Research Watch

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

What do market crises and traffic accidents have in common? They are both caused by over-regulation, which lulls “idiots” into a false sense of security, according to Dylan Grice. In fact, Societe Generale’s resident bear warns that the impending wave of new financial rules is already hurtling investors towards the next global crash: supposedly “risk-free” government bonds. Conversely, that could be good news for equity investors, who are already battling record bearishness from the big investment banks. Bank of America says strategists haven’t been this panicky in 15 years – including after the collapse of the tech bubble and during the aftermath of the global financial crisis in 2008 – a contrarian indicator that suggests stocks could rally 20% over the next 12 months. For the more adventurous, Goldman Sachs’ Jim O'Neill has spotted a disconnect in the pricing of the BRICs that is flashing “buy”, while Citigroup has named and ranked the frontier markets it expects to outperform in the years ahead. We present the Bloomberg investigation China doesn’t want you to see – in which the publisher exposes the extreme wealth of the family of Xi Jinping, the man in line to be China’s next president – and Standard Chartered’s fascinating analysis of the nation’s Google searches, which the bank treats as a gauge of public opinion. Meanwhile, the world’s richest offer their best investment advice, Bob Diamond’s daughter rushes to her father’s defence and, on video, money-manager-cum-country-music-star Merle Hazard goes drag racing towards the fiscal cliff.

A crisis of regulation...

Dylan Grice starts his latest note in the small town of Drachten in Holland, where the removal of road safety measures has doubled traffic flow and resulted in zero fatal accidents. From Grice: “The traffic lights and road signs are well intentioned, but by subtly encouraging us to lower our guard they subtly alter the fundamental algorithm dictating micro-level driving behaviour. This causes a perverse macro-level outcome. You might be thinking that traffic lights don’t have anything to do with the markets we all work in. But I think they do. Instead of traffic lights and road signs think rating agencies; think Basel risk weights for Core 1 and Core 2 bank capital; think Solvency 2; or think of the ultimate market regulators of our currencies – the central banks – and the Greenspan/Bernanke 'put’ which was once imagined to exist. Haven’t these regulators provided the same illusion of safety to financial market participants as traffic safety tools do for drivers? And hasn’t this illusion of safety been even more lethal? The regulations which told banks that AAA-rated bonds were 'risk free’ were designed to make markets safer. But they created an artificial demand for such bonds, which created an incentive for issuers to dress up bonds as 'risk free’ when they were anything but. The regulations effectively incentivised ratings agencies to rate them as 'risk free’ when they clearly weren’t. And today, the same madness is going on in the government bond markets. It’s very difficult to see how government bonds are anything other than 'risk assets’ (let’s face it, all assets are). Yet insurers are buying them because they've been told to 'take less risk’ (whatever that means) by the regulators. So they are taking more risk, and they will one day suffer the consequences. '¦ So, is this crisis one of regulation rather than capitalism? And, if that is the case, are we at risk of adding more idiots to the pile [with a new wave of financial reforms]?” (Dylan Grice of Societe Generale via FT Alphaville, June 29).

A bearish buy signal...

“After triggering a 'Buy’ signal in May, our measure of Wall Street bullishness on stocks declined again, marking the ninth time in 11 months that the indicator has fallen. The 0.8% decline pushed the indicator down to 49.3, the first time below 50 in nearly 15 years, suggesting that sell side strategists are now more bearish on equities than they were at any point during the collapse of the Tech Bubble or the recent financial crisis. Given the contrarian nature of this indicator, we are encouraged by Wall Street’s lack of optimism and the fact that strategists are recommending that investors significantly underweight equities vs. a traditional long-term average benchmark weighting of 60-65%. '¦ The level of the indicator suggests an S&P 500 target of 1,665 in a year, or a 22% return.” (Bank of America, July 2).

An emerging investment opportunity... “Brazil, Russia, India and China, known as the BRICs, will comprise 20% of the world economy this year after growing more than four-fold in the past decade, International Monetary Fund data show. At the same time, their combined stockmarket value has dropped to a three-year low of 16% of the total invested in equities, according to data compiled by Bloomberg. To Jim O’Neill, the chairman of Goldman Sachs Asset Management who coined the term BRIC in a 2001 research report, the 4 percentage point difference makes stocks in these markets irresistible. The last time the gap was this wide, in 2005, the MSCI BRIC Index jumped 53% in 12 months, more than double the gain in the MSCI All-Country World Index. “Unless we are seeing a major collapse of those economies, it’s a huge opportunity for investors,” O’Neill, who helps oversee $824 billion, said. “The BRIC stockmarkets may double by 2020 as their share of world gross domestic product increases to about 27%”, he said. (Bloomberg, July 3).

