Fear Of Recession Overblown

INVESTING SCENTS
By S.DALI

MOST professionals, as well as the average investor, are likely to follow the release of economic data to get a grasp of the direction of global economies and markets. To get a sense of capital flows, they will look out for data such as trade surpluses and deficits, interest rate differentials, leading indicators and so forth. To analyse the strength of domestic consumption, data that is relevant data include housing starts, loans growth, interest rate trends, foreign direct investments, local currency outlook, employment rates and so forth.

Presently, there appears to be much concern over US recession fears – the killer of all stock market bulls. Understandably, one of the biggest fears of professional fund managers and investors is to be caught in a massive bear market. So, can we better predict bear markets by following economic indicators?

If we were to look at the massive bear periods in recent times, you will find that they were bubbles pricked by reality. The dot-com boom-bust was based on over-hype; the pouring in of excessive liquidity via private equity and venture capital funds to latch onto the next dot-com star.

The debilitating 1997 Asian financial crisis was caused by years of excessive foreign liquidity into the South East Asian economies and financial markets, driving up prices artificially and resulting in significant market inefficiencies and misallocation of capital in the process.

The current market phase is not a bear market, well yet at least, to most investors. To many, it is just a correction within a bull market, but the longer it stays in a funk, the quicker it will morph into a bear market. I would categorise the current market as a proper bear market because it is the implosion of a genuine and massive bubble, just like the previous bear markets.

Recent data and implications

The latest jobs data and housing data confirms that the contraction is still underway despite the genuine efforts by US Federal Reserve chairman Ben Bernanke and Treasury Secretary Henry Paulson. The point here is this – Can we have a bear market in the US without it having to effect markets? The answer to that is very much up in the air.

As in most bubbles, these excesses are aided and funded by over-eager banks.

Back to the fear of recession; tracking and predicting recession are good, but they will not save you from bubbles imploding. Hence it is more important to look for bubbles forming in pockets of markets and economies. Bubbles will also take some time to come to a boil before becoming unsustainable. To pull back on the slightest hint of any bubbles forming would be way too early and will likely turn out to be a disappointing investing strategy.

Fears of recession are healthy but they should not blinker investors into a 0% or a 100% invested decision. In fact markets do continue to perform even during a recession as markets are forward discounting mechanisms (18-24 months forward would be a good gauge).

Fears of recession essentially stem from fears about a major collapse of consumption. As we can see from the recent market corrections, they are a result of bubbles imploding, rather than a consumption-contraction led collapse.

The main reason for that would be that most economies now have more depth and breadth. Pick any of the top 40 countries in terms of GDP and you will discover that their dependence on a single industry are now much less than 20 years ago. For example, in Australia manufacturing took up 29% of GDP back in 1960. Today, it stands at around 10%. Agriculture used to be 25% of GDP but now it is less than half of that. The lack of dominance in any one sector would surely reduce the risk of a collapse in consumption in an economy.

Even though Malaysia's trade in oil and gas, plus CPO, are high, they are not dominant. Manufacturing, business services and property also hold significant chunks of GDP.

The same argument can be made even for the US, which is why we may see a contraction in consumption but not a collapse. A contraction is usually short term and should recover relatively quickly.

With that, scrutinising economic trends and variables with the hope of catching signs of a potential recession may not be as useful or rewarding, as it seem. Keep a lookout for “bubbles” formation and study the variables and developments closely. Most will only look up terminologies such as SIVs (structured investment vehicles) and CDOs (collateralised debt obligation) after the bubbles have imploded.

Typically, bubbles imploding are the major cause of a sharp correction in stock markets as they are big enough to lop off a huge chunk of a certain sector. The fact that bubbles are formed in a sector that eventually morphs itself onto stock market valuations and earnings, further points to the all-encompassing and far-reaching effects of a bubble implosion.

Nassim Nicholas Taleb's books - Fooled By Randomness and The Black Swan -(Note: Black Swan is a surprise event; the black bird was discovered in Australia when all along only white swans were known to exist). attempt to capture randomness of risk and implosions that are hard to plan for. It is hard to capture potential systemic risks by just looking at run of the mill indicators. One must be attuned to possible catastrophe for selected industries as some are exposed to positive Black Swans and others to negative Black Swans.

Financial markets have a very high negative Black Swan. Sound business is often compromised by two factors in financial markets - excessive leverage and inter-connectedness of companies / products/ markets. In many ways, being aware of these two factors would go a long way to better understand potential negative Black Swans of the future.

The other variable for a major correction is a dramatic collapse in business profitability. That is even more unlikely in most economies as they are now broader and not so concentrated in certain sectors.

So, the question arises – Why then should one be possessed by such an overzealous fear of recession?

p/s photo: Kelly Lin