A Fear Driven Meltdown

``A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful. And most certainly, fear is now widespread, gripping even seasoned investors. To be sure, investors are right to be wary of highly leveraged entities or businesses in weak competitive positions. But fears regarding the long-term prosperity of the nation’s many sound companies make no sense.”-Warren Buffett, Buy American. I Am.

As we pointed out in Another Grizzly Bear Transforms To A “Cautious Bull”: Jeremy Grantham of GMO former super bear Jeremy Grantham turned bull has been precise about the market’s mean reversions and market overshooting.

This implies that yes, even if the market is already “cheap”, there is that prospect or risk for markets to always overshoot to the downside in as much as markets can overextend upwards. It is plainly called momentum. Since markets over the short term are mostly about emotions, investing today should translate to having a time horizon expectations of at least 12 months.

Take a look at the inflation adjusted chart of the US Dow Jones courtesy of chartoftheday.com

Figure 2: chartoftheday.com: Dow Jones inflation adjusted

The above chart indicates that support levels have broken down from the 2002 levels and could likely see more downside action. This chart squares with the reaction in the Nikkei chart above suggesting for a little more downside action. But from our perspective any ensuing fall could likely signify as a “selling climax”.

Besides, considering the magnitude of the selloffs, it cannot be discounted that markets can always make sharp countercyclical reactions, which means we can’t discount dramatic rebound anytime from now. Yet short term rebounds do not suggest the end of the bear market until the technical picture materially improves.

As Societe Generale’s Albert Edwards recently wrote, ``But cheap(er) markets will not alone generate a rally. The technicals need to be aligned for that to happen. Notwithstanding the forced liquidations now taking place amidst the wreckage of catastrophic Q3 hedge fund performance link, we see the conditions as ripening for a decent bear market rally.” (emphasis mine)

The reality is that markets or even economies always operate in cycles. And the present bear market developments suggest that this has yet to reach its full maturity before a bottom can be found.

So we are delighted to see a growing band of former contrarian bears converting into contrarian bulls. Aside from Jeremy Grantham, known perma bears like Warren Buffet, Dr. John Hussman, Pimco’s Mohamed El-Erian, Societe Generale’s Albert Edwards and James Montier are some of the prominent names that have began to see “value” in markets today.

Figure 3: Pimco: Massive Risk Aversion and Cash Levels

The point is that while none of them is calling for a market bottom, as none of them are known market timers, although they see the present the market activities as opportunities to steadily accumulate in anticipation of future recovery.

They understand that the present fear levels are indicative of near market bottoms as shown in Figure 3 courtesy of Pimco’s Mark Kiesel. Where market psychology has reached panic levels (left) and equally reflected in massive cash hoards (right).

Vanishing Hedge Funds

So what appears to be the source of the present worries?

With many credit spreads seen improving except for corporate bonds, the present concerns have been directed to mainly three areas, namely, hedge funds, emerging markets and fears of global economic recession.

As we noted in It’s a Banking Meltdown More Than A Stock Market Collapse! ``So as hedge funds continue to shrink from redemptions, TrimTrabs estimates a record $43 billion in September-liquidity requirements, margin call positions, maintaining balance sheet leverage ratio or plain consternation could risks triggering more negative feedback loop of more forced liquidation.”

The unraveling motions of investor redemptions appear to be in full gear where the $1.8 trillion industry is at risk of substantial contraction. According to a report from Bloomberg, ``U.S. hedge-fund managers may lose 15 percent of assets to withdrawals by year-end while their European rivals shed as much as 25 percent, Huw van Steenis, a Morgan Stanley analyst in London, wrote yesterday in a report to clients. Combined with investment losses, industry assets may shrink to $1.3 trillion, a 32 percent drop from the peak in June.” That’s $500 million of asset liquidation if such projections turn to reality.

Some experts have opined that the sheer force from the stampede out of hedge funds may compel governments to even suspend markets. According to another report from Bloomberg, ``Nouriel Roubini, the New York University Professor who spoke at the same conference, said hundreds of hedge funds will fail as the crisis forces investors to dump assets. ``We've reached a situation of sheer panic,'' said Roubini, who predicted the financial crisis in 2006. ``Don't be surprised if policy makers need to close down markets for a week or two in coming days.''

