The Pain Report - Go Fishing

‘If governments can enforce the wearing of seat belts surely they can regulate common sense lending practises..’

The Pain Report

From the desk of HFA Asset Management’s Jonathan Pain

 HFA is a Pentad Group preferred fund manager.

GO FISHING

You would be best served taking the advice of Iceland’s Prime Minister who this week told the devastated citizens of Iceland to “go fishing”. For the record the top three banks in Iceland, now nationalised, had combined assets of more than 12 times Iceland’s GDP.

I am not going to waste your time or mine reminding you how we got into this mess. Regular readers of this report will know our views as to the root cause of the “financial Armageddon” that we are now all witness to.

Can we, once and for all, admit to ourselves that too much money was lent to too many people. Can we also please, once and for all, accept that the American version of free market capitalism, over the past decade or so, has been a catastrophe and that it is now over? How could American regulators and policymakers allow the creation of NINJA loans? How could the world’s largest economy allow hundreds of thousands of dollars to be lent to people without any income, any job or assets?

So yes the greatest debt bubble in history has burst and the economic consequences will be unbelievably painful and yes, as we have said before, we have commenced the mother of all credit contractions.

So what kind of new world order do we face?; In my view, a world with much better balance and a world with less greed, a world where no one nation can dominate. This means that the United Nations can never again be dominated and manipulated by any one nation.

A world which never again allows the kind of corporate greed we have seen over the last decade. In 2007 the average compensation for the chief executives of the top 500 companies in America was more than 300 times the average worker’s pay. Three decades ago it was about 30 times and in Japan today it is about 18 times. So here we have two developed democratic free market economies with a stunning divergence in their approach to executive compensation. Perhaps we have a lot to learn from Asia.

On January 9th 2006 we wrote in a paper available on our website, the following:

“The imbalances in the U.S. are simply unsustainable. The housing market is set to fall, which in turn will weaken the economy. America has spent too much and saved too little. In contrast Asia has spent too little and saved too much. Over the next decade these trends will, through necessity, be reversed. More than 3 billion Asians have embarked upon the path of rapid economic development. Their savings are vast and as their incomes rise, which they shall, they will spend more. Asia will become the consumer of last resort. In this fundamental regard, such an outcome will restore a much better balance to a very “unbalanced” world.”

I wouldn’t change a single word of this today.

So now we’ve broken the financial system lets think about how we put it all back together again.

Greater regulation of lending practises would have to be close to the top of the list so as to prohibit predatory lending hence no more NINJA loans and no more “No deposit, no worries” advertisements.

If governments can enforce the wearing of seat belts surely they can regulate common sense lending practises.

And now for one that you were not expecting, but please hear me out, and I did tell you to go fishing. I very strongly believe that not only our financial system is broken, and needs to be rebuilt, but in fact the money management system needs serious surgery too.

We currently have a very large part of the money management industry where the objectives of the money manager and the client are not in alignment. This is a fundamental and conceptual flaw which has serious consequences for the whole financial and economic system.

Many people have wondered how and why money managers continued to buy technology stocks, at “nosebleed” valuations in early 2000. Many people couldn’t understand why they kept being told by their money manager that they were ahead of the benchmark, having lost significant amounts of their money. The simple plain fact is that the client wants to make money and the mainstream “relative return” manager wants to beat the benchmark. These objectives are not the same.

This is not a complex issue and the solution is very simple. Simply tell people what they are buying, or in this case what they are investing in.

Over my 25 years in the investment industry I cannot tell you how many people I have spoken to regarding the “relative return model” and they simply don’t understand it and I would argue that the mass majority of investors have no idea that “relative return” money managers had to buy technology stocks because they were part of the benchmark.

Investors intuitively understand the absolute return model, and in most case the indexation approach. But they cannot get their heads around a money management approach which says it is active but remains pretty much fully invested through bubble after bubble.

Am I asking too much to suggest that the appropriate regulatory bodies and perhaps even the media take some time to understand the various money management models and how they work?

