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Wednesday, September 28, 2011

A rumor-driven and politics-driven market

The Euro solution: Dissolution of EU or a United States of Europe?

THE EURO: A Machine Of Perpetual Destruction

Rolling blog: The eurozone crisis by Financial Times

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Rolling blog: the eurozone crisis | The World | International affairs blog from the FT – FT.com

Goldman Sachs rules the world: UK trader


A financial trader in London caused a storm of outrage by suggesting that world leaders cannot do anything to prevent a global market collapse, saying that investment bank Goldman Sachs ruled the world.

Alessio Rastani's comments on BBC Television on Monday have gone viral, viewed by more than 360,000 people, but they fit so closely to the stereotype of a heartless banker that rumours are rife that he is actually part of a hoax.

Answering questions about world leaders' response to the eurozone debt crisis, the 34-year-old said traders "know the stock market is finished. The euro, as far as they're concerned, they don't really care".

"Goldman Sachs rules the world" ... Alessio Rastani.

"For most traders, we don't really care that much how they're going to fix the economy, how they're going to fix the whole situation, our job is to make money from it," he said.

"Personally I've been dreaming of this moment for three years. I have a confession, which is I go to bed every night, I dream of another recession."

As the BBC presenter looked on in shock, he added: "The governments don't rule the world. Goldman Sachs rules the world. Goldman Sachs does not care about this rescue package, neither does the big funds."

A Goldman Sachs spokeswoman said the bank had no comment. (Probably this is what they've been doing :P)

The remarks by Rastani, described by the BBC as an independent trader, caused a storm on Twitter and in British newspapers, and prompted Spanish Finance Minister Elena Salgado to brand him "mad and immoral."

The Daily Mail website said it was the "moment trader told shocked BBC presenter the City just LOVES an economic disaster," while The Independent described him as "the trader who lifted the lid on what the City really thinks".

The Guardian asked readers in an online poll if they were shocked, with two options: "No, this is how capitalism works", or "Yes (but only by his honesty)".

Asked about his warning that millions of people's savings could vanish in the next year, Salgado said this was not the case as savings were guaranteed across Europe.

"He thinks that he can get money simply with this threat, with this statement," she told Spanish public television TVE.

"So he is not only mad, he is mad and immoral."

Other commentators meanwhile speculated that Rastani was simply expressing views in public that were privately held by many.

BBC business editor Robert Peston said on Twitter that Rastani had merely "voiced what traders working for big firms and funds say in private," while the Financial Times asked in a blog entry "Do traders dream of defaulting Greeks?"

Some media reports have suggested Rastani is a member of The Yes Men, a US-based protest group who claimed responsibility for a bogus report in 2004 on the BBC that Dow Chemical would compensate victims of the Bhopal disaster.

In an interview with Forbes website, he denied he bore any resemblance to the fictitious Dow spokesman who orchestrated that hoax and insisted he was a genuine trader who worked for himself.
The BBC also stood by him, saying it had carried out "detailed investigations" but could find no evidence to suggest Rastani was not what he claimed.

Monday, September 19, 2011

Does the euro have a future? | The Great Debate by George Soros

By George Soros
The opinions expressed are his own.
 
The euro crisis is a direct consequence of the crash of 2008. When Lehman Brothers failed, the entire financial system started to collapse and had to be put on artificial life support. This took the form of substituting the sovereign credit of governments for the bank and other credit that had collapsed. At a memorable meeting of European finance ministers in November 2008, they guaranteed that no other financial institutions that are important to the workings of the financial system would be allowed to fail, and their example was followed by the United States.

Angela Merkel then declared that the guarantee should be exercised by each European state individually, not by the European Union or the eurozone acting as a whole. This sowed the seeds of the euro crisis because it revealed and activated a hidden weakness in the construction of the euro: the lack of a common treasury. The crisis itself erupted more than a year later, in 2010.

There is some similarity between the euro crisis and the subprime crisis that caused the crash of 2008. In each case a supposedly riskless asset—collateralized debt obligations (CDOs), based largely on mortgages, in 2008, and European government bonds now—lost some or all of their value.

