The end of leverage as we know it

Tuesday, September 30: Clearly the voting down in Congress of the bailout package caused complete market meltdown last night. The night had started badly in Asia and Europe, but when Congress voted down the rescue package the markets went into complete meltdown despite shorting bans. That was a crash last night; make no mistake about it.

It's not often you turn on CNBC at 5am and hear Maria Bartiromo tell you "the Dow is down 694 points, off its low for the session"!!!!
Two weeks ago, when I got back from overseas, I wrote: "I was surprised that the Dow hadn't had a down 1000 points down night". Well, that nearly happened last night with the Dow closing on its lows 778 points and the financial system in complete disarray. The VIX index spiked to 47 points, and this was the biggest points drop in the Dows history. US Financials fell 17% despite shorting bans.

Unfortunately the seriousness of these events will dawn on Main Street now and avoiding global recession will be almost impossible (China excluded). At this very moment we have complete counterparty contagion in the financial system with all institutions fearful to do business with each other. This has reached a point none of us thought possible, but it is here and we must deal with it.

The world started pricing global recession last night and quite frankly it's hard to argue against that view. After a decade of cheap money and low lending standards due to the fact lenders could "repackage risk" we now find ourselves going back to the future in terms of leverage. Unfortunately, I suspect we are all underestimating the short-term and long-term economic ramifications of "the great deleveraging".

Three things are certain in the world going forward. One is there will be less credit available; two, the price of that credit will rise to reflect the true default risk, and three, access to that credit will be much harder as lending standards increase dramatically. It is going to be harder and more expensive to access funding for just about all businesses and households in the developed world.

The other certainty is we are all underestimating the "multiplier effect of the great deleveraging" in terms of liquidity in all asset classes. You can see equity market volumes have already collapsed (assisted by shorting bans), while the commercial property markets have ground to a complete standstill. As we all know credit and credit derivative markets are effectively frozen which is the core problem (counterparty contagion).

The daily collapse of investment banks (or in some cases their move to become banks) is just such a monumental event for all forms of liquidity and leverage. We have all taken as a "given" the leverage and liquidity these institutions have pumped into all asset classes over the last decade, but in the heavily regulated and capital constrained world we are moving into there's a likely probability that less than half the leverage and liquidity the investment banks provided will be available. That is in raw terms.

The knock on, or multiplier effects, of this dramatically decreased liquidity and leverage pool are enormous as so many business models were built on the premise that it would always underpin asset classes. I suspect many household balance sheets are also built on the premise of "eternal liquidity". I have to admit I, for one, believed equity market liquidity would always be strong. How wrong you can be.

Many, many people in the hedge fund, private equity, venture capital and commercial property sectors need to consider whether their business model actually exists in the liquidity conditions we now find ourselves in. Perhaps we are moving into a period of "normalised liquidity" as acknowledged by Goldman Sachs and Morgan Stanley abandoning the last bastion of the independent investment bank model and becoming banks.

So I sit here wondering about the future. Not just what tomorrow brings, but what this means from a more medium-term perspective. While many people tell me "Charlie, you're getting worried at the bottom", and I freely acknowledge that's a real chance (Good Lord above I hope it's the bottom), the reality is that the world changed dramatically for the worse when Lehman Brothers was allowed to fail. Now we are seeing the market reality of that decision.

Up until that point it appeared we would be able to muddle our way through this mess, yet we now don't have an investment banking sector globally and that must have seriously negative ramifications for liquidity, leverage and the pace of global growth. It's pretty hard to grow without credit. We may even have to save before we buy something! Also, clearly investor and corporate confidence is completely shot, and it won't be long before consumer confidence is too.

Interestingly, the most vehement criticism I get for "getting worried at the bottom" is from Australian investors over the last two weeks. I have not had one offshore investor or global corporate give me that feedback. It continues to concern me that most Australian's are in denial about the seriousness of these events and their ramifications for Australia. It took me way too long to realise Australia was not immune to a global credit crunch, but I won't make the further mistake of underestimating the second round and multiplier effects of this global credit crunch on the Australian economy.

