Investment Management Blog - Montague Capital

If Asia’s markets this morning are any guide, the UK and Europe are not going to be striking out on an independent course after last night’s 7.3% collapse on Wall Street.  At the time of writing, the Nikkei may be off its worst for the day, but it’s still down 7.6%.  To what do we attribute this fresh bout of nerves?  And can anything be done about it?

First suspect up is the removal in the US of the ban on short selling.  This doesn’t wash.  US bank stocks have collapsed even while the ban was in place.  If a company is rubbish, investors will have no hesitation in dumping the “underlying”.  Replacing the ban wouldn’t achieve anything.  So no joy there then.

Next up is a fresh panic in the US about the true state of the “rescued” US financial system.  The market has been digesting Paulson’s remark two days ago that banks could yet fail.  Insurers, whose difficulties were not explicitly addressed by The Plan, are now in the sights too.  And Paulson has woken up to the fact that a UK-style state recapitalisation of the banks is not such a bad idea after all, even though it wasn’t invented in the great US of A.  It would have helped if this had been in the original script, as it has re-introduced anxieties that shouldn’t be there.

But most damaging is how the illness is now spreading out across the wider market and to a broader class of investor.  The prospect of recession wiped about one-third off the value of General Motors.  Speculation abounds that it may be beaten into the bankruptcy courts by Ford.  Panicked reactions both, but understandable when US new car sales in 2009 look set to fall by about a fifth and only the Japanese make the sorts of cars for which there is still a demand.

As for professional investors, Robert Tchenguiz provides a good illustration of the second-stage effects at work.  He is a big customer of the failed Icelandic bank Kaupthing.  When his lender found itself facing the grim reaper, it began to call in its loans, perfectly prepared to throw its customers to the wolves if that is what it would take to keep itself in business.  As a result Tchenguiz finds himself having to dump big chunks of his tottering empire, for example Mitchells and Butlers, at whatever price he can get.

Less spectacularly (or vicariously), but perhaps more insidious, falls in share prices now seem to be triggering covenants which mandate positions to be reduced or sold outright.  Sadly, this increase in selling pressure does nothing to remedy the initial problem.

Ironically, however, this mechanistic reaction does offer a glimmer of hope.  The big index funds are constantly comparing actual with target weights.  Even though they are “index” funds, these two weights are not always the same thing.  Like Martinis, index funds can have a “twist”.  And being big, achieving that “twist” can translate into some big transactions.  With markets falling as they are, that is now more likely to be achieved through purchases to top-up on stocks that have been battered.  Index funds tend, sadly, to be indifferent to what a company may really be worth, but right now this could help

Secondly, with the luxury of a few hours in which to think rather than just panic, what should now be taking place is a comprehensive re-assessment by the big institutions of companies’ fundamentals.  Many will doubtless have changed for the worse.  With recession now inevitable and of uncertain duration, there are whole chinks of the market which should be off limits even though they are apparently “cheap”.  And anyway cheapness needs a whole new definition, as it not now based on what prevailed in the market’s boom times as much as on what will pass for acceptable over the next couple of years.  One vital difference there is that there is going to be nothing like as much spare cash around to drive prices up.  Valuations come down and recovery doesn’t happen overnight.  “A prescription for some patience tablets please Doctor.”