A Time for Conviction

After six weeks in the bear suit, I'm officially taking it off. It had been getting itchy and uncomfortable, so I'm wrapping it in plastic and putting it back behind the "safety glass" for another day.

A leading fund manager understands my change of attire. “You couldn't wait to take the bear suit off; you hate being bearish”, he said, and he was absolutely right: bearishness and pessimism simply don't come naturally to me. I will only put on the bear suit begrudgingly when absolutely necessary, at market and sentiment extremes, and for me it's pretty similar to a "Break Glass in Case of Emergency" situation.

In just one trading month, we have see the benchmark ASX200 reverse 657 index points from intraday trading high of 5407 on the "euphoric" post federal budget day, to a low of 4757 (mid-week). That's a 12% trading correction from "euphoria" to "capitulation", all driven by macro-economic fears and leveraged investor liquidation; not earnings or dividends. Smaller caps have been hit harder than large caps, and "lobster pots" are everywhere.

The most volatile periods in equity markets are always between earnings seasons, when investors and traders alike have no choice but to focus on macro-economic data and liquidity. There's no stock specific news, so macro prices the market. This is exactly the time when you should be focused on stock specifics, and be taking advantage of the fact that appropriate equity risk premium has been priced back in.

Manic to panic in just 30 days

Over the past few trading sessions we saw some panicky trading action, with "stop losses" from leveraged players being triggered as prices fell. It actually appeared that "stop losses" were triggering "stop losses" at lower levels, in a sort of leveraged "domino effect". You could see the unprecedented effect of contracts for difference (CFDs), margin lending, principal trading, and options through the capitulation phase.

Hedge funds have played the key role in the trading correction, with a tightening of liquidity by the Bank of Japan being the trigger for leveraged liquidation. One thing you can be sure of is the world grossly underestimates how much leveraged money now plays in all asset classes. They probably won't again after the events of the past month.

The way this all works now is people who have borrowed in Japan and invested in US equities then use those US equities as collateral for investing in emerging markets, then use the collateral from their emerging markets investments to invest directly in oil, then use their collateral from oil to invest directly in base metals. It's like the ultimate leveraged pyramid scheme, and when the cost of borrowing in Japan rises, and US equities fall simultaneously, the whole pyramid scheme falls apart because the amount of "equity" the investor physical has is minimal. You can see the final "dominos" fell last night, with the gold and copper prices being dealt with aggressively.

While everyone was looking for a catalyst for the capitulation, and most ended up blaming Ben Bernanke (are we serious?), the truth about the capitulation is that leveraged investors and short-termists have been forced to liquidate related long positions across all higher-risk asset classes. It has been a total and textbook sentiment capitulation, and almost identical to what occurred at the bottom of the October 2005 trading correction.

If the world is truly concerned about inflation and the US Federal Reserve being behind the curve, why are US bond yields rallying? Surely, if the world truly were about to end in an inflation and interest rate bloodbath, US bonds would be 200 or 300 basis points higher than they are today. The rally in bonds also improves the relative valuation of equities versus bonds; with the equity earnings yield in Australia now 7% versus long bond yields of 5.7%. That's a key development to focus on as it shows you this is just a trading correction, albeit an almighty one in an era of unprecedented access to leverage.

Only as good as your next call

I've had many very supportive emails from readers over the past few weeks, and it is encouraging that investors, company directors, and corporates take the time to reply to these notes.

However, I have gone back through some of my old writings although I called a trading correction and recommended caution as such, I did also make some other forecasts that have turned out to be dreadfully inaccurate.

Some has proved accurate and well timed, including all the stuff about "pass the parcel", "leverage", "up by the stairs; down by the elevator"," pretty girls and the bus crash", "when you see a bandwagon it’s too late", "rotation to quality", "cash raising", "index protection", "Bellevue Hill cocktail parties and Oxiana", and small cap "lobster pots".

However, I also wrote that gold would prove defensive through the volatility '” and gold has fallen $US150 an ounce! I also wrote that the trading damage in resource leaders would be significantly less than in mid and small caps, and that's only marginally the case. I thought 4900 would be the low of the correction, but we did go 150 points below that at one stage; I also thought the ASX20 would outperform the ASX200, which it did, until leveraged investors realised the only place they could actually raise cash was in the large-cap liquid stocks.

So, while I got a few things strategically right, I also got a few wrong, and that's what I love about markets. They are always trying to teach you who is boss, and always testing your ability to react appropriately. They are always testing your ability to learn from your mistakes. They are also always testing your pain threshold and mental constitution.

I'm certain that emerging with the highest-quality, longest-duration, highest barrier to entry, strongest balance sheet, highest return on equity, best run, excess capital, highest margin, lowest geared, oligopoly or duopoly companies, that possess clear final pricing power is the way to generate outperformance from this point.

This is not the start of a bear market; this is a trading correction in a bull market. This is an opportunity to accumulate the highest-quality Australian companies at appropriate risk-adjusted prices, and now that leveraged money has exited the space, it actually means we can move higher without the load of expectation. Our strongest medium-term, large cap recommendations remain BHP Billiton, Rio Tinto, Woodside Petroleum, News Corporation, Cochlear, Wesfarmers, Brambles, Lend Lease, Caltex Australia, Commonwealth Bank, St George Bank and Suncorp-Metway, and you should be accumulating all of them.

The natural human response to volatility is to run and hide, and get as far away from the volatility as possible. The idea is to wait for the storm to pass, and then return to a calmer and safer environment. That's fine if you are talking about weather strategy, but when it comes to investing strategy, it's exactly the wrong course.

Twice a year the opportunity to make serious money, and generate serious outperformance, presents itself in the equity market. Right now is one of those times. To do nothing is the wrong answer. To do nothing would be like walking past a roll of hundred-dollar bills in the street. To do nothing now is as flawed a strategy as it would have been to do nothing a month ago, when the market was at record "euphoric" highs.

I can see the cynics saying, 'Charlie, you're a broker, you live on transactions." Incorrect, this firm only has a business if we consistently make clients money. If you don't make people money, you won't have any transactions to do. It doesn't work vice versa. I urge you to act when we see "clear and present" opportunity, and particularly when we see irrational price action and forced liquidity.

Right now is one of those periods that require unusual conviction. It requires psychological strength that is beyond the average investor. It requires a calmness that is beyond the average investor, and it also requires a steely focus that is beyond the average investor. But most of all it requires strength of conviction to act on instincts honed by experience. You need to be able to pull the trigger, not just take aim at the targets.

My first job was as trainee futures trader on the floor of the Sydney Futures Exchange. It was an open outcry system, and to a novice 19-year-old, it was the best education in supply/demand, fear/greed, that you could get.

What I observed was that the biggest money-making opportunities came at extremes of volatility, and the guys who made the most money were the traders who stood up on those extreme days. The best traders didn't trade every day, or trade for the sake of trading; they held their firepower back for extremes (stop losses, etc), and when everyone else was running out of firepower, they unleashed theirs.

The liquidity and mass psychology lessons of the futures floor have stayed with me, and that's why I remain certain that the right course of action in periods of extreme volatility is to act with an educated calmness and conviction.