Economically this is going to get significantly worse before it gets better. That doesn't necessarily mean equity markets get significantly worse before they get better as they are now discounting economic contraction. However, it will be hard for equities to fight the negative sentiment of weak economic data and falling consumer and business confidence. That probably caps the upside in equities in the shorter term. But rest assured, the equity market will bottom six months before the economic data does.

Kicking into the breeze

I did attend the excellent AFL Grand Final on Saturday and spoke to quite a few company directors and leading Australian businessmen. I just wanted to hear their views on the current situation. To a man the responses were "this is the most serious event I have seen in my career" and "I am very concerned about how Australia handles this". "We are monitoring events closely" was a popular response, which translates to "we will be sitting on our hands for a while seeing how this evolves". (i.e. I wouldn't expect much M&A despite prices falling)

As I reported last week, there has been a clear step down in my readings of Australian business confidence over the last week and it suppose then it's no surprise that we have seen stories starting to trickle through about job losses and other cost cutting measures. I suspect most Australian businesses (including resources) are in "batten down the hatches" mode. They are shoring up their balance sheet defences while concurrently attempting to lower unnecessary costs (advertising, contractors, consultants, etc).

If the feeling I get from the leaders of corporate Australia is correct then this move to a highly "defensive" strategy is going to firstly see unemployment tick up and secondly see GDP growth slow more quickly than currently anticipated due to the genuine multiplier effects of their reduced spending.

Australian households have not had to worry about job security for over a decade. In my view job security issues started in the financial sector and are slowly edging into the broader economy. Hiring intentions have also come right down. Perhaps the worst of wage inflation is behind the Australian economy which opens the window for the RBA to lower rates aggressively, however, any rate lowering will have a lagged effect on economic growth/stability.

The question then becomes "can commodities save us"?

Commodities; can they hold on?

A couple of offshore investors have pointed out the complete carnage in the "B.R.I.C" equity markets. The Brazilian (-34%), Russian (-47%), Indian (-32%) and Chinese (-57%) equity markets have been completely belted this year. They then point to the collapse of the "Baltic Dry Shipping Index" and ask the valid question "surely industrial and bulk commodities are next?"

The view is the same hedge funds that generated all their alpha in emerging market equities are still heavily involved in long industrial commodity positions. On a different tilt, with HRC steel and scrap metal prices falling globally many people now believe it is unlikely that the bulk commodity producers will be able to get the expected 20% gains at the next contract price negotiations. Again, a valid concern.

In the last two weeks all the headlines on global growth have been correctly negative. There are reports of the Japanese car makers reducing production, while there are also reports of stockpiles of iron ore and coal building at key Chinese ports. Copper inventories also rose in Asian warehouses.

The question is whether these rising stockpiles/inventories are simply the aftermath of the Olympic manufacturing slowdown, or a genuine reflection of slowing Chinese demand?

The answer is most likely "both". However, the "trading" jury will probably not care what the fundamental reason is and will most likely shoot first and ask questions later as they did the UK last night. I realise Australian resource stocks can't be currently shorted but I do smell some large foreign long only investor selling starting in our resource sector attempting to take advantage of the shorting ban.

You can see UK investors, where you can still short resource stocks, have taken the glass half empty view on the outlook for commodities. BHP and RIO are trading a record discounts to their Australian dual listings (circa 17%), while Xstrata is now trading at less than half the price that Vale offered less than six months ago. This is despite the best balance sheets in the listed world being in large cap global resource stocks.

If you "backsolve" from what the UK resource stocks are pricing (in terms of earnings contraction as implied by the P/E discount to an average P/E), it tells you that a further -20% correction/liquidation of commodities is now expected. That would take the key copper price to around $US2.50 a pound. Interestingly, the CRB index had its worst night ever last night on fears of global recession.

This is all around the "demand side" of the equation. We shouldn't forget that the supply side growth is greatly overestimated as a direct result of the credit crisis and the inability for second and third tier resource companies to source expansion capex. I expect to see further project postponements over the next 12 months and that will lead to reassessment by analysts of the true "supply response".

However, in the short-term and let's face it everyone only cares about the short-term at the moment, we are starting to see analysts wind back consensus commodity price assumptions for 2008-09 which is leading to earnings downgrades.

It does concern me that we have entered another short-term commodity price and resource stock purge. Clearly, there is a plethora of ammunition for the bears and with sentiment so bad in equities it is unlikely anyone will aggressively fight the negative short-term momentum.

