Research Watch

Are the bulls ready to run, or should we de-equitise altogether? Facebook's loss of face, Paris Hilton's love life, and on video: Greece's exit strategy.

PORTFOLIO POINT: This is a sampling of the week's best research notes. In a world of too much information, we hope our selection helps you spot the market's key signals.

As stockmarkets continue to slide the world over, many investors have found comfort in the hope that the foundations are now being laid for the next big bull market. Some forecasters say stocks will turn in weeks, others in months or years. But Citigroup has broken from the pack with a bold warning that the return of the so-called “equity cult” might still be decades away. In the meantime, Deutsche Bank points out that de-equitisation can actually be a positive for investors '” who benefit from increased capital returns '” and explains why it expects the number of shares on issue will continue to fall. As for the general direction of markets, Societe Generale finds some ominous lessons in Japan’s lost decade, as Jeff Saut provides a more up-beat forecast based on the political cycle. At Bronte Capital, John Hempton defends the bankers involved in Facebook’s IPO, while ANZ tells local investors not to worry about reports of defaults from Chinese commodity buyers, and UBS identifies a trend that should provide some support for the Australian dollar. Analysts calculate Spain’s likely bailout bill, while Europeans should find some hope in Paris Hilton’s sad love life. And on video, JPMorgan’s head equity strategist outlines three likely scenarios for skittish stockmarkets.

The rise and fall of the equity cult...

“Global investors spent the second half of the 20th century raising their equity weightings, mostly at the expense of bonds. The associated re-rating culminated in the late 1990s bubble. Since then, two 50% bear markets have taken their toll. '¦ The equity cult looks dead in Continental Europe and Japan. These are the geographies where deep value contrarian investors, whether corporate or institutional, should be focusing their attentions right now. '¦ [In the US, Canada and Australia], the equity cult looks sickly if not defunct. One noticeable exception is Emerging Markets, where stocks markets continue to attract investor flows and corporate issuance.

This does not mean that we are bearish on the asset class. Indeed, we can see de-equitisation as the natural corporate response to the high cost of capital prevalent (low PE) across most equity markets. The corporate has become the key marginal buyer. This powerful force should eventually clear the oversupply, but it is a long process. In the meantime, de-equitisation should continue to reshape the global corporate sector. Capex should remain constrained. Investor desire for companies to return capital will likely remain considerable. Lowly rated mega caps should remain under intense pressure to realise value through break-ups.

We would love to see the cult of equity make a re-appearance soon, but are not counting on it. The 1990s represented the peak of a 50-year investor shift away from bonds to equities. At just 12 years old, the shift back the other way still looks immature.” (Robert Buckland, chief global equity strategist at Citigroup, via Business Insider, May 26)

And the curious case of vanishing stocks... “The total amount of equities has been steadily decreasing recently, as companies engage in share buy backs while simultaneously issuing fewer shares to investors and employees. That trend will likely continue to accelerate, said David Bianco, strategist with Deutsche Bank. “High cash, strong free cash flow generation and abundant unused debt capacity suggest that this vanishing of equities will accelerate despite higher dividend payout ratios,” he said. Share buy backs, of course, are considered good things for many investors. Like dividends, repurchasing shares is a way to return money to shareholders. As well, such a move signals a vote of confidence from the company. The recent spate of buy backs come as companies on the S&P 500 are sitting on massive cash reserves, a direct result of cost cutting measures carried out following the financial crisis. '¦ Deutsche Bank estimates that companies on the S&P 500 will generate about US$500 billion in surplus free cash flow in 2012 and 2013, even after higher dividend payouts and capital expenditure spending are taken into account. '¦ And it’s not just cash on hand companies can use to buy their equities. Bianco points out that non-financial firms on the S&P 500 tend to have low leverage compared to historical figures, leaving them the option of using debt to fund buy backs as well.” (Financial Post, May 29)

The end of the bear market rally...

“SocGen thinks the next EU summit could be crucial in determining the next move in developed world stock markets: “A Japanese-style scenario for the eurozone could gain traction, particularly if the 28-29 June EU summit fails to deliver concrete results. The capacity of European leaders to agree on the eurozone’s future is key to restoring the Greek population’s confidence and avoiding social unrest. In contrast, if the outcome is paralysis we can expect equity markets to plunge even deeper, to 2009 levels and even below if the Japanese-style scenario were to materialise.” (Societe Generale via Money Game, May 29)

Facebook’s ethical investment bankers'¦ “The buy-side customers of investment banks have got used to playing in a little game of theft [from bank clients selling IPOs]. We – as buy-siders – like to be able to buy IPOs and have instant stag profits. '¦ The moral corruption of investment banks not only became accepted but we redefined morality around what investment banks did rather than what they should do. '¦ Not only have people with hurt hip-pockets complained about the Facebook IPO, their supplicants in the press have been sucked into supporting the buyers same self-interested immorality. The Wall Street Journal derides Michael Grimes (the Morgan Stanley banker) for not standing up to David Ebersman (Facebook’s CFO) and allowing Facebook to sell too many shares at too high a price. This is tits-up-backward. David Ebersman in this context is the client. He paid the fees. Michael Grimes had a duty to act in Ebersman’s interest. Ebersman wanted to sell more shares at a higher price. Michael Grimes and Morgan Stanley obliged even at the cost to their own franchise. And for that he is being pilloried in the press. What we have here is an investment banker acting ethically. And the whole financial press is a twitter about it.” (John Hempton of Bronte Capital, May 29)

