Sunday, March 24, 2013

First Iceland then Greece now Cyprus and who is next in Asia?

Ever wonder why the shit is starting to hit the fan (SHTF) in Europe now? This kicking the can down the road thingy will have to come to an end one day. The whole financial system is on the verge of collapsing right now as every available effort utilized to pump up the system seems to be going nowhere. Ever since the financial crisis erupted in 2008, the system has been kept afloat by pouring more money into it. Unfortunately the unlimited injection of funds by means of Quantitative Easing has not been very effective as of late mainly because most of it went to unproductive sectors such as the real estate and stock market. Thus what we are ended up is inflated property and stock prices which resulted in a Great Disconnect between the asset prices and the real economy.

The Great Disconnect

What do we mean by the Great Disconnect? It means asset prices and the real economy is moving in different directions. In normal conditions the movement of the stock market follows the economy, meaning if the economy improves then the stock market will follow. However such a relationship does not seem to exist anymore. It seems that the age old investing axiom of good-is-good and bad-is-bad does not hold anymore. What does it mean? A classic case for the good-is-bad is the following. In the olden days when a company announces better than expected earnings its share price will normally go up but nowadays it reacted on the opposite and its stock price plunges. This has baffled many investors for many years.

Similarly when a dodgy company from a low-growth industry announces cost cutting measures such as laying off workers, cutting overtime, no pay rise and bonus, its share price jumped because the public viewed that its projected future earnings will somehow be improved due to the measures taken currently. This is a classic case of bad-is-good because cost cutting measures will only help to improve the bottom line of the company in the short term and will not be sustainable in the long run because there are only so much costs and wages to cut. To achieved a sustainable earnings improvement the company should seek out measures to improve the efficiency of the company and thus to bring in a sustainable sales improvement in the future.   

In fact there is currently a Great Disconnect between the financial markets and the Global economy. They no longer follow the axiom of good-is-good and bad-is-bad. The situation has already reached the point where the badder-the-news then the-better-the-market. Heck, currently the situation in Cyprus can be considered critical with threatening bank runs and the closure of its two main banks namely Bank of Cyprus and Cyprus Popular Bank. Thanks for the manipulation by the authorities; stock markets around the world are making record highs instead of plunging. They had no choice because the financial market is their last line of defence against the collapse of the entire global financial system and economy.

But many policy makers failed to realized that it is this very act of saving their financial markets by artificially propping them up is what kills them. Failed and uncompetitive companies and too big to fail banks are bailed out with tax payers money.  As a result of such moves the global financial market has turned into a giant casino. Currently the Global GDP is worth about $70 trillion with the total derivatives bet around the world estimated to be between $800 and $1500 trillion. This means the total bets on derivatives had reached a leverage of more than 10x the world GDP. If this house of cards were to come down anytime in the future, how are we going to survive?

We believe that Central Banks around the world has lost this battle when Iceland went down in 2008. One of the main causes of the collapse of Iceland is due to the rapid growth of its balance sheet and assets of the three main banks namely Glitnir, Kaupthing and Landsbanki. The following table is the total assets (in ISK) of the three banks from 2003 to 2008.

Chart 1  (Combined Assets of 3 main banks of Iceland)

New Bank Assets (Deposits) to GDP ratio

As can be seen from the above the total assets of the three biggest banks in Iceland gone up tremendously since 2005 and by 2008 it had grown by more than 250%. At that time the GDP of Iceland was only worth ISK14 billion. So how exposed are the Icelandic banks since more deposits means more lending? A new financial metric to stress test banks introduced by Bloomberg is the Bank Assets to GDP ratio. Hence Iceland’s Bank Assets/GDP ratio is more than 10x (144/14) which is one of the highest at that time. With such a high leverage it did not take long for the financial crisis in 2008 to wipe out the Icelandic banking system.

Coming back to present – Cyprus

Cyprus has long been an offshore haven for foreign investors especially the Russians. Due to the massive inflow of funds, Cyprus banks started to invest in Greek Government Bonds to the tune of €4.7 billion. So when Greece went through the restructuring and austerity measures last year so does the fortunes of the Cyprus Banks.  As a result The Bank of Cyprus and Popular bank of Cyprus has lost an estimated of €3.5 billion which is about 20% of Cyprus’s GDP. Cyprus is another country that depended much on its banking sector. Its banking sector is much larger than its economy. It is estimated that the total assets of Cyprus Banks is 8 times the GDP or Banks Assets/GDP ratio is more than 8x. The following is the Chart on Bank Assets/GDP for selected European countries.