Unfortunately the euro crisis is more intractable. In 2008 the U.S. financial authorities that were needed to respond to the crisis were in place; at present in the eurozone one of these authorities, the common treasury, has yet to be brought into existence. This requires a political process involving a number of sovereign states. That is what has made the problem so severe. The political will to create a common European treasury was absent in the first place; and since the time when the euro was created the political cohesion of the European Union has greatly deteriorated. As a result there is no clearly visible solution to the euro crisis. In its absence the authorities have been trying to buy time.

In an ordinary financial crisis this tactic works: with the passage of time the panic subsides and confidence returns. But in this case time has been working against the authorities. Since the political will is missing, the problems continue to grow larger while the politics are also becoming more poisonous.

It takes a crisis to make the politically impossible possible. Under the pressure of a financial crisis the authorities take whatever steps are necessary to hold the system together, but they only do the minimum and that is soon perceived by the financial markets as inadequate. That is how one crisis leads to another. So Europe is condemned to a seemingly unending series of crises. Measures that would have worked if they had they been adopted earlier turn out to be inadequate by the time they become politically possible. This is the key to understanding the euro crisis.

Where are we now in this process? The outlines of the missing ingredient, namely a common treasury, are beginning to emerge. They are to be found in the European Financial Stability Facility (EFSF)—agreed on by twenty-seven member states of the EU in May 2010—and its successor, after 2013, the European Stability Mechanism (ESM). But the EFSF is not adequately capitalized and its functions are not adequately defined. It is supposed to provide a safety net for the eurozone as a whole, but in practice it has been tailored to finance the rescue packages for three small countries: Greece, Portugal, and Ireland; it is not large enough to support bigger countries like Spain or Italy. Nor was it originally meant to deal with the problems of the banking system, although its scope has subsequently been extended to include banks as well as sovereign states. Its biggest shortcoming is that it is purely a fund-raising mechanism; the authority to spend the money is left with the governments of the member countries. This renders the EFSF useless in responding to a crisis; it has to await instructions from the member countries.

The situation has been further aggravated by the recent decision of the German Constitutional Court. While the court found that the EFSF is constitutional, it prohibited any future guarantees benefiting additional states without the prior approval of the budget committee of the Bundestag. This will greatly constrain the discretionary powers of the German government in confronting future crises.

The seeds of the next crisis have already been sown by the way the authorities responded to the last crisis. They accepted the principle that countries receiving assistance should not have to pay punitive interest rates and they set up the EFSF as a fund-raising mechanism for this purpose. Had this principle been accepted in the first place, the Greek crisis would not have grown so severe. As it is, the contagion—in the form of increasing inability to pay sovereign and other debt—has spread to Spain and Italy, but those countries are not allowed to borrow at the lower, concessional rates extended to Greece. This has set them on a course that will eventually land them in the same predicament as Greece. In the case of Greece, the debt burden has clearly become unsustainable. Bondholders have been offered a “voluntary” restructuring by which they would accept lower interest rates and delayed or decreased repayments; but no other arrangements have been made for a possible default or for defection from the eurozone.

These two deficiencies—no concessional rates for Italy or Spain and no preparation for a possible default and defection from the eurozone by Greece—have cast a heavy shadow of doubt both on the government bonds of other deficit countries and on the banking system of the eurozone, which is loaded with those bonds. As a stopgap measure the European Central Bank (ECB) stepped into the breach by buying Spanish and Italian bonds in the market. But that is not a viable solution. The ECB had done the same thing for Greece, but that did not stop the Greek debt from becoming unsustainable. If Italy, with its debt at 108 percent of GDP and growth of less than 1 percent, had to pay risk premiums of 3 percent or more to borrow money, its debt would also become unsustainable.

The ECB’s earlier decision to buy Greek bonds had been highly controversial; Axel Weber, the ECB’s German board member, resigned from the board in protest. The intervention did blur the line between monetary and fiscal policy, but a central bank is supposed to do whatever is necessary to preserve the financial system. That is particularly true in the absence of a fiscal authority. Subsequently, the controversy led the ECB to adamantly oppose a restructuring of Greek debt—by which, among other measures, the time for repayment would be extended—turning the ECB from a savior of the system into an obstructionist force. The ECB has prevailed: the EFSF took over the risk of possible insolvency of the Greek bonds from the ECB.

