Published November 12, 2008

Be wary of rising complacency

By R SIVANITHY
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SIX weeks ago, just after the Straits Times Index (STI) had successfully tested the seemingly firm support level of 2,300 for the second time, this column recommended investors to exercise patience before buying because the worst of the bear market was in all likelihood yet to be seen (Hock Lock Siew, Oct 2, 'Time to buy? No - patience is a virtue').

The arrival of a bottom does not automatically herald the start of a new bull market - stocks can drift for months within narrow channels before any permanent change in direction takes hold.

Since then the STI has crashed by an astounding 30 per cent, led lower by large- scale collapses in Hong Kong and the US where fund redemptions and panic selling have swept the floor out from under stocks.

However, now that prices around the world have fallen to multi-year lows (most markets are at their lowest in about 4-5 years) and governments everywhere have desperately pumped in as much cash as they can spare to shore up the financial system, there seems to be a sense of relief and maybe even complacency creeping back into the markets.

A large part of this complacency stems from bailouts because of the explicit guarantee they provide. The bailouts have even prompted some research houses and investment advisers to start calling a 'buy' on equities on the premise that the worst could be over.

It's likely that stocks are closer to a bottom now than they were six weeks ago before the coordinated rate cuts by central banks, before the UK's bank nationalisation efforts and before the huge international pump- priming packages were announced. But the arrival of a bottom does not automatically herald the start of a new bull market - stocks can drift for months within narrow channels before any permanent change in direction takes hold. So before investors get carried away by the bullish camp which seems to be finding its voice again, it's worth pointing out a few things.

First is that many 'buy' calls are coming from the same bullish brigade that have got it wrong throughout 2008. There is an old adage that if you keep calling a 'buy' long enough, you'll eventually be proven right.

Second is the argument used by the 'buy' brigade that much of the bad news has already been factored into the price, a mantra that was chanted in March when US investment bank Bear Stearns had to be bailed out and has continued to be chanted even as stocks continued to crash over the past seven months.

As the events of the past year have demonstrated, markets are highly inefficient - or at least they are not efficient enough to be able to factor in all that needs to be factored in. All throughout 2008's crash, one thing was painfully obvious: heightened risk was never properly taken into account because of complacency and an over-reliance on over-optimistic valuation models.

Third is that urgings for clients to buy are often tantamount to the selling of hope. The problem is, hope is not an investment philosophy. This is not the time to be telling clients to start buying stocks just because prices have plunged. Recommendations need to take into consideration financial discipline, prudent spending and increased savings. Given the failure of the traditional investment banking/stockbro- king model, what is needed is a large dose of scepticism about all aspects of the financial market, particularly with 'buy' recommendations.

Fourth, and perhaps most important, is the state of the US economy. The fall in oil and commodity prices means that it probably isn't inflation or stagflation that investors have to worry about now; instead, the collapse in housing, credit, labour, banks and stocks means that the incoming Democratic administration will have to grapple with deflation, possibly on the scale that Japan has had to worry about for almost 20 years.

Still, there is one glimmer of hope. Federal Reserve chairman Ben Bernanke has studied deflation in depth and in a lecture six years ago to the National Economists Club said that if deflation were to ever rear its ugly head in the US, the government should place its faith in the power of the printing press and churn out US dollars to reflate or inflate the economy.

So it could be that the US central bank has the right man for the job at the helm, one who is familiar with the economic conundrums posed in a deflationary environment.

Then again, Mr Bernanke did say at the time that deflation was not likely because the US economy was so strong and shockproof, the banking system so robust and well-regulated, and household balance sheets were in such good shape.