My views on the US subprime crisis 4 comments

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The crisis which erupted in August last year is now generating a full-blown domino effect on the "real" US economy and half a year after things have developed sufficiently for me to make an informed opinion on the state of affairs so far and how things could go from here.

Firstly, a confession to make. Although my mental analysis framework was pointing to a reduction in equities allocation as the problems in the US led to one hole after another in its economic fabric, I instead shifted my allocation to more defensive themes and stocks well-supported by NTA (net tangible assets), but ultimately it turned out everything was hit anyway. So the lesson of the day was not to ignore the tide, especially when it had a fundamental basis.

Two qualitative analysis frameworks work well here (which I sadly discounted). Firstly, that the general market is driven by three factors: fundamentals, liquidity and sentiment, and that one should watch out if the first two look to be declining or when the last factor is peakish. That credit creation (and hence liquidity) would be affected was clear, while the fundamental situation seemed mixed for a while as the US employment situation remained strong until December. Sentiment was mixed. It was a time to be careful. The second analysis framework was described in an earlier article: "The financial statement as an analysis framework". It showed a systematic way of thinking about revenues, costs, profits and how they eventually filtered through to stock valuations via P/E ratios, which were a function of liquidity. As liquidity declined, as did sentiment, there was a P/E de-rating, which is essentially what has happened over the last few months, especially for the small/mid caps and China stocks in particular. It remains to be seen whether the E will be affected in the coming months, in which case there could be another round of downward pressure on stock prices.

Another major issue is with regard to the seriousness and enormity of the crisis. There are actually two parts to this issue: how deep the crisis could become in the US, and how the rest of the world could be affected (the so-called decoupling hypothesis).

For the first part, the situation has the potential to deteriorate and comparisons have been made to the Asian financial crisis a decade ago where currency failures led to corporate bankruptcies led to mass loss in consumer confidence. The contagion effect within the various credit sectors and now consumer and business confidence in the US certainly shows that developed economies are not immune to such domino effects, and it would take a brave analyst to say things are not going to grow more pear-shaped, especially when everyone now seems to be talking themselves into a self-fulfilling prophecy that is recession. But there are several mitigating factors: (1) rate cuts are implementable without a seriously deleterious effect on exchange rates because of the USD's position as global reserve currency, an option not available to the hard-hit Asian nations in 1997 (indeed, they were forced to raise rates which worsened things); (2) the employment situation still looks relatively robust which if it continues might suggest the banks could actually write back some of those CDO losses if defaults are less than market prices suggest; (3) US companies have stronger balance sheets than during 1999-2000, derive more profits from overseas operations than ever before, and hence there is less potential for sudden bankruptcies (and mass loss of jobs). Arrayed against these mitigating factors are the sobering facts: (1) consumption constitutes 70% of US GDP, and hence a decline will filter through to GDP stagnation strongly; (2) asset values, of which home and stock market valuation are dominant, form two of the three pillars of consumer liquidity (especially when loans can be drawn against home equity --- a US invention), and asset values are almost certain to fall; (3) pessimism suggests US businesses will be reluctant to invest in new capacity. I feel things might swing more to the downside, though I feel the market is discounting this quite aggressively already. Actually, I am seeing a soft rather than hard landing where the economy slows as consumers spend less and businesses invest less, but no panic as general job losses and hence debt defaults are limited. (You notice I focus on the "credit demand" side and do not talk about the "credit supply" side (ie. the banks): that is because I feel there is general internal commitment to do big-bath writedowns that will put a bottom on valuation, general commitment from US government to support them, and general commitment from international governments to recapitalise them; the worst might be behind them. As a caveat, I will be watching the development of the monoline insurers episode and the moves of the credit ratings agencies closely.)

As for the decoupling issue, my view has always been that Asia decoupling from the Western economies is wishful thinking, because even if trade flows can decouple, it is quite impossible to expect financial flows to as well. I have been avoiding exporters as long-term holds for 1.5 years now given that US consumption has been slowing down since late 2006 ("US Consumption Slowdown"), but financial flows are impossible to trace though. But --- Asian economies have strengthened structurally both macro-wise and micro-wise since the painful lesson ten years ago and are in a position to substitute domestic investment for loss in export growth given their healthy surpluses. What it means is that if positioned correctly in correct sectors, one might still be able to make money. The likely credit destruction process in the West, however, means profit-taking must be more disciplined and less ambitious.

The third issue I wish to talk about is with regard to the management of this crisis by governments. There are many who criticise the Fed's emergency rate cut as being panicky behaviour that will send a signal that the economy is worse than it looks or that it is creating a moral hazard, or that the Bush tax plan is ineffective. They seem to want markets to right themselves by massive plunges to price in the desperate situation. I wrote something about this in a forum and I thought I will reproduce it wholesale here as representative of my thoughts:

"It is naive to think that the market and the economy can be separate from each other. George Soros' views on their inter-relatedness has been well-espoused and indeed, they can feed on each other in a death spiral if not managed. US markets have operated under what he calls market fundamentalism and if a free hand is given for markets to run they can become unstable because confidence and psychology is a big part of markets.

Understood in this context, we might be able to better understand the Fed's predilection for emergency rate cuts. They are signalling to the markets that they will not let market death spirals happen and further destabilise the "real economy". A big source of consumer expenditure, besides income, is the wealth effect from asset values, as well as from consumer debt/borrowing. Market valuations hence constitute a bigger part of the real economy than people give credit for. When banks mark down their balance sheets based on market value, as happened recently, the assumption is that markets produce "fair value". But is it true? My view is that mass hysteria and complete loss of confidence has produced unrealistically low valuations of many high-quality debt; because of mark-to-market requirements, banks have no choice but to write down up to 70% of their value. Probably the true value, in the form of discounted cashflows, is between the mark-to-market and mark-to-model valuations.

If the confidence crisis is allowed to develop and those in a position to do something instead do nothing, then that will truly be reproachable behaviour."

If one believes that the market is efficient all the time, then perhaps it's best to let the invisible hand rule. Behavioural finance has identified the flaws in such assumptions due to human psychological tendencies that distort rational behaviour and especially in extreme times these tendencies can be exacerbated either by rapidly falling prices or even rumours that might have seemed absurd in more normal times. Left unchecked, instabilities could develop and feed on themselves; perception becomes fundamentals which further reinforces perception. That, incidentally, also applies to many other things in life.