Perspective Unlimited

Thursday, November 08, 2007

Not a Short Downturn

Two months ago, I suggested that markets were overly exuberant after Fed's first rate cut, which if you recall sent US and local stock markets to record highs - as if the subprime problem never occurred. The market rallied, and for two months I was wondering if I was missing out on something. But the problems associated with the US housing market have not gone away. The US financial system and overall economy cannot return to good health before the housing market problems are worked off.

Property as a Collateral

Compared to other assets, housing property is very unique. A large section of the population own it, with most people taking out mortgages in the process, using the purchased property as the collateral. If you buy a $1 million house and borrow 80 per cent, your net worth is $200k. A 10 per cent increase house prices will increase your net worth by 50 per cent, while a 10 per cent fall in price has the opposite effect of minus 50 per cent.

Conversely, a 10 per cent decline in the stock market does not have the same macroeconomic ramification since not many people own shares directly. More pertinently, not many people borrow or leverage to buy shares.

The effect of using property as a collateral is that small changes in house prices can have a large impact on the net worth on many people, and its macroeconomic impact therefore significant. As the net worth of individuals falls, many activities in the economy are dragged down with it. For example, if an entrepreneur has taken out a loan against his property to fund his business (like many small businesses initially do), a housing downturn will have financial consequences for the business itself.

For most consumers, the wealth effect - and even the psychological impact of falling house prices - will lead many to cut back on consumption. The bad loans on the banks' books will force them to cut back on lending as well, hence the credit crunch.


What compounds the problem is the feedback effect. The effect of more foreclosure is to send housing prices even lower, hitting the net worth of families with previously healthy financial balances. A LSE Professor Kiyotaki - now in Princeton - modelled this effect. Because of this feedback effects, the initial shock is propagated, resulting in dramatic, and prolonged, negative impact on the rest of the economy which is unlike stock market corrections. It is for the same reasons why Japan took so long to recover from the asset bubble. If you recall, Singapore's economy also took rather long to work of the excess of the last property bubble.

Alan Greenspan has repeatedly warned that the housing inventory in the US is still very large. There is still an estimated 9 months' worth of excess supply, not including those property put on fire-sale in the market. Overall, US housing prices have fallen only very little (average of about 5 per cent or so), and there is therefore a long way to go potentially. Some metropolitan areas in the US are expected to see at least a 20 per cent price decline. It is going to hit the families, banks and financial system hard.

On and off, we will no doubt get some good news to push the markets up a little but have no illusions about it: this US downturn will not be a short one.


  • Yeah, i saw a BBC article on this. The scale of the subprime problem astound me.

    And it seems that all the CDOs, even those of AAA rating, are becoming worthless.

    By Blogger at82, at 6:53 pm  

  • I was thinking of picking up Citibank stock. Even if all its CDOs become worthless we are looking at $88B, this is a stock with $2trillion in assets and earns $20B a year. I've no doubt Citibank will bounce back in my lifetime. The question is from which level? $30 or $20?...or really bargain basement $15?...I'm still waiting.


    US financial stocks got dumped. US growth is sluggish even if the Fed keep pumping money. The thing is US equities is not expensive. I went through the numbers again and again and through all sectors in the US market to check if it is discounting bad news and the impending doom properly. Here are the facts:

    1. The Dow moved up about 6% this year. With the 3+% depreciation in US$ most global shareholders will walk away with about 3% return. Pathetic.

    2. The US markets appear to be discount the slowdown in domestic demand. Why? Indices such as Russell 500 for smaller companies without international exposure is down for the year.

    3. P/E ratios are in the teens. This is not the Nasdaq bubble we are looking at. It is hard to crash from these levels. Nasdaq itself is half of what it was during the bubble.

    4. Component stocks on the Dow have roughly 30-50% exposure to the global economy.

    Except for financials the earnings coming in is quite respectable. The weak US$ is good for US exporters and multinationals.

    I saw Bernanke's testimony yesterday. It is very clear the US economy stinks! ...Inflation is going to be a big problem and the FED has no choice but to fuel it by cutting rates to keep the US economy going.

