“When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing,” Chuck Prince, former Citigroup Chief Executive and Chairman referring to credit boom before the financial crisis.
No better words can sum up the general mood of the current market than the words of Mr Prince. Well, Chuck Prince stopped dancing not many months after making that statement to FT- he was forced to retire out of Citi. But that was not before he was warned that timing the end of the song was a really hard thing to do. Citi suffered some huge losses because of risky assets the bank held and originated.
None of the local investors may be forced out when the music stops but they will be bruised when the equity markets self-correct. Notice, Mr Prince did not say “if” rather he said “when” – an acknowledgement that the music will stop. In the same way, money managers and investors alike marvel at how stocks are out of step with reality yet they are still on the dancing floor- holding the same assets they know are extremely over-priced.
Today ‘music’ is akin to the equities bubble that has inflamed in the last three months. Every trader and investor believes they will foresee the correction and jump off the market at its highs just in time for the correction. How that is possible is difficult to tell.
Fundamentals vs Technicals
“The problem with experts is that they do not know what they do not know” Nassim Nicholas Taleb
Dizzy heights at which the market is trading today do not suggest that money managers are not paying attention to fundamentals. The rush into equities is now beyond the pretext of ‘inflation cover’. This is now more about fear of missing out perhaps the greatest and shortest rally in the history of the ZSE. By staying out of equities, when peers are recording double digit monthly returns, a manager can lose assets to competitors. As an advisor at a respectable brokerage firm succinctly put it “How do you give advice to your clients without looking conflicted: when your fundamentals are suggesting a value of 100cents but the market is still buying at 150cents”.
At a retail level, a local money manager had these few pointed words about what characterises this stage of the bubble – “when your mother calls advising you to buy shares because her friends’ children are doubling their money overnight”. Unsurprisingly, calls by Diaspora friends sounding off the idea of putting together some hard currency, trading for RTGS at premium and then buying some raging growth shares have all become too common recently.
When Liquidity dries up
“Only buy something that you’d be perfectly happy to hold if the market shut down for 10 years” Warren Buffett
Recently a local advisory firm made the insightful observation that that in the last weeks of August share prices were going up rapidly without corresponding volumes – suggesting a dearth in liquidity. But the lack of liquidity is not two way. Liquidity is dry for buyers and galore for sellers. Simply buyers are queuing for shares that sellers aren’t willing to give up – hence demand has been driving prices up with very few shares changing hands.
Today’s investors and traders ought to be wary of the contrary, that is, when markets go down. When the market self-corrects, suddenly everyone turns from being a buyer to a seller and liquidity for sellers evaporates as prices slide. Holders are locked in until buyers come to party – often at rock bottom prices. At that moment it is better to be the choosy buyer and not the desperate seller.
It is therefore important that when thinking about holding assets one should consider the nature of investors buying at the same time. Investors with the same motives often act in unison or uniformly leading to sharp price movements. Today, equities trades in the last four months have for the most part been driven by short term holders or simply speculators driven by other factors other than fundamentals or fulfilling their portfolio allocation goals. These are traders who will dump the assets at the faintest sign of a decline.
Potential catalysts for a correction
“Risk means more things can happen than will happen” Peter Bernstein.
We may not know when and how things will pan out. Not even the policy maker knows. However, as Mark Twain puts, “history may not repeat itself but it often rhymes”. To the extent that cycles are predictable to continue, investors can be assured that the bubble is going to burst. We cannot tell when the correction will occur, but at least we can get a sense of where we are in the cycle. That sense is we are way past in the second half of the match.
To Howard Marks’ point, we need to resist narrow perspectives and challenge ourselves to consider all possible outcomes, even the black swans. Below is an attempt to be as encompassing as possible in identifying potential events that could burst the bubble. The idea is not to be overwhelmed by thinking about the number of things that could go wrong but to factor in these possibilities in one’s decision making.
• Liquidity withdrawals – in the last four months most pension funds and money managers have moved funds from bank balances and TBs into equities. In an event of anticipated or forced redemptions, managers will look up to the equities market for liquidity and withdrawals. If the cause of a sale is affecting a number of funds at the same time or a large pension fund, the sale may spark a dump of shares as speculators rush to be the first out of the door.
• Risk off event in RTGS and other assets – a major part of the rush in equities has been devaluation of RTGS against hard currency. The prevailing discount is a risk-on case which reflects an aggregate of the fears of market participants. But behavioural finance teaches us that this discount is neither correct nor wrong but mostly a reflection of the market’s perspective – in this case of policy makers’ trustworthiness. This discount, is a highly fallible figure that can be altered by a single political/policy event, announcement or
act. Such an event would re-rate the risk attached on TBs or RTGS securities drawing funds back to these asset classes and punching a hole in the bubble.
• A return to fundamentals – less likely is a possible gradual return to sensibility. Where a few courageous funds will question the current prices and trigger respect for the fundamentals.