The 15 hottest frontier markets...
(Citigroup, June 28).

Deconstructing the great firewall of China... “Looking at what’s being searched for on Google in simplified Chinese characters is potentially meaningful in terms of what people in China are really thinking:

1) Concern about the economic slowdown is on the rise; few are thinking about a recovery. But people do not think of this slowdown as a 2008-style crisis. 2) Policy stimulus by Beijing has been noticed, but has not generated as much of a splash as in 2008-09. 3) Inflation concern is falling rapidly; there is little interest in pork prices these days. This should give Beijing more space to loosen policy. 4) Searches for 'wealth’ show a strong correlation with spending. Google searches suggest that as people get wealthier (and presumably search for what they should do with it), they want to spend more on buying cars, travelling, and studying or emigrating abroad. Beijing now faces the challenge of generating wealth without inflating the housing market again.” (Standard Chartered, July 3).

China’s privileged princelings... “Xi Jinping, the man in line to be China’s next president, warned officials on a 2004 anti-graft conference call: “Rein in your spouses, children, relatives, friends and staff, and vow not to use power for personal gain.”' As Xi climbed the Communist Party ranks, his extended family expanded their business interests to include minerals, real estate and mobile-phone equipment, according to public documents compiled by Bloomberg. Those interests include investments in companies with total assets of $376 million; an 18% indirect stake in a rare-earths company with $1.73 billion in assets; and a $20.2 million holding in a publicly traded technology company. '¦ While the investments are obscured from public view by multiple holding companies, government restrictions on access to company documents and in some cases online censorship, they are identified in thousands of pages of regulatory filings. The trail also leads to a hillside villa overlooking the South China Sea in Hong Kong, with an estimated value of $31.5 million. The doorbell ringer dangles from its wires, and neighbours say the house has been empty for years. The family owns at least six other Hong Kong properties with a combined estimated value of $24.1 million.” (Bloomberg, June 29).

Billionaire investment advice... “Peter Hargreaves: 1) Health care: The developed world is getting older, while living standards in the developing world are improving. Medical discoveries and new technologies add to the excitement. The industry’s cash flow and dividends are prodigious. 2) Water: With the population passing 7 billion, the need for water won’t drop. Sales turn into cash flow and dividends very quickly. 3) Technology: Apple is sitting on $100 billion of cash; Microsoft is still one of the big beasts of the tech jungle; Google is dominant in search. Companies are using technology to become more efficient. Consumers want the latest gadget. I see no reason for these trends to end. '¦ Denis O’Brien: Vodafone has an excellent footprint in both wealthy and big emerging markets, such as India. '¦ Bharti Airtel and Millicom International Cellular SA are also undervalued. Phil Ruffin: No stocks. Choose hard assets that have a cash flow and appreciate with inflation. They should cost triple to replace. '¦ Mark Cuban: Unless you know an industry or company better than everyone, keep your money anywhere but the stock market. Pay off debt.” (Bloomberg, July 1).

To Bob Diamond’s detractors... “While most offspring are typically not available for comment following the resignations, voluntary or otherwise, of their banker dads, prolific Tweeter and 2011 Princeton graduate Nell Diamond had this to say to the Brits who have been cheering her father’s departure: “George Osborne and Ed Miliband you can go ahead and #HMD.” (That is, ahem, “hold my d'”k”.) Unfortunately the note has since been deleted and replaced with “'No one in the world I admire more than my dad. 16yrs building Barclays. Shame to see the mistakes of a few tarnish the hard work of so many.” (Deal Breaker, July 3).

At least they're honest...

(via @AntonKriel, July 4)

Video of the Week: Drag racin’ towards the fiscal cliff... Merle Hazard’s latest song takes a humorous look at the US budget crisis that looms as 2012 creeps inexorably toward December 31, when the old budget deal expires.

(PBS, June 27).