Once again, as we had following the tech bubble, we are going to see millions and millions of investors asking the question why their money manager did not sell in the face of the biggest debt bubble in history. And in fact may I suggest that if they had been a bit more selective about what they bought we would not have the bubble we have today. So perhaps rather than shooting the messenger and those of us who declared “The emperor has no clothes”, we should look into why money managers bought shares in companies like Fannie Mae which were sixty times leveraged.

I will no doubt be either ignored or punished for making such incredibly ridiculous observations and once again words of mass deception will be employed by the very powerful to silence this necessary debate. I will surely never again be invited to speak at any investment industry conferences which will be a great relief as I don’t think I can tolerate anymore pseudo intellectual debates about tracking errors and other such meaningless statistics of mass deception. If any of you are at an investment conference, as my invitation looks destined for the bin, and you hear a “relative return” manager talk about tracking error as a measure of risk, could you on my behalf please publicly disclose that this is not a measure of the client’s investment risk.

Now where were we?

Oh yes back to saving the world.

As I write this it would appear that the G7 countries are attempting to do just that and have agreed on a series of measures to stabilise and moreover underwrite the banking system. The U.S. Treasury will inject equity into the banks, following on from similar actions taken by the U.K.

All of this will help slow the rate of de-leveraging, but it will not stop the process. It will also not stop the recessions that have commenced in America, Britain, Ireland, Spain (all nations with housing bubbles). We are facing a very brutal recession in the above countries and in fact through most of the developed world.

Now here is the really painful bit. Australia now faces a recession and as I said at the beginning of the year house prices will fall very significantly. Yes Asia will help soften the blow, but it won’t prevent a decline in economic activity which will be driven by a continuing fall in discretionary spending as house prices decline and banks cut back on lending. As we have said before we have some of the most expensive housing, relative to incomes, in the world and we have massive levels of household debt.

We were a very lonely voice, at the beginning of the year, calling for a significant cut in interest rates by the RBA (Reserve Bank of Australia) and we were very impressed by the recent 1% cut, but we need rates near 3 % to 4% as soon as possible. Please believe me that inflation is not a threat, deflation is.

I told you to go fishing!

So let’s try and reach some conclusion to what has been a particularly painful Pain report.

Some of you may remember the Twin Peaks chart (showing the S&P500 for the last 10 years) that we used in our July road show.

Twin Peaks - S&P500 - 1996-2008

 At the time we suggested that we could see a similar pattern in this bear market. In point of fact we have seen a much more brutal and concentrated collapse than we saw between 2000 and 2002. In this bear market we have fallen 43% in just one year and last night we saw the Dow trade in a 1,000 point range for the first time in history and the VIX index hit an all time high of 76.94%, so this one is much more serious in its intensity.

I said in an earlier report that the bear market would probably only bottom when the last “bull is dragged out kicking and screaming”. To be honest I think the bulls no longer have the energy to kick or scream and they now simply just sit and stare in disbelief and whimper the only words they know, “it’s time to buy”.

In every bear market in history, and there are no exceptions, there are great buying opportunities, so long as you never lose sight of the fact that you are in a bear market.

Yes we are still in a brutal bear market and I have no idea when it will end.

What I do know is that we have just commenced one of the most painful economic contractions in history and yes we should all be so incredibly grateful that 3 billion Asians have embarked upon the path of economic development and they will be our salvation.

But I am willing as of today at 1.35 pm Saturday 11 October 2008 to say that we are going to see a very significant rally in global equity markets. Is it Monday or Tuesday I have no idea, but it is a tradeable rally. Markets are grossly oversold and now better factor in the economic reality that we now face. Is it the end of the ‘Great crash of 2008”, probably not?

Time to go fishing

All the best,

Jonathan Pain
HFA Chief Investment Strategist

Disclaimer: HFA Asset Management ABN 25 082 852 364 (HFA) AFS Licence 246747 does not guarantee/warrant, the accuracy/correctness of the information in this document. This document is not financial product advice. Neither HFA, its employees and/or agents shall be liable for any claim resulting from any person relying on such information. Professional advice should be obtained in respect of your own particular circumstances. Past Performance and asset allocation is not a reliable indicator of future performance.

15th October 2008

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