Chart 2  (European Bank Assets/GDP)

Source : World Bank

How about the rest of Europe?

Again as you can see other than Cyprus countries such as Ireland (550%), Luxembourg (2100%), Switzerland (680%) and U.K (600%) are definitely at risk being the next victim.  Three banks in Luxembourg had already seeked financial assistance to the tune of €1 billion last week. We present to you the two European countries with the highest Bank Assets/GDP ratio. Presenting our number one candidate is Luxembourg. The following table exhibits the top 10 banks by total assets in Luxembourg.

Deutsche Bank Luxemb.
Societe Generale
BNP Paribas
BIL Luxembourg
Luxembourg Bank
Total $ (billions)

Chart 3 (Luxembourg banks by Assets)

Source : World Bank

The following is the composition of the banks with the largest assets that make up the Swiss banking sector. The following table shows the assets held by the top 10 banks in Switzerland. UBS’s assets are already more than twice the GDP of Switzerland (€593 billion) and when all of its banking assets are added up together it will certainly qualify Switzerland as a mega-bank country.

Credit Swiss
Zurich Insurance
Schweiz Natb
Swiss RE
Swiss Life
Ace Ltd
Juluis Baer Group
Total $ (billions)

Source : Bloomberg

Chart 4  (Swiss Bank by Assets)

Do you notice the similarities between them? The assets of top 4 banks in each country accounted for almost 5x their GDP. As for Luxembourg the total assets of the top 4 banks are $268.6 while its GDP is $55 billion (2011 figures) which gives a Bank Assets/GDP ratio of 4.88x. While Switzerland’s top 4 banks assets totalled €2942 billion while its GDP is €593 which give a Bank Assets/GDP of 4.96x. Hence if any of the top 4 banks were to be in trouble then it will greatly affects their banking system.

How about Asia?

Based on the Bank Assets/GDP ratio as an indicator of the health of a country’s banking system, Singapore and Hong Kong will certainly qualify as the most likely candidates to suffer when the next financial crisis hits. Singapore which is dubbed as ‘The Switzerland of Asia’ has been lucky being on the receiving end of the mass exodus of funds from Switzerland in the past few years. Due to the crackdown by the authorities and also the pressure from Western governments to open up the secrecy of the Swiss Banking industry, many well to do investors who feared clampdown from the authorities, transferred their funds to Singapore.

As a result total assets of its banks have grown rapidly over the past few years. The following is the breakdown of the top ten banks in Singapore based on their assets. Again at top of the heap is Malacca Trust whose assets are more than 3 times the GDP of Singapore ($305 billion). Their total assets are more than 7x the GDP of Singapore.

Another country that is worth mentioning here is Hong Kong whose Bank Asset/GDP ratio has risen to 6.2x recently. However we are confident that Hong Kong will be able to weather any financial storm as it has the backing of China.  

Malacca Trust
DBS Group
UOB Bank
Great Eastern Hldgs
Yanlord Land Group
Saizen REIT
Capital Land LTD
Global Logistics
Total $ (billions)

Source : Bloomberg

Chart 5  (Singapore Banks by Assets)


What we found from our analysis is that in all the cases there seems to be a pattern of ‘too few controlling too much’.  By this we mean that the control of a country’s finances fell to only a few players which we reckon is very risky. In an event of a financial crisis the survivability of a country will be at stake.

However we believed that most Asian countries are able to weather the coming financial crisis much better than their European counterparts because their fundamentals are still strong. Most of them are running budget surpluses and also the interest rates in the region are still way above zero. Thus it will give them some extra ammunition in their monetary policy arsenal to fight any economic downturn before resorting to other means. Singapore and Hong Kong which recorded a Bank Asset/GDP of 7.7x and 6.2x will certainly be of interest if the financial crisis in Europe were to spread to Asia. How well they are able to overcome the crisis and whether the authorities will resort to raiding the bank account of depositors ala Cyprus is left to be seen.