    What I believe is the US stock market has discounted alot of it and the downside can be limited. The open short position in stocks is very high and if you watch CNBC,there are plenty of gloomy faces. The recent plunge was cause by very heavy speculation in a triple play - Long crude & gold, short equities, short US$. This resembles the attack on the US$ near Thanksgiving in 2006 when the US dollar & US stocks were shorted to bring about a suddenly gloomy situation.

    This is a case of speculators making their own news in a wave of attacks. There is no irrational exuberance on the upside, but there is wild gambling on the downside of this economy... yesterday night I heard heavy betting on call options for $200 crude.

    I believe we will rebound, the US market/economy will decouple from Asia & BRIC....

    By Blogger LuckySingaporean, at 4:38 am  

  • Lucky,

    I agree with the facts you mentioned, but is less sanguine. At the beginning of the subprime crash - analysts coalesced around the US$100bn mark as the total subprime writeoff. By my own rough tally, we are at best halfway there only - ie, the total writeoffs reported by the major banks worldwide. And that is on the assumption that subprime problem does not become a prime problem and that the US$100bn is a fixed (not moving) goal post.

    My view is that P/E ratio is probably better used as a comparison of similar firms within industries, rather than to assess the overall market's potential for upsides or downsides. Classical theory suggests that P/E should be high in a downturn and low in an upturn (because current earnings tend to fluctuate more than average earnings in the life of a company), so you could interpret the P/E ratio the other way around.

    As you also rightly pointed out, even if the US market eke out a gain, USD will wipe most of it away. I just don't see a lot of upside, considering the risks of sudden and sharp adjustments.

    The only big question is: How would Asia/Singapore be affected?


    Did you see the map of Ohio - the black dots showing foreclosures? It is blanketing the whole state!

    By Blogger Bart JP, at 9:17 am  

  • Bart,

    Yup, I saw that. That is why i am astound.

    How is Deutsche Bank going to get rid of the properties is beyond me.


    I agree with you that citibank might be a good buy for buy and hold. :)

    The stock of citibank is dropping to near usd$30 already. Maybe it is possible for it to hit usd20!

    By Blogger at82, at 10:10 am  

  • at82 & Bart,

    I was looking at C (citibank) today and despite the 200+pt drop in the DOW, it went up. Some analyst wrote that the break up value of C is far higher than what it is valued by the stockmarket.

    The most interesting market is Hong Kong with its peg and US$ plunging. To maintain this peg as US$ weakens, the HKMA has to keep pumping money into the banking system to prevent it from rising. The higher the weakness on the US$, the more they have to pump. Friday saw interest rate cut announcements by all major hong kong banks. The weakening US$ is forcing the HKMA to pump liquidity into a red hot economy.

    In addition to that, the Yuan has gained more than 10% against the HK$.

    Remember the Hong Kong economy has a large domestic component and property is a large part of it.

    Image that a weaker US economy = falling US$ = more liquity pumped into HK economy. HK gets from hot to red hot. Money has to go either to property or stocks. Despite the gigantic bubble in Hong Kong, it looks like it is going to get pumped up even more.

    By Blogger LuckySingaporean, at 9:50 pm  

  • Lucky,

    "I was looking at C (citibank) today and despite the 200+pt drop in the DOW, it went up. Some analyst wrote that the break up value of C is far higher than what it is valued by the stockmarket."

    That was what I noticed too! I wonder where can I get the Price to book ratio for citigrp and other financial firms like MS and ML.

    Where did you normally get your information on financial market from? Can to share?

    It would be most interesting to see if there is some bargain to pick up . But I still think it is better to wait till the 4th Quarter results to come out before dipping into the mkt.

    By Blogger at82, at 7:40 am  

  • I agree with AT. Until I count to US$100bn in writeoffs (assuming the goalpost is a fixed on), I think there will be more announcements.

    By Blogger Bart JP, at 8:05 am  

  • at82,

    I'm not too sure where you can find the price to book. If this ever gets to below 1, we are probably in severe recession.

    I was going through some old magazines at the library and in the issue of 9 Aug 2007 there was a whole feature on how "big bargains" are to be had among US financials. At that time Citibank was $55 and the analyst made a very strong case to buy Citibank arguing its dividend yield is 4.5% and its long term earning growth rate is was a total "mystery" to him why Citibank stocks is so cheaply valued.

