Tuesday, 28 October 2008

On request: What do I think about the markets?

Some readers have mailed me asking for my no holds barred statement regarding the direction of the markets, probably because they hope it will help them in taking positions. Here it is, but I emphatically reserve the right to change my mind as things develop. And if you do take positions on the basis of this post, it is entirely at your own risk.

Interest rates: Worldwide interest rates are heading downwards and will end up in negative territory globally, when corrected for inflation. ECB will likely be a tad slower than Fed. Some countries have gotten themselves in trouble with their currencies and will need to keep interest rates high, or choose the obvious solution of abandoning whatever pegging arrangements they have. Speculators are already picking out some of the weaker links and they will have to defend themselves with determination.

Bond yields: Government bond yields will fall as the global recession scenario unfolds. Any remaining inflation fears will quickly evaporate. Corporate bonds are more of a problem. The recent widening of lower-grade spreads over sovereign issues indicate a much steeper downturn and much higher default rates than the stock market appears to believe in. At least for the coming 24 hours. All things mortgage related will be in deep trouble and no prisoners will be taken.

Currencies: Unwinding short yen positions may still have some legs. Strengthening of dollar will eventually peter out, as the design of the US banking rescue package is as designed to weaken the currency with a dramatic easing of monetary policy. Add that there are still no signs of an improvement in one of the fundamental imbalances in the US, the current account deficit. Unfortunately some individual currencies may still be picked out for speculation. So if you are long a small currency where the central bank has been running some kind of shadow peg against one or two major currencies but still have no real swap arrangements with a big central bank, head for the exit.

Stocks: All bets are off and it is not really the time to be discerning. If you believe (as I do) that there is still a lot of off-loading to be done by hedge funds, sell into rallies, and those rallies can be strong, 15-20 per cent. If you believe that the recession scenario is now priced in, go buying. It is time to bring out your copy of Graham and Dodd’s Security Analysis. If you do not have time or patience to read that, try and find stocks trading at a market value lower than their net current assets. Dividend yield and other indicators are off, for who knows where dividends will be a year from now.

Oil: I am getting hesitant on this one after the huge fall. I do believe, however, that there is one more downside attempt left, and the geopolitical implications of an oil price lower than $50 per barrel are visible with the naked eye. It must be very difficult to sit in the US Treasury, with a newly minted shareholding in the world’s largest commodity traders, and NOT calling them to tell that a further fall would be, ahem, highly convenient. Of course not a good idea if you are still long in companies producing alternative energy technologies.

Commodities: It is the ultimate recession play and I believe that there is still a considerable downside across the board. Gold will suffer as inflation expectations wither away, base metals will suffer with the unfolding recession scenario. Reason is still not available in these markets. They overshot on the way up, and it could well be that they overshoot on the way down as well.

Emerging markets assets: have been pummelled as it became clear that the much-vaunted status of being self-contained has not yet been achieved. Next shoe to drop: these markets do not have any significant built-in automatic stabilisers as demand slows, due to the recession in the export markets. It can turn uglier, still.

Hedge funds of the long-short or equity derivative variety: I would like to believe that the worst is over. In my post yesterday I gave the arguments that there is a certain probability that it will instead get much worse. The combination of margin calls, bank deleveraging, and investors wanting to leave look deadly to me. And Paulson has made it clear that the cavalry will not be charging to help bailing hedge funds out.

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