Sunday, March 17, 2013

Why Commodities lead and Stock Markets follow - Case study : Copper and KLSE

As an astute investor we should know that we are now living in a more globalized and inter-connected world than the one that was 10 years ago. A drought in the U.S will result in higher prices of Soybean and Corn in the global market. The crash of the Dow Jones overnight will have devastating effects throughout the world markets the next morning. Similarly rising commodity prices will be bad for stock prices.

Why rising commodity prices bad for stocks?

Commodities such as Copper and oil are essential raw materials to many industries. They are the main ingredients in many of the products we buy. Whenever commodity prices go up there are two profound effects on the economy that will eventually affects the stock prices.

  1. Reduced earnings for companies. Due to the competitive business environment companies will find it very difficult to pass on their increased cost to consumers at their whims and fancy without losing sales. As a result companies that are unable to pass on their costs will have to resort to cost cutting measures in order to maintain their customer. This will result in lower margin and hence lower profits. Lower profits will translate to lower stock prices.

  1. If the higher costs are passed on to consumers then it will result in consumers paying more for these products and hence will have less money or disposable income to spend on other products. Since the economy depends a lot on consumer spending and a reduction in the consumer spending means there will be low or no growth (stagnant) in the economy. A slower economy will translate to lower sales for the companies and hence earnings. Since earnings is the main driver of stock prices, a reduction means softer stock prices.

So when the economy improves the demand for commodities such as copper and oil will naturally be on the upswing. In the law of supply and demand when demand exceeds supply in any given commodity the price will have go up. This will have the tendency to create an inflationary pressure and  thus will be reflected in higher prices of good and services. In other words it will create a higher inflationary effect on the economy. The authorities will not just sit tight and let inflation to create havoc in the economy. Sooner or later it will have to fight inflation by raising interest rates so as to cool down demand which will eventually help to bring down the prices of goods and services. As you know the effects of higher interest means lower stock prices due to the competition from alternative investments like term deposits and bonds.

Relationship between Commodity and Stock Prices?

The following are two charts that represents the price of Copper and the Kuala Lumpur Composite Index as from February 2010 till March 2013. As you can see from below there is a direct correlationship between them. Both chart was at the low during the June-July 2010 period. Thus when price of Copper is at the low so does the FBMKLCI. Again during the September 2011 and October 2011 both readings are at their lows.  Similar occurrences happened in May and November 2012 and also recently during the month of February 2013. The question is ‘whether these are pure coincidences’?  We doubt it.

This is only one small example that we have shown you and if you dwell deeper into different markets you will be amazed by their relationships. So the lesson that we can learn from here is that different markets are certainly inter-connected and it pays to study inter-market trends so as to improve our odds of success in trading the markets.

Tuesday, March 12, 2013

How to Profit from an Inverted Yield Curve?

In normal market conditions a yield curve will slope upwards from left to right as shown by Chart 1 below. This is because the short term interest rate is higher than the long term interest rate. The reason for the upward slope is that investors will always seek a higher return on their capital in the long term because they are exposed to higher risk of default and counter party risk. Also their funds are tied to the investment and hence denied it of any opportunity that arises along the way. This is why short term ( 2 years or less) interest bearing investment tools such as bond pays a lower interest rates than longer term bonds.

Chart 1

However during certain times the yield curve can be inverted. The reason for the yield curve being inverted is because the short term interest rate is higher than the long term interest rate. As shown in Chart 2 below the interest rate for a 6 month might be trading at 18% while the 3 year bond fetches 16%. Why is this so? One of the main reasons is that the Central Bank believed that the economy may be over heating and hence by raising the short term interest rate it hoped to slow down the economy. Or in other words it hope to cool down the economy so that it will have a ‘soft landing’ in future.

Chart 2

What effects will an increase in the short term interest rate on the economy and stock market? One thing for sure is that it will make the short term borrowing more expensive and hence will deter people from borrowing funds. The following are the effects on both the corporations and individuals.

  1. Corporations will find it too costly to borrow funds to finance any new projects such as building new plants or expansion of existing plants and hence will delay or even shelve them for the moment. On top of this corporations will also need to allocate more funds to pay for the higher cost for their existing loans. Hence this will have the effect of lowering their profits and hence will later translate to lower stock prices.