Calculating Spain’s bailout bill... “If a Spanish EU/IMF bailout package covered the government’s gross funding needs through the end of 2014, and included €75 billion for bank recapitalisation, then it would amount to around €350 billion. A traditional package would keep the burden of adjustment squarely on the shoulders of the Spanish taxpayer. Spain could be accommodated in the liquidity hospital as currently designed, but a Spanish admission would force the region to think hard about both the size of the fiscally based liquidity hospital and its funding. It would push the region closer to a hybrid liquidity hospital, where governments provide capital and the ECB provides funding.” (JP Morgan via Zero Hedge, May 30)

China’s rich head for the exit... “EB-5, a little-known programme in the US designed to attract more foreign investment, has seen a surge in interest from Chinese applicants as the country’s wealthy look to settle abroad or at least secure foreign citizenship. The programme, which grants a green card to any foreigner who invests at least US$500,000 in a business that creates 10 jobs in the US, received 2,408 Chinese applications last year, compared to just 772 in 2010, and 63 applications in 2006... Chinese applicants accounted for 70% of the global total last year and demand shows no sign of abating. '¦ Topping the list of reasons for emigration is the deteriorating quality of life – including fear over worsening pollution, food safety scandals and inadequate social services. A desire for better medical treatment and access to an US education were also cited. '¦ For all its economic gains, it seems fewer and fewer of China’s elites have faith in the country’s ability to protect them or their wealth.” (Beyond Brics, May 24)

But never mind Chinese defaults... “Chinese [commodity] buyers have a long history of not showing up with the cheque when the cargo lands, in what is termed locally, a “wash-out trade”. We saw a string of defaults in 2009 and again in 2011 in the copper sector, to the point where European scrap metal dealers were unwilling to ship material until full payment had been made. '¦ [But] trade recovered after the defaults in copper and soy and the defaults dried up as soon as prices started to rise again and will likely recover in coal and other products, once prices stabilise. '¦ In coal markets, the defaults are centred on shipments from Indonesian producers in the next 1-2 weeks for lower quality grades, which are instead being diverted elsewhere. We think the key reason is the 13% decline in physical coal prices to US$92/tonne over the past seven weeks. There appears to be an oversupply in the market, with top consuming nations, China & India running down inflated domestic stockpiles, while supply from the US, Colombia and Russia continues to hit Asian markets. A call around to major Australian coal producers found no signs of Chinese shipment defaults. There was anecdotal evidence of a slowdown, but only in relation to smaller Chinese traders at this stage. Where they were feeling the pinch was from lower prices, believing that many of the smaller producers must now be operating near break-even levels. '¦ Our short term view is that spot coal price activity will remain subdued until the latter part of Q3, by which time a pick-up in China’s seasonal demand should start to reduce the current high supply overhang.” (ANZ Research, May 28)

M&A and the $A... “Cross-border merger and acquisitions affect the foreign exchange markets through both an initial 'announcement’ effect and the associated flow which follows. The announcement of a potential deal tends to cause FX volatility even though there may or may not be any direct FX flow, and usually there is a 'self-fulfilling prophecy’ at play, as FX primary dealers mark down the potential future flow. Various studies suggest that the associated flow from the deals rarely tends to influence FX markets, but the anticipation of this flow does. One of the main determinants behind subsequent FX moves is the liquidity of the underlying market, and inevitably, speculation of, and associated flow from cross-border transactions tends to have a bigger impact on the illiquid crosses. '¦ Even if a deal falls through, it can still move the market. Little data is available, though, due to the secrecy and privacy generally associated with these deals. After the 'announcement effect,’ M&A flow will depend on the deal and what type of financing is used: ... share transfers (no effect), debt certificates or loans (an effect if not issued in local currency), and cash (an effect if in foreign currency and must be traded). Furthermore, any FX hedging can be undertaken, which will have an effect, too. In the liquid crosses, deals must be of substantial size before affecting the market. '¦ liquidity in the euro-dollar market for example was substantial enough to absorb up to $3 billion if spread out over several days. '¦ Trends in cross-border M&A are still important and we believe currencies which have direct associations with industries which have a high propensity for cross border flow [such as the Australian dollar] will marginally benefit from this.” (Chris Walker of UBS via FT Alphaville, May 28)

Following the presidential year script...
(Bespoke Investment via Jeff Saut, May 29)

The Hilton indicator... “According to a press report, Paris Hilton has been dumped by [a Dutchman named] DJ AfroJack, who is someone that we have never heard of. Not only is it the way was she dumped, but the articles about her are filled with snarky items about how she’s over [now that she's 31]. '¦ We hadn’t realised that things had gotten so bad for her, but then it actually makes perfect sense. Paris Hilton’s dating habits have always been an important macro economic indicator. '¦ When she was dating hoteliers in 2004, you knew that the real estate boom was peaking. Then she switched to dating Greek shipping heirs (remember Stavros Niarchos?) right around the time that the commodity super-cycle was peaking in 2006-2008. Then that went bust. '¦ Our only conclusion is that with Paris hitting rock bottom (getting dumped by a Dutch nobody and having her friends make fun of her for being 31) coincides with the bottom for things in Europe.” (Business Insider, May 30)

Germans are incapable of enjoying life... “A recent study by Rheingold, a market-research and consultancy institute based in Cologne, found that 46% of Germans say they are increasingly unable to enjoy anything due to the stress of everyday life... The difficulty was even more pronounced among the study's younger participants, 55% of whom claimed to feel they have lost their ability to feel good. Whether it’s with food, alcohol, vacation or relaxing – Germans apparently don’t have the leisure to enjoy things. '¦ According to the researchers, the bottom line is: “Our joy gene is increasingly defective – we’ve forgotten how to enjoy ourselves.” (Der Spiegal, May 24)

Video of the Week: Three paths for equities... Thomas Lee, JPMorgan’s top US equity strategist, lays out some scenarios for a Greek exit from the eurozone, and how it could affect equity markets. According to Lee, the odds of an exit are currently about 50%.


(Bloomberg, May 11)