By Albert Lim
Investment
director, IPP
Financial Adviser

SEVERAL industry experts have written about the fear and greed that have wreaked havoc and caused billions of dollars to be wiped off from the capital markets. No doubt, most investors are fearful of the markets today. Enough said about the fears. Instead, let's review the situation to try to identify the fitting times to pick up investments of good value.

Down memory lane

The Bretton Woods Agreement was signed into effect in July 1944. Under the Bretton Woods system, each participating country had to adopt a monetary policy that maintained the exchange rate of its currency within a band of fixed value - resulting in a 'pegged rate' currency regime. In practice, the 'reserve currency' used is the US dollar. To boost faith in the US dollar, the US agreed to link its currency to gold at the rate of US$35 per ounce of gold. This allowed countries and central banks to exchange dollars for gold. By 1971, inflation and the cost of the Vietnam War had caused the US dollar to decline in value. The US began to find it more difficult to defend its fixed peg of US$35 per ounce of gold. The Bretton Woods system eventually ceased in February 1973. From that day on, the global financial system has collapsed as money is now backed up by nothing. Since then, every time we have a financial crisis, the only thing governments can do is to inject money and confidence into the system, which has given us a false sense of prosperity.

Ignoring value, fundamentals

The current financial crisis morphed from a credit crisis into a crisis of confidence. When Lehman declared bankruptcy on Sept 15, investors worldwide began to have great doubts in the credibility of financial institutions and whether the financial system will hold up. I think, technically, the real financial system failed when the Bretton Woods system perished in the 1970s. The real financial system collapsed back then when world leaders decided that the US dollar 'reserve currency' need no longer be pegged to gold. A currency backed by nothing tangible is simply an 'IOU' - no difference from the bond notes issued by corporations. The financial system has become a system of faith. We deal only with entities we have faith and confidence in.

Therefore, strictly speaking, the current crisis is really about confidence. Will the system be able to survive this horrible lashing by shaky investors? The answer is probably yes - for now.

With experience gained from the Great Depression, the Asian financial crisis, the bursting of the dotcom bubble and after the 9/11 terrorist attacks, world leaders and central bankers have learned invaluable lessons. Thus far, government leaders and central bankers have been able to restore confidence among investors and in financial markets. Leaders have observed that swift and coordinated action by various governments and central banks is important in re-establishing confidence. However, this time, with new financial innovations, super-leveraged instruments, derivatives and indiscriminate lending, the financial markets are flush with toxic 'assets'. The market size for one type of derivative instrument alone - credit default swaps - was US$62 trillion at the end of 2007. In comparison, world GDP was only US$54 trillion in 2007. This is why financial markets need a lot more money and probably a lot more time to repair the system and restore confidence.

When credit seizes up

The credit squeeze is not only affecting the financial sector, the drying up of liquidity has also affected the real economy. There is hardly any inter-bank lending. This, in turn, means businesses who approach banks for loans are not getting them. Both strong and weak companies that depend on credit are becoming victims. For example, the shipping industry, which relies on letters of credit, is stuck. The Baltic Dry Index has fallen an alarming 90 per cent since January 2008.

Deleveraging effects

The financial markets need to go through a huge amount of deleveraging. Past several years of easy credit and ready access to funding has fuelled a boom in investment management industry, housing and consumer spending. We will be going through a period of clean-up, where people revert to buying property priced at a level they can afford, consume within their means and invest with care.

Where the economy is going

The real economy undoubtedly will go through a slowdown. However, the equity markets are traditionally a leading indicator, racing ahead before the real economy. Value and opportunities are coming into view in Asia and emerging markets. In terms of fixed income, those with shorter duration will benefit with more interest rate cuts to come. Some companies are trading at 1x PE, yet hardly anyone is interested in them. Fundamentals are being ignored now. Everyone is fearful of further horrible fallout. To get a grip on our fears, perhaps we should put our risk appetite and investment horizon into perspective.

When do we invest?

Recently, I have been using this analogy a lot when communicating with clients about when to invest. Imagine this scenario: you are a prospective house buyer and you have your eyes on a lovely house in a charming neighbourhood. Do you buy:

• 1) When the house is on fire and at risk of being razed to the ground?
• 2) When a large part of the fire has been put out, but there are kindlings that may erupt into flames?
• 3) When the fire has been put out and renovation works begins?
• 4) When the house if fully renovated?

If you choose (1), you will likely get your house at a fire-sale price but you are taking very high risk. If you choose (2), you will likely get a cheap price but there is still a risk of a new fire restarting. However, the large fire has been mostly put out. If you choose (3), you will still get a bargain but the risk lies in the possibility of the renovation taking a long time. If you choose (4), you pay full price for a renovated house.

Today, we are at the stage where the main fire, which represents the credit system seize-up, is largely extinguished. But there are still some small fires to deal with. The global stock market is rebounding not because of improved fundamentals but rather for the reason that the financial system is still intact. I think that investors who have a mid to long-term horizon and can take on some risk should choose option (2) or (3). At the end of day, investments come with risk. We should be taking calculated risk, be comfortable with it and understand it.

This article was first published in The Business Times on November 08, 2008.