Emerging Market Shoes Drop

Next we have emerging markets.

Countries which had large current account deficits as % to the GDP, those that relied heavily on foreign and or short term borrowing or have been internally leveraged have endured a beating.

Figure 4: Danske Bank: Emerging Market Credit Default Swaps

For instance, Credit Default Swaps which indicates the cost of insuring sovereign debts against a default have spiked for several countries such as Argentina, Pakistan, Ukraine, Iceland, Ecuador, Venezuela and Indonesia as shown in Figure 4 (see right-1 month change of 5 year CDS). This means that the jittery environment has led investors to see higher risks of prospective government default on their debts. Argentina’s proposed nationalization of pension funds seems to underscore such distress.

And the spate of heavy market selling in the currency and debts markets has likewise caused a spike in inflation levels of some EM economies. So while some countries have been suffering from “deflation” symptoms (mostly advanced nations), others are seeing higher inflation rates due to the lack of access to funding and falling currency values. Hence the unfolding crisis has produced divergent impacts and is unlikely deflationary as some contend.

Korea which suffered from a spectacular market collapse last week (Kospi down 20%!) is said to bear the typical emerging market infirmities, according to Matthews Asian Fund ``For many, the collapse of the won is a sore reminder of the Asian financial crisis of about a decade ago. It highlights some of the weaknesses of regional capital markets—bond markets are underdeveloped and there is consequently little long-term funding for corporations as well as an over-reliance on short-term debt. In addition, Korean bank loans are about 30% greater than their deposit base, which means that the banking system has been more reliant on U.S. dollar-denominated funding.”

Although foreign currency rich neighbors of Japan and China have been reported as in a standby mode to provide assistance. In fact, the region is reportedly in a rush to put up a contingency fund ($80b) aimed at assisting neighbors in distress. So it isn’t just a function of IMF doing rescue efforts, foreign currency rich neighbors appear to be doing the same today.

Aside, the South Korean government extended a $130 billion rescue package-guaranteeing $100 billion of external debt and provision of $30 billion loans to banks. Nonetheless, these measures have not prevented foreign investors from rushing into the exit doors.

Figure 5: Danske Bank: Last Shoe to Drop

So not only has the recent credit crunch shrunk the available capital base among international banks, it also compressed investors’ appetite for emerging market investments. The recent outperformance of emerging markets finally phased into contagion side effects (see figure 5). What used to function as a “safehaven” has now caught up with the EM asset class as seen by the huge spike.

Meltdown in Commodity Markets More Fear Related

Given that many emerging markets have been enduring financial and economic turmoil, many see this as telling signs of deterioration in the global economic front enough to justify an across the board selling of commodities as oil, copper and others.

Figure 6: stockcharts.com: Commodity selloffs signs of FEAR!

But the recent behavior in the commodity markets appears to be pricing in a steep global recession if not a depression.

The meltdown has been focused on the assumption of a dramatic decline of global demand. They seem to forget that with the current credit crisis, many of the planned projects will be put on hold or shelved or cancelled, giving way to constriction of supply. If supply falls far larger than the rate of decline in demand then you end up having lack of supply thus higher prices.

Besides, commodities are not the equivalent of opaque and complex financial papers that have triggered this crisis. Commodities essentially don’t go bankrupt.

So even the commodity markets are pricing in more fear than rationality, hence you have an across the board selling of practically all asset classes except for US treasuries and the US dollar.

Albeit we are inclined to think that US treasuries could be the next shoe to drop considering the vast scale of debt issuance needed to bailout the US financial sector and the US economy.

On our part we think that the magnitude of market deterioration demonstrates exaggeration of such concerns, especially seen from our ground levels in the Philippines.

We certainly agree with Mr. Buffett that the deleveraging process has reinforced the fear psychology to the point of excessiveness. And this level of fear means opportunities for him and those with cash.

Moreover, we think that the market, functioning as a forward discounting mechanism, has already factored in the worst outcome and is pricing in fear more than fundamentals.

And when mainstream becomes afraid, this usually denotes of a bottom.