For a change, read the good news

Business Times - 28 Feb 2009

Recent events signal that the credit market is on the mend and the worst is behind us
By Sani Hamid Director, wealth management (economy & strategy) Financial Alliance

I GET weird looks from people these days when they ask me what my call is on the market and I say 'buy'. Apparently, 'buy' has become a dirty word in investors' minds as much as other three-letter words such as CDO and CDS. In fact, calling for a 'buy' today is seen as equally insane as it was to call for a 'sell' in the latter half of 2007 - just as the market was about to peak.

Nevertheless, it's not hard to see why this is the case as investors are inundated with (largely negative) noise emanating from both the economic and stock market fronts, which grab most of the headlines daily. Spreading good news doesn't seem to be in vogue these days but I'll do it anyway.

There has been some good news from the credit market in recent weeks. The TED Spread - which in very basic terms measures the level of risk adversity between banks which lend to one another and is a widely used gauge of the credit market's health - is now back down to 100 basis points, levels last seen in the months before Lehman's collapse, and a big improvement to the spike up to 460 bps in October 2008. Anecdotal evidence also suggests that trade financing has resumed again, thus allowing for global trade to flow after being virtually frozen late last year. And to top it up, large, well capitalised companies such as Cisco (US$4 billion), Caterpillar (US$3 billion), Novartis (US$5 billion) and News Corp (US$1 billion) have successfully tapped the market in recent weeks for amounts unthinkable just a couple of weeks ago.

I believe these events signal that the credit market is on the mend and although it will take time for it to function as per normal, the worst is behind us. However, investors have generally ignored such good news, as they remain fixated on the multi-year or record lows that many economic data have slumped to and on the continued decline in the stock market as some, like the Dow, take out their November lows.

So how do we reconcile all the negative news around us with the good news from the credit market? In order to do this, we first have to understand two things.

Firstly, the news flow we are hearing daily emanates from three cycles: the credit market cycle, the stock market cycle and the economy cycle. I will call the aggregate news flow from all three cycles, 'The Tri-Cycle Noises'. While fairly simple to understand, it is critical to differentiate the news which belongs to each cycle because as you will see they carry different degree of importance.

Secondly, one needs to understand that a lag exist between these cycles. A sustained shock to the credit cycle will take time to impact the stock market and thereafter, the real economy. The Tri-Cycle Concept looks to make sense of the noise we experience and is best explained as we look back to 2007, when the seeds of the crisis actually began to sprout. It began in February 2007 as HSBC warned that its provision for losses on US sub-prime mortgages could hit US$11 billion. This was followed by write-downs from other major banks but in July 2007, two Bear Stearns hedge funds collapsed under the weight of related sub-prime mortgages. And in September 2007, UK mortgage lender Northern Rock became the first British bank to suffer a run in 140 years. During this period, the TED Spread increased from 20 bps in February 2007 to a high of 190 bps in August 2007.

But did the average investor pay heed to this back then? No. The STI, for example, continued its fairy tale run only to peak in early-October 2007 at 3906. Similarly, Singapore's economy continued chugging along and it was not until mid-2008 did it began its sharp descent. This explains clearly the lag between all the three cycles.

The Tri-Cycle can be represented on a chart showing the sequence of these three cycles and lags between them. From a news flow perspective, one can pick any period from the accompanying chart and deduce the type of news (positive or negative) emanating from that particular period. For example, in the box representing 4Q 2008, all three cycles are on a decline, thus suggesting news from all three are negative. As we all know, 4Q 2008 was indeed one of the worst quarter in living memory and we were bombarded with negative news from each of these cycles.

Separately, in the box representing Now (1Q 2009), the credit cycle has begun to turn up although the stock market and economic cycles remain on the downtrend. This explains the mixture of news flow that we see presently: improving news from the credit market but continued bad news on both the stock and economic front. While investors unfortunately prefer to focus on news flow from the latter two, news from the former is actually of greater importance as it actually leads the other two cycles.

In essence, just as many had been caught up in the euphoria of a rising stock market in early 2007 and thus, totally ignored the fact that the credit market was tightening, investors are once again totally ignoring the fact credit markets are showing signs of thawing. All said, investors risk repeating the same mistake of focusing on the wrong noise. Only this time the risk is not that they will miss the top but instead the bottom in the equity market.