  1. As for the individuals, they too find it difficult to contemplate on the higher cost of funds. They too will delay their purchases on big ticket items such as cars and houses. This is because they find that purchasing such items with credit may be too expensive and hence either be curtailed or shelved completely. When consumers cut back on their purchases it will also affect the bottom line of corporations that produces them. When corporations failed to meet earnings estimates then naturally their share price will get hammered.

So when the Central Bank announces an increase in the interest rate then it signals that it is going for a Contractionary Monetary Policy. We as investors should take heed on such moves because in future there will be a slowdown in economic activity and will not be good for the performance of corporations. Continuous tightening by the Central Bank will have the effect of pushing the economy towards recession and hence might cause a bear market in stocks. One of the first logical things to do is to lighten up on your portfolio.

In summary, when the yield curve move towards inversion then we should gradually lighten up our portfolio and hold on to more cash because at the later stage ‘cash will be king’. Moreover when interest rates are high other forms of investment such as term deposits and bonds will be more attractive and hence more funds will be flowing out of the stock market. The end result will be a softer stock market. So what we should do is to move our cash into term deposits or the money market while the market is still soft. When the authorities felt that the economy needs a boost it will need to reduce the short term interest and hence the yield curve will revert back to normal. When interest rates are low, stocks (especially interest rate sensitive stocks such as utilities, banks, telecommunication and construction) will rebound. So we reckoned that when the yield curve is inverted, it will only be a temporary effect because it will have to revert back to normal sooner or later and hence offers an opportunity to buy interest rate sensitive stocks at a discount.

However in order to capitalize on such a move you are require to stick to the 'buy and hold' strategy preferably for at least 1 year. This is because Central Bank interest reductions will have a 'lagged effect' of at least 3-6 months for it to work its way into the economy.

Tuesday, March 5, 2013

Understanding Market Cycles to improve your Stock Market Trading

A cycle is a chain of events that repeats over time. The outcome might not be the same each time but the characteristics are quite similar. Take for example the four season weather. Each year we have spring, summer, autumn and winter. After winter we have spring again and the cycle of weather will begin anew itself again. However this year’s summer will not be the same as last summer as the temperature varies every year.

Cycle frequencies can both be short and long, it can last from minutes until thousands of years. Understanding long term cycles in stock market helps you determine the overall market trend and similarly short term cycles helps you determine your timing in the entry and exit points in the stock market. The following chart shows some short and long term cycles.

Perhaps one of the most extensive studies on cycles is done by Dr Raymond H. Wheeler, Chairman of the Department of Psychology, University of Kansas. He commissioned 200 researchers to work for 20 years to study the effect of weather on mankind and also cultural activities dated back to the dawn of civilization. Over 3000 years of weather pattern was studied and so was 20,000 pieces of art and literature. After the extensive study he concluded that there exists a 100 year climate cycle and phases that influence human behaviours. The different phases can be described as the following:

  1. Cold-Dry
  2. Warm-Wet
  3. Warm-Dry
  4. Cold-Wet

510 years World Dominance Cycle

According to his calculations we are now in the Warm-Wet phase and should last until 2100. Further to this he also discovered the 510 years world dominance cycle. His record dates back 3000 years ago during the Greek and Roman eras. The following are dates and events that took place since then.

  1. 570 BC - The Romans came to power after the Greeks collapsed

  1.  60 BC - The Romans weakened and gave rise to the emergence of Asian Powers

  1. 450 AD - Asian Powers declined and gave rise to Charlemagne and Britain power

  1. 960 AD - Global power shifted back to Asia with the rise of Genghis and Kublai Khan.

  1. 1470 AD - Europeans at the forefront of global dominance. Spain and Portugal were at their height of power when their naval fleet reaches the four corners of the Earth. Later we also see the re-emergence of Britain and also other European powers like The Netherlands and Germany. The United States came into the scene at a much later stage when the Global Power is about to be shifted back to Asia.

  1. 1980 AD - As can be seen since 1980 the shift in the Global Power from West to East began once again. Since the 1980s we can see the re-emergence of Asian powers like China, Russia and India. So once again the balance of power will stay in the East for the next 510 years which will go right into the year 2490.