The resolution of this dispute has in turn made it easier for the ECB to embark on its current program to purchase Italian and Spanish bonds, which, unlike those of Greece, are not about to default. Still, the decision has encountered the same internal opposition from Germany as the earlier intervention in Greek bonds. Jürgen Stark, the chief economist of the ECB, resigned on September 9. In any case the current intervention has to be limited in scope because the capacity of the EFSF to extend help is virtually exhausted by the rescue operations already in progress in Greece, Portugal, and Ireland.

In the meantime the Greek government is having increasing difficulties in meeting the conditions imposed by the assistance program. The troika supervising the program—the EU, the IMF, and the ECB—is not satisfied; Greek banks did not fully subscribe to the latest treasury bill auction; and the Greek government is running out of funds.

In these circumstances an orderly default and temporary withdrawal from the eurozone may be preferable to a drawn-out agony. But no preparations have been made. A disorderly default could precipitate a meltdown similar to the one that followed the bankruptcy of Lehman Brothers, but this time one of the authorities that would be needed to contain it is missing.

No wonder that the financial markets have taken fright. Risk premiums that must be paid to buy government bonds have increased, stocks have plummeted, led by bank stocks, and recently even the euro has broken out of its trading range on the downside. The volatility of markets is reminiscent of the crash of 2008.

Unfortunately the capacity of the financial authorities to take the measures necessary to contain the crisis has been severely restricted by the recent ruling of the German Constitutional Court. It appears that the authorities have reached the end of the road with their policy of “kicking the can down the road.” Even if a catastrophe can be avoided, one thing is certain: the pressure to reduce deficits will push the eurozone into prolonged recession. This will have incalculable political consequences. The euro crisis could endanger the political cohesion of the European Union.

There is no escape from this gloomy scenario as long as the authorities persist in their current course. They could, however, change course. They could recognize that they have reached the end of the road and take a radically different approach. Instead of acquiescing in the absence of a solution and trying to buy time, they could look for a solution first and then find a path leading to it. The path that leads to a solution has to be found in Germany, which, as the EU’s largest and highest-rated creditor country, has been thrust into the position of deciding the future of Europe. That is the approach I propose to explore.

To resolve a crisis in which the impossible becomes possible it is necessary to think about the unthinkable. To start with, it is imperative to prepare for the possibility of default and defection from the eurozone in the case of Greece, Portugal, and perhaps Ireland.

To prevent a financial meltdown, four sets of measures would have to be taken. First, bank deposits have to be protected. If a euro deposited in a Greek bank would be lost to the depositor, a euro deposited in an Italian bank would then be worth less than one in a German or Dutch bank and there would be a run on the banks of other deficit countries. Second, some banks in the defaulting countries have to be kept functioning in order to keep the economy from breaking down. Third, the European banking system would have to be recapitalized and put under European, as distinct from national, supervision. Fourth, the government bonds of the other deficit countries would have to be protected from contagion. The last two requirements would apply even if no country defaults.

All this would cost money. Under existing arrangements no more money is to be found and no new arrangements are allowed by the German Constitutional Court decision without the authorization of the Bundestag. There is no alternative but to give birth to the missing ingredient: a European treasury with the power to tax and therefore to borrow. This would require a new treaty, transforming the EFSF into a full-fledged treasury.

That would presuppose a radical change of heart, particularly in Germany. The German public still thinks that it has a choice about whether to support the euro or to abandon it. That is a mistake. The euro exists and the assets and liabilities of the financial system are so intermingled on the basis of a common currency that a breakdown of the euro would cause a meltdown beyond the capacity of the authorities to contain. The longer it takes for the German public to realize this, the heavier the price they and the rest of the world will have to pay.

The question is whether the German public can be convinced of this argument. Angela Merkel may not be able to persuade her own coalition, but she could rely on the opposition. Having resolved the euro crisis, she would have less to fear from the next elections.

The fact that arrangements are made for the possible default or defection of three small countries does not mean that those countries would be abandoned. On the contrary, the possibility of an orderly default—paid for by the other eurozone countries and the IMF—would offer Greece and Portugal policy choices. Moreover, it would end the vicious cycle now threatening all of the eurozone’s deficit countries whereby austerity weakens their growth prospects, leading investors to demand prohibitively high interest rates and thus forcing their governments to cut spending further.

