Master Rider Blog

The Big Trend

October 9th, 2007 NW Teong

We all know that US economy is slowing down this year, and probably more next year. However, the selected sectors such as energy related sector, and export-oriented sector which include most big tech companies would still be doing well. This is partly helped by a weakening US$ in two ways, one is the made in US products or services are getting more competitive vis-à-vis those from other countries as these are seen to be cheaper when converting to local currencies and second is when these foreign revenues are being repatriated back to US. The added translation gain will further swell the bottom lines of these US companies.

Hence, we have to be extremely careful when investing in stock markets at this juncture. Under the scenario of a slowing economy, we should not get overjoyed simply because US Fed has cut its interest rates. The key thing to monitor is that whether this cut will reverse its course of a slowing economy. In short, we need to go back to the basic. We need to ask ourselves what drives a stock price up? It is not the interest rate and it is also not the cheap currency. Yes, it is the bottom line as well as the potential of making even more money in the future that really attract investors to load up the shares. Of course, the cut in interest rates would help all companies as the cost of borrowing is lower but that does not really affect your decisions to pick the winners. To put it bluntly, a company would still lose money even if the interest rate is zero for a host of reasons (e.g. mismanagement, obsolete technology, wrong cycle, expansion aggressively at the wrong time etc).

Similarly, when an economy is slowing down (or worst still go into recession) which means that many companies are going to slow down too. You see, the aggregate of all outputs of companies forms the economy (You may wish to refer to my book, “The Essence of Stock Investment” to understand the supply and demand side of GDP). So, if we have concluded that the economy is slowing down, we will deduce that companies’ growth would slow down too, we will then deduce that the valuation of the stocks should come down too. What happens to a stock price in a slowing economy? First is the profit contraction and from valuation point of view, the stock price of a stock will need to come down so as to maintain the same valuation (e.g. same price to earning ratio) and the second thing to happen is the valuation or PER contraction. In other words, investors now accord the valuation of the stock at a lower PER as the potential of making more money is simply reverse now.

What happened in the markets in the past few weeks is what I called a “relief rally” which is of course triggered by the aggressive cut of interest rates by the US Fed. Investors feel a great relief that the worst of the credit crisis is over. Of course, the rally also built on the hope that the interest rate cut could reverse the slowing down in the US economy which remains to be seen. As I argued in the past few weeks that this liquidity driven markets are likely to create asset bubbles here and there and would have to be deflated one day. While we continue to enjoy the wild run of these asset bubbles, we have to be mindful that this might be the last leg of a bull run since early 2003. In short, we need to monitor the markets closely and be the first one to run if there are signs of a market meltdown.

My personal take is that there is still a good chance for the regional stock markets to reach record level in the remaining months of the year barring unforeseen circumstances (especially this month). My view is that the 3Q earnings for most US companies should still be respectable albeit those companies directly affected by the sub-prime loan problems. As long as there is no huge disruption in US stock markets, regional markets should continue to do well. If the stock markets are doing well in the final quarter of the year as expected, we should be more careful come 2008. The reason is as explained above, i.e. we are facing with a slowing down US and global economy. I am not saying we should not look at stock markets in 2008, however we have to be more selective in choosing the markets that we wish to invest. Look for markets that are mostly spurred by domestic demand, or sectors that still enjoy strong potential growth looking forward. Cheers!

Master “The Essence of Stock Investment” and ride towards the journey of your financial freedom to be the “Master of Your Own Destiny”!

Disclaimer: Investors are investing at your own risk. Please read full disclaimer at the end of the blog or from the main page of the website.

Entry Filed under: Macro, Stocks, Singapore