The above are extracts from Dr Raymond’s book called ‘The Big Book’ which contains most of his cycle studies. In it you will find that the 510 year ‘civilization cycle’ can further be broken down to three 170 year cycles which itself contained three 50-56 years cycles and so on. In other words there are cycles within a cycle. The most famous economic cycle is the Kondratieff Cycle (50-54 years). Kondratieff, a Russian economist whose cycle study is based on wholesale prices, interest rates, wage levels and production indexes from the period 1780 to 1920. In his paper titled ‘The Long Waves in Economic life’ he showed that there is an existence of a 48-60 years cycle in the overall economic activity in the Western world. The following chart shows the Kondratieff wave in action in the U.S Stock market.

Where are we now?

Historians have found that 50 years business cycle has already been in existence since the biblical days. In the Old Testament it did mentioned about farmland being lie fallow in the seventh year of cultivation. After a total of seven groups of these seven years (7x7 = 49 years) the land was to lie fallow two years in a row. The main question is where are we now in the Kondratieff cycle? From his study on economic cycles he found that the most valid recent peaks are occurring in 1814, 1865, 1929 and 1974s and the next peak will be around 2020s. The 50 years Kondratieff cycle can be classified by the following phases which are divided into five equal decades.

  1. First Decade – Recovery (1974-1984)
  2. Second Decade – Boom (1984 – 1994)
  3. Third Decade – Peak and Transition (1994 – 2004)
  4. Fourth Decade – Collapse (2004 – 2014)
  5. Fifth Decade – Trough and transition (2014 – 2024)

We reckoned that we are now in the fourth decade of the main cycle because currently global economies are engaging in competitive currency devaluations and also at the same time enacting protectionism policies. The following graph shows a more detailed succession of events leading to the current situation and also what to expect from now on.

Does a Stock Market Cycle exist?

Edward R Dewey can be considered the modern day authority in cycle studies. In his book ‘Cycles’ he documented his studies on cycles with data dating back to the 1830s. His book is considered the bible of cycle studies as to Benjamin Graham’s Security Analysis to Fundamental Analysis. What he found that the 9.2 or 9.225 years cycle to be exact is the most accurate of all. He estimated that there is only 1 in 5000 chance that the occurrences can be coincidental. 

Then we have Veryl L. Dunbar in his 1947 article ‘The Bull Market’ printed in Barron’s June 1952 issue discovered the 46 month cycle. His analysis on cycles for the past 123 years yielded a 97% accuracy rate or predicted 62 out of the 64 cycle occurrences. John Hurst, another pioneer in cycle studies identified 12 dominant cycles existing in the stock market. Below we present to you a table of compilations of various cycles and different timeframes of the stock market that has existed and still valid till today although there might be some slight changes in the timeframes.


How cycles can assist you?

As a Stock Market investor would it be nice to add a tool to your arsenal that may help you to determine the general trend of the market and also to buy or sell before the market reverses. As you know Stock Market prices move in trends either up, down or sideways. For long term investors (defined as holding stocks more than 1 year), a solid knowledge of long term market trend or cycles is sufficient. This is also known as the Primary Trend in the Dow Theory.  

For medium term investors who are holding their portfolio between three weeks to a year, it will be advantageous to have some knowledge of the Secondary Trend or cycle. Secondary Trend refers to stock market trends that last between 3 weeks to a year. Lastly for short term investors who are likely to hold stocks for not more than 3 weeks again it will be advantageous to have some knowledge of the Minor Trend or cycle in the stock market. The following chart represents a cycle in the form of a sine wave. It also shows the different stages of market activity in one market cycle. During the trough stocks are accumulated and will be mark-up on the way up. At the peak stocks will be distributed and when done then it’s time to mark-down their prices and the cycle will begin anew again.

We will demonstrate to you using a live sample with the FBMKLCI. The following chart of the FBMKLCI clearly exhibits the existence of cycles. There are two cycles in existence and the first is between October 2012 and December 2012 while the second starts from the beginning of December 2012 to Mid February 2013.

If you have bought during the first low during the end of November 2012 and also the second low in mid February 2013, we are confident that your investments will performed much better than other times during those periods. So we hope that by now you should realised that with a clear understanding on market cycles and trends it will certainly help you make better informed decisions in your stock market investments.