For long-term believers in the structural change in commodity prices, such as myself, this is just another buying opportunity, but we may get an excellent and unexpectedly deep value buying opportunity this time around if we do get the genuine "purge" or "capitulation" that seems to have started from offshore investors in resource equities and hedge funds in the physical commodities.

Long-term technical uptrend support kicks in for BHP Billiton around $31.00 and around $88.00 for Rio Tinto. Under any "purge" scenario those technical support levels will be tested, perhaps even today. However, those prices would be low risk entry prices if you are prepared to take the long view.

For those longing for something to sell/take profits in resources that are still holding up well, I'd be directing you to the coal seam gas, underground coal gasification and "wannabe LNG" sectors. This sector is trading on corporate valuations and most don't start producing until 2012. 2012 seems three light years away right now. The game has played out here in the short-term and I'd be very tempted to reduce the load into what appears the closest thing to a full valuation in the Australian resource sector. It would also appear that hedge funds are very long the gas space. Arrow Energy, Queensland Gas, and Origin Energy look vulnerable to profit taking despite the strong long-term fundamentals.

Contractors: had it too good for too long?

With the resource sector watching their share prices fall each day and feeling their margins come down a notch or two it would be fair to expect the sector to then turn some heat up on its suppliers.

It's always baffled me why the resource company majors struggle to command high or even mid single-digit P/Es yet those who supply and service them command up to double the P/Es. How does that work? Surely the suppliers are even MORE leveraged to the underlying commodity cycle? People have very short memories and some of the multiples you see today in the listed service providers to the resource industry seem to neglect the fact this contracting sector has a dramatic history of "boom and bust".

Yes, balance sheets are in dramatically better shape in the contracting sector as we speak, but the point I am making is I can smell a groundswell building in the resource sector about the "price gouging" the contractors did over the last few years. Every contractor or resource services company tells you "we have a great relationship with XYZ". The question I would be asking the contractors and resource service companies is "are you sure you do?"

There could be a little of the "empire strikes back" here as the resource companies feel a little pressure, focus on costs, and postpone projects. In contractors I'd be focused on those who do a high percentage of business for Government in terms of road building and critical public infrastructure as genuinely" defensive debottleneckers", yet those that are basically a leveraged derivative of the commodity cycle I'd be a little careful on from this point.

The tail has wagged the dog in this relationship for the last few years and I just get the feeling the dog (resource companies) is going to be wagging the tail (resource service companies) from this point. You are past the point of peak cycle margins for the mining service companies which most likely means you have also seen peak cycle P/Es.

I'd be very tempted to switch from resource service companies to the big cap resource companies (in to weakness) and save myself around 8 to 10 P/E points.

Into the abyss

We have attempted to write cautionary strategy since I returned from offshore two weeks ago after it became obvious at "that meeting in New York" two Saturday's ago that the financial world as we know it had completely changed. We are witnessing events none of us can believe, and this is our generations 1929.

As I type credit markets are frozen, the world is in total panic, and the ramifications for economic growth are extremely large. Yes, in the long run you should follow Lord Rothschild's' advice to "buy on cannons", but the problem right now is you just don't know when those cannons are going to stop firing.

The problem now moves from hedge fund redemptions to pension fund redemptions and we are going to continue to be pressured by forced selling of equities. Yes, there will be tremendous medium-term bargains through all this, but the key to everything is getting the timing right.

On a positive note you will see coordinated interest rate cuts by the world's central banks, but unfortunately that won't be enough to save us from a very ugly economic period. The next six months may well prove the ugliest any of us have seen. We simply have to acknowledge the magnitude of these events and work our way through their ramifications. Consensus earnings forecasts for ALL Australian companies are too high and will be lowered over the next few weeks.

While we may well get an oversold situation in the next few days the likelihood of a quick recovery from these events is extremely low. Now we have to take our economic and market medicine. Technical uptrend support for the ASX200 kicks in around 4200 points and it wouldn't be out of the question to see that index level hit over the next few months as the reality of the severity of this situation hits home.

On a brighter note, we are all alive and we all have our health and families. The world will eventually get through this horrible mess and this period will be looked back upon as another period of "creative destruction".