Lessons of Financial Crisis Forgotten in Heady Speculation

Includes: DIA, QQQ, SPY
by: Jeflin's Investments

Financial crisis or the Great Recession, if you still remember them, seem so far away. We are now in the best six-month stock market rally since 1933. The bulls have been running riot in the stock market, seemingly unassailable and making money effortlessly, while the bears are licking their wounds.

Green shoots have “blossomed” but it is during such exuberant times that we have to be cautious. Of late, I noticed that the debate has intensified on whether the stock market has topped or will continue to break-out. In the last week of August, there are days when the stock market came under furious selling pressure at the open, only to end in positive region by aggressive buying towards the end of trading sessions.

Clearly, there are manipulative forces at play, aided by a media which put a positive spin on any economic news. As they say, "less bad is the new good". But the rally will not work without greater fools hopping on the bandwagon. What eager retail investors see is the stock market advancing each day, thus they are happy to stay vested and let their profits ride.

If the Federal Reserve hikes interest rates and stops creating money from thin air tomorrow, the party will be over. Since that is not likely to happen and the US stock market is buoyed by so much liquidity, I wouldn’t be surprised if there is more upside to this rally.

However, given that September is historically the worst month of the year and with some big boys getting uneasy, selling pressure could escalate in the coming weeks as they unload their huge inventories of stocks.

Already, interest in U.S. stocks is waning. Last week, trading was dominated by a few counters, namely the notorious gang of nationalized financial institutions (Fannie Mae (FNM) , Citigroup (NYSE:C), AIG (NYSE:AIG), and Freddie Mac (FRE)). If the top traded stocks are discounted, market volume is pretty thin which doesn’t make a convincing case for the stock market rally to continue.

In Singapore, penny stocks came into focus while blue chips fail to break out from the highs set in late July and are mostly undergoing consolidation. While some penny stocks warrant a long-overdue value discovery due to their low P/E ratios, I am surprised that investors are jumping headlong into stocks which are struggling with dismal operating cash flows and refinancing woes.

Of greater concern is the Shanghai Composite Index. It was quick to awaken from its slumber back when the world were still skeptical of the first sightings of green shoots. However, the behavior of the index has been anything but robust in August, tumbling 22% after registering seven consecutive monthly gains. On Monday, the index plummeted 6.7% to a three-month closing low and its second-biggest monthly loss in 15 years.

China policymakers have warned that unprecedented lending aimed at fighting off the economic downturn could be withdrawn and have signaled its worry about overcapacity in the steel and cement industry. According to the latest Reuters poll, Chinese fund managers have reduced their allocation to equities for the first time in six months.

This is a clear sign that investor sentiment is weakened by concerns over shrinking liquidity. Demand for stocks also declined as investors grew jittery over sky-high valuations which stood at odds to corporate earnings and dividend yield. The further stocks rises, the more unbalanced the Chinese stock market as it pulls away from fundamentals. In addition, a boom in initial public offerings has also mopped up much liquidity in the system.

Residential Properties Overheating Again

Many people are still struggling with defaults and foreclosures but there are no shortage of new investors willing to take a bite of this fruit and see for themselves if the pain of foreclosures is real. The moribund property sector is back in business. In fact, it is in rip-roaring form.

In some locations, China property values already rival Hongkong, Singapore and US in terms of cost per square meter but the per capita income of China workers is about US$6000, lowest among its counterparts. If speculation is not curbed, affordability and valuation may be skewed dangerously.

Though the Chinese governmnet is intent on achieving 8% economic growth to maintain internal stability and investors’ confidence, a housing bust will derail their plans and possibly spark mass civil unrest. I believe they are right in restricting loans from being funneled into the property and share markets but trying to stay on top of the bubbly situation is tricky, without damaging any nascent recovery.

In Singapore, crowds are thronging sales rooms, queuing up overnight, handing over blank cheques, all in the hope of snapping up residential properties (see here and here). The price for some of these condominiums, in suburban locations and on 99 year leasehold, is not cheap, to say the least. Yet, the projects were launched to great fanfare and selling like hotcakes.

Wasn’t it only in February that developers were worried about mass defaults and banks making huge provisions for non-performing loans? I doubt if such interest is sustainable. Currently, rental yields are not impressive and unlikely to improve with more supply entering the market. Unemployment figures, though not getting worse, are not pretty either.

At this frenzied rate, I believe there could be another bust in the housing sector by 2011 or 2012 and this could be the real bottom when people swear off investment in housing for a long time. For developers and the construction industry, this is bad news but something which has to be expected as part of a business cycle.

