funds for shorting;
5. We have a stock exchange that supports volatility as a business case;
6. We have broking houses that are hopelessly conflicted with their owners; and
7. We have debased the formation of permanent capital in this country with the destruction of mutual institutions.

The recent gyrations in world equity markets are disturbing. The volatility and the intraday moves demand an international enquiry. However, there will be none and the true facts will only become apparent after private investigation. The sharp rally last night in the US equity market of 5% in just 90 minutes was a rerun of Australian and German markets. It was clearly a short covering rally much like those UK thugs running from the scene of the crime.

But there is some good news. From a value-based investment perspective, the sharp falls are opportunities to invest at attractive prices. In recent days we have bought stocks slowly at excellent entry prices. The major banks offer some outstanding examples. Interim results and trading updates from both the Commonwealth Bank and NAB released this week show continued balance sheet strength, improving net interest margins, and declining bad debts. In the words of retiring CBA CEO Ralph Norris, “a good, solid result in what has been a difficult year”.

Yet at a point on Tuesday 9 August, the CBA was trading at under $43.50, thus offering investors a grossed up dividend yield of 9.9%. On our assessment, CBA also offers a sustainable return on equity in the mid 20% range, and a required return at 12%. We regard that as a wonderful combination and were actively buying CBA at prices around $44 for client portfolios. We believe that we will get more opportunities in coming months because the wolves of the world are active and unregulated.

Who was throwing away their Commonwealth Bank shares at $44? Like the alienated young thugs torching parts of London, distressed and fearful retirees and baby-boomers contemplating a dismal retirement and mistrustful of their politicians probably decided they couldn’t face any more pain and capitulated. They have lost confidence in the rational functioning of the capital markets and in the traditional sources of advice: who wouldn’t when we see bond markets and share markets behaving in seemingly random and irrational fashion, and when large institutions like the investment banks appear to manipulate markets for their own short term trading profits?

Finally, a quick comment on interest rates. The decision by Westpac and CBA to lower fixed rate home loans, the influx of retail deposits into banks and the sharp declines in rates in the US, suggest to us that deposit interest rates will fall. Those investors who were spooked out of equities in the last few days will see their deposit rates fall sharply in coming months. The only thing stopping rates from falling now is the tightness in European markets. We suspect that by Christmas the Australian deposit rates will be between half and one percent lower then current rates. Then Australian bank shares will become even more attractive from a yield perspective.

With so much excitement in markets at present and so many unanswered questions we cannot wait for ”The Big Short 2” to become available on Kindle!

Some interesting charts
The following explains why Standard and Poor’s downgraded the US last week from AAA to AA+. The US has gross public debt equivalent to 100% of GDP and proposes to lift this level to about 115% in the next year. This is because the debt limit has been lifted by $2T whilst over the same period the economy is likely to grow only by $200B. Hence the debt to GDP ratio gets worse.

At that point the US joins Japan, Ireland, Italy, Greece and Iceland as countries that have extraordinary high government debt.

In the meantime the bond markets of the US are oblivious to credit risk but focused on slowing growth. The yields on ten year bonds touched 2.14% last night and have staged a dramatic rally since the end of QE2 on 30 June. One wonders if the Federal Reserve is unloading its $600B of bond purchases into a spooked market. We suspect that it is and is sanitising purchases which will allow it to re-enter markets in coming months. Indeed it may enter equity markets at some point if stability is required.

 

The following table show who owns the US debt. Other countries are dominated by OPEC nations and China is now the single largest foreign owner. In recent weeks China has been a more vocal critic of the US Administration debt policy and it would be extraordinary if China is a continuing buyer of US debt. In coming months it will be interesting to monitor the purchases of US bonds and we suspect that the US public, through US banks, has been the major buyer. The funds are the repatriated flows back to the US from foreign markets (like Australia) and is indicated by the rise in the $US.

The following is the debt maturity profile of the European economies. The next two years see over 1 trillion Euros of maturities and we suspect another 1 trillion Euros of new debt. The emergence of the ECB with a quantitative easing programme to buy Spanish and Italian bonds was essential. In essence the ECB will buy bonds held by European banks and eventually reissue a form of ECB bond at a lower yield and higher rating.

The chart does show the massive bond raising task and suggests continuing strain in the European debt market. Australian banks continue to rely on this market for offshore wholesale funding but the credit rating of our banks are superior to some European countries and there is the omnipresent support from the AAA rated Australian Government.

We note the exposure of large German banks to Greek government debt. The proposed private owner loss on the Greek debt restructure does expose some German banks to capital ratio problems. Generally, the largest exposures to Greek sovereign debt reside in those banks with the lowest capital ratio. This suggests that there are large capital raisings likely in Europe in coming months and this will keep a lid on the affected equity markets.

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