Leaving the euro would make it easier for them to regain competitiveness; but if they are willing to make the necessary sacrifices they could also stay in. In both cases, the EFSF would protect bank deposits and the IMF would help to recapitalize the banking system. That would help these countries to escape from the trap in which they currently find themselves. It would be against the best interests of the European Union to allow these countries to collapse and drag down the global banking system with them.

It is not for me to spell out the details of the new treaty; that has to be decided by the member countries. But the discussions ought to start right away because even under extreme pressure they will take a long time to conclude. Once the principle of setting up a European Treasury is agreed upon, the European Council could authorize the ECB to step into the breach, indemnifying the ECB in advance against risks to its solvency. That is the only way to forestall a possible financial meltdown and another Great Depression.

Saturday, September 10, 2011

Valuation models and value drivers of stock returns: The Malaysian context


This post is a summary of the research I’ve undertaken for my thesis with regards to price multiples valuation models such as price-to-earnings (PER), price-to-book (PBV), price-to-sales, price-to-cash flow, EV/EBITDA, EV/Sales etc coupled with value drivers of share prices in the Malaysian context. The aim of this study is to give investors a better understanding of the appropriate valuation models and value drivers of stock returns in making investment decisions coupled with providing a faster way of analyzing the whole stock universe (though still nothing beats an in-depth analysis of individual stocks). This could be quite lengthy, so pardon me. If you don’t feel bored, read on :p Perhaps you could get a tip or two if you’re interested to do similar studies on other markets probably, and maybe share with me as well :)

Samples used are 373 firms listed in KLSE that cover most of the constituents of FBM EMAS spanning from year 2000 to 2010.

Identifying comparable firms:
Firstly before analyzing the appropriate price multiples to use, identification of comparable firms is needed. There are basically three industry classification systems available from Bloomberg terminal (The lifeline of most investment or finance professionals) for Malaysian firm such as Global Industry Classification Standard (GICS), Industrial Classification Benchmark (ICB) and Bloomberg Industry Classification System (BICS), though there are plenty of other classification systems such as SIC, Dow Jones, Fama and French Classification etc which are not available in Bloomberg though. To determine the most appropriate classification system, the system which has the highest explanatory power of industry’s averages of variables over the individual firms’ variables coupled with the lowest intra-industry variances is considered the most appropriate. The variables tested include PER, PBV, PS, ROE, operating margin, sales growth and stock returns, representing the valuations, profitability and growth of the firms. It was found that GICS clearly had the best results by having the highest explanatory powers and lowest intra-industry variances. The results were consistent with prior researches on EU and US markets as well where GICS clearly outperformed other industry classification systems. Therefore, next time when you want to extract comparable firms in Bloomberg terminal, GICS would likely give you the closest comparable firms for your analysis.

Appropriate valuation models:
Valuation models include market value multiples and enterprise value multiples based on 1-year forward and 1-year trailing net income, profit before tax, operating profit, EBITDA, sales, book value and cash flow. 1-year forward values are based on ex-post data, assuming perfect foresight by research analysts. Two empirical tests were done to determine the appropriate valuation models. Firstly, OLS cross-section regression and valuation errors were done to determine how best the fair values computed by different valuation models explain and fit onto the stock prices, a method commonly used by prior researches in the past. However, this could be of little contribution to investors as they would not be able to take advantage of the arbitrage opportunities if the fair values fit perfectly the stock prices. A more practical empirical model would be the convergence test where the convergence rates of the market values towards the fair values are measured. The winner among all the valuation models for the OLS regression as well as convergence test was price-to-earnings before tax (P/EBT), followed by PER and PBV. The worst valuation models appeared to be price-to-sales (P/S) and price-to-cashflow (P/CF). For convergence test, price multiples based on forward values outperformed trailing values, implying that investors would have greater arbitrage opportunities using forward values. Other observations included: (1) Market value multiples outperformed enterprise value multiples; (2) As we move the value drivers from bottomline to the topline of the income statement (i.e. net income to sales), results were poorer; (3) Convergence rates of market values towards the fair values improved as convergence duration increased, an indication of the