    I haven't bought it yet. The various crisis I've been through tells me banks stocks can go down alot to absurd levels when confidence is shaken. I managed to buy 5 lots DBS at $3(or was it $5 long ago, I forgot) when the Asian crisis struck. Suppose the US goes into recession, US banks can see plenty of consumer loan defaults and remember they were lending like "there was no tomorrow" for a few years. You look at how aggressive the consumer arm of Citibank behave in Singapore trying to push unsecured debt to consumers. Unemployment rate goes up default rate goes up like the consumer credit bubble in Korea and you can see Citibank alot lower. It looks cheap if the US economy holds out. If you look at parallels between the Japanese bubble economy when the stock bubble then the real estate bubble...when both bubbles burst, they were buried in 20 years of sluggishness.

    I think the Fed might run out of tricks. Like Bart said, this(recession) can be the long one.

    I read Ravi Batra book on the "coming revolution" and Soros book on the crisis of capitalism. The central idea is the same that a long lasting economic crisis will come when the economic boom fuel by rising debt comes to an end when you just can't create anymore credit. The "credit crunch"....and the inability of US consumers to keep borrowing (savings rate is negative) spell a probable end and a "crisis of capitalism". The FED can try to inflate its way out of debt by printing more money if it is willing to accept the consequence of runaway inflation.

    In the book Greenspan's Fraud, Ravi Batra tells us a terrible end resulting from Greenspan's "fraud" is inevitable and we could be seeing it now unless Bernanke can pull one more trick out of the rabbit's hat.

    For the past 5-6 years, I have been buying dips. Including the dip in Aug 2007. I really think this is no "temporary" downturn. I'm working out an exit plan. I'll try to update my blog on some of my thoughts on the market this weekend.

    By Blogger LuckySingaporean, at 9:47 am  

  • Hi Bart and Lucky,

    I have found the ratios.

    The P/E ratio for Citigrp is below 8.91, while it P/B ratio is 1.29.

    However with all the writedowns and losses the P/E and P/B ratios can change drastically when the 4th Quarter results are out.

    Frankly I think most of the long-term forecasts are Bullshit. The assumptions they used to make the forecast are either too optimistic or pessimistic depending if the forecasts are made in boom time or recession.

    Anyway I think the statistics to watch is the US credit card default rate. Credit cards is really the last line of credit for most US consumers. If the default rate start climbing rapidly we will know recession is near.

    Bart, do you know where we can get the data for monthly US credit card default rate? I thought the data is available at the Fed website, but I can't seem to be able to locate it.

    Anyway lucky, it is really cool that u managed to get DBS at $5 lolz.

    By Blogger at82, at 11:54 am  

  • at82,

    Good work. 1.28 certainly does not look too expensive but it has not become compelling yet. I wonder if the market will get to the point when we see a "Buffett buys Amex" type moment when you buy $1 for 60cents.

    I'm think a US recession is almost inevitable. It will come this year or next it is a matter of time. Until last year Americans sitting on record prices for their homes ATMed their homes to spend by remortgaging their homes. The rate cuts are just postponing at a cost. Contrary to what you hear on the media, initial rate cuts are very often accompanied by sharp market declines. On the other hand in the past 2-3 years the market rose as the Fed raised rates. I'm bearish when it comes to the US market - the only stuff I'm holding are biotech stocks whose fortunes depend on whether they discover the next cure for cancer rather than the economy.

    If the situation is similar to a few years back when we relied alot on the US economy for growth, I would have dumped all my stocks 2 weeks ago. I've sold some due to so-so quarterly results and kept the cash...I was wondering if the Chinese & indian economies which continue to grow can cushion the impact of US slowdown. Already I see there is relative strength in some of the emerging markets....could investors be shifting out of US equities into emerging markets? There is still plenty of liquidity sloshing around seeking higher returns.

    There might a risk of a shock which will result in a complete selloff and flight to US treasures. I'm still sitting on the fense but I'm likely to raise more cash on monday by selling some of the stocks I hold...and wise investors often do this "sell and regret, but sell anyway".

    By Blogger LuckySingaporean, at 2:32 am  

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