Banks who hold mortgages will also be in trouble if the economy nosedives again and jobless rate spikes. The problem with banks is that when times are good, they are extremely flexible and generous with their loans, so long as they can get a bigger piece of the action. Customers, for better or worse, are spoilt for choice, thanks to their financial engineering.

I have nothing against financial engineering. Given that individual consumers have different financial goals and background, tailoring loan packages according to their needs is supposed to be a boon. However, the US housing crisis has taught us that financial engineering is not as helpful as it seems. Unless you know what you are getting into, plain vanilla fixed mortgages is still the best option.

At the height of the housing boom, a lot of subprime debtors were sweet-talked into taking on loans with adjustable rate mortgages so that they can buy bigger houses which are beyond their affordability level. Some even went for negative amortization (ie, they pay less than interest only on housing-backed debt) and the result is that every month, their amount of debt increases despite making payments. Not surprisingly, foreclosures have exploded in states like California and Florida where such loans are concentrated.

Economic Recovery Without US Consumers?

We have been drilled often by media reports that the worst is now behind us. There are broad signs of stabilization and emerging growth but is it time to pop the champagne? Can we expect the same heady, export-led growth, prior to the 2006 subprime crisis?

You know, those groovy days where American consumers spend beyond their means? During those reckless decades, American consumers expend whatever avenues of credit available to them - refinancing their homes, maxing out credit cards, taking loans for vehicles, second homes, and education.

The US government and export oriented markets will like to see American consumers get back to their old spending habits but the deleveraging process is far from over. Banks are still expecting over-extended Americans to pay down existing debts first before lending more money. You can’t blame the banks, when they are in trouble, they become cautious and avoid lending money, regardless of your credit history.

Unless wages increase or the government takes on more debts to issue stimulus packages, there are not much discretionary cash for consumers. The US government is making some headway in stoking the spending psyche of Americans through programs like Cash for Clunkers and cash for refrigerators but it is unclear how much of a multiplier effect they have on the economy.

I doubt Americans are in a hurry to take on more credit for spending purposes. Frugality is the new order. Savings have risen and and consumer spending patterns are changing. This could have adverse impact on the US economy which is 70% driven by consumer spending.

Worsening Credit Of US Government

84 US banks have already failed in 2009. If the 1980s savings and loans crisis is any indication, this is only the tip of the iceberg. There is also a strong suspicion that the Federal Reserve is still propping up some of the too-big-to-fail US banks, without which a catastrophe could wreck the financial markets again. The Fed is fighting tooth and nail against full disclosure of its dealings but it is clear that financial institutions are not out of the woods.

In order to rescue the financial markets, the US government has put its credit on the line by bailing out shaky institutions and offering guarantees on deposits and loans. Obama has also revealed that America is likely to increase its debts by $9 trillion in the next ten years. Add this figure to the existing $12 trillion of federal debts, that is more than $20 trillion.

Assuming an interest rate of 5%, that is about $1 trillion which has to be allocated in the budget to pay creditors yearly. Where is Uncle Sam going to get the bulk of this money except to turn to its printing press? And we are not even thinking about other liabilities in its social security and health care.

Is there a point where the party stops and nothing works anymore? Very likely yes. The Federal Reserve cannot cause the market to rise indefinitely by printing money at will. Its status as the global reserve currency is at stake after abusing it for so long.

It is a matter of time before we experience another major recession because the key lessons from this financial crisis were forgotten easily and people are back to their greedy speculative ways. But the next time round, the Federal Reserve may find its hands tied, with very few options available.

The financial market may not respond as positively to a deeply insolvent America issuing another $700 billion TARP fund or its wafer-thin guarantee of deposits for the next crisis. If the situation spirals out of control, there could be bank runs, bank holidays or even total economic shutdown till everything is sorted out, which means that a lot of what we own is at risk of becoming irrelevant in a new world order.

As a lot of economic activities and assets are denominated in US dollars, the problem arising from this battered reserve currency is not confined to America alone. Clearly, there are some tough monetary issues which have to resolved during calmer moments.

I believe the stock market is likely to dip again before embarking on another bull run but don’t try timing the market as it is a matter of luck and has little to do with superior foresight. Instead of being obsessed with selling at the peak and buying right at the trough, we should adjust our portfolio allocation at this point of time and not be overly exposed to stocks.

Whether the stock market or property market advances further or dramatically declines, having a healthy cash hoard gives us the flexibility to buy on the dips and not rush into panic decisions.