• Leverage – it is not unthinkable that seeing the stock market double in 3months some players in the market may be leveraging stock purchases. Few months back, regulators allowed investors to borrow against their listed shares. For leveraged purchases, significant drop in price could trigger a situation akin to margin calling triggering forced selling.
• Negative news in a blue chip – as Nassim Taleb puts it “it is contagion that determines the fate of a theory in social science, not its validity”- yet contagion is one of the least recognised phenomenon. Negative news in the performance of a share or underlying company is good enough reason to spark a market wide crash. It can be news unrelated to fundamentals such as Econet’s share price plunge when investors protested the rights issue terms. Speculators will jump at the sound of panic setting off a negative chain reaction across the market. Bear in mind, speculators are not interested to understand what is driving the share movement more than they are interested in the movement itself.
How are we pricing risk?
“There are old investors, and there are bold investors, but there are no old bold investors”. Joel Greenblatt.
All the writing until this point should take us to this vital question – “how are we defining and pricing risk”? After all, ostensibly, it is ‘risk’ which is behind the volatility. Among the panel discussions at the recent Financial Markets Indaba held in London was the topic “Zimbabwe risk – how are we pricing risk”? It was interesting to notice the varying views towards risk. What would you say is the most important risk in Zimbabwe? Is it policy consistency; currency; corruption; red tape; labour skill; or is it price.
How we define and measure risk determines our investment decision making. But herd mentality, fear and greed are all too powerful forces that often how we think about risk. The examples below help to probe this assertion.
Equities risk- value vs growth investing.
Risk definition and pricing does drive investment decision making-whether right or wrong. For example, at 380 points, ZSE has more than doubled year to date. That presents a 50% price risk if you, like me, believe that the market was fully priced beginning of the year. Money pouring into equities is leaving RTGS currency making the case that investors are attaching a devaluation risk of >50% on RTGS. Implicitly, we can argue that at the suggested current discounts of 35-45% to the dollar, investors buying into the ZSE believe RTGS will experience a further 50% devaluation.
Another place where risk pricing is strange is in equities. Beginning of the year SeedCo share price was 98cents and today it hovers at around 250cents – a 150% rise. At the same time, BNC share price has in recent years plunged from highs of 10cents a few years ago and has remained unchanged at 4cents since beginning of the year. Both companies have turned from loss making to profit in just under one year. Without going into deeper fundamental analysis and despite BNC’s underlying issues, such a discrepancy may help to outline the important observation that buyers of the current market are momentum driven and not concerned with the fundamentals.
How risky are Treasury Bills
Treasury bills have also been unjustifiably neglected. Perhaps I am too young to be assertive here, but for as long as I have followed markets, the Zimbabwe government is yet to default on local TBs. Not because the State is a faithful borrower but that it always have means to either print the currency or make capital markets actors like banks and pension funds buy TBs to refinance maturing ones. But more important than government’s “track record” one needs to assess the potential impact of TBs’ defaulting to understand the likelihood of that happening. For example, if TBs were to default, some of the local banks will grind to a collapse and pension funds would fail to honour redemptions by retiring working men and women. Consequently the whole ZAMCO programme would have been a self-defeating exercise – replacing an NPL with another NPL. But again, the unthinkable has often happened in Zimbabwe.
If my questioning of the risk attached to TBs holds water then prevailing discounts of up to 30% maybe the result of an excessively fearful market. More glaring are cases where TBs have traded at double digit discounts weeks to their redemption.
If betting against the stock market (growth stocks and blue chips) is an informed strategy, perhaps it may be useful to think of holding TBs now. In the event of a correction, some of the funds will rush out of equities into TBs and bank balances as the only near- liquid assets. The result is a price appreciation from which holders of TBs can realise a return.
Final words for policy makers
If a lack of confidence is the main cause of the forex cash shortage and the massive discounts to RTGS, then more confidence is the solution.
Each time the invisible hand feels arm-twisted by policy makers it knee jerks swinging to extremes. Such is the case in the currency market. Granted government accepts that we have three currencies and allow them to trade freely, the discount to US dollar will moderate and settle for a rate that is much smaller than prevailing on informal market.
By outlawing this currency market government is creating a pricing vacuum which media and informal traders are happy to occupy – however informed they are. As currency trading is pushed into the grey area, policy makers are inadvertently responsible for paving way for the large discounts we see today. If banks, shops and bureau de changes are all allowed to freely trade bond notes, RTGS and forex at market related rates, US dollars will eventually move off streets and back into official markets.
More important, a drying in foreign investment in the economy emanates from a worry that an investor will not be able to retrieve his US dollar investment down the road. That lack of currency certainty is a stronger push force than high returns in Zimbabwe are a pull force.
With a predictable market where banks and funds can market-make the demand and supply of different currencies, foreign investors can be comfortable to invest their dollars at a premium knowing there will be a fair market to convert their RTGS back into US dollars when need be. The answer lies not in some unconventional monetary thinking but in returning to that simple faith in the power of the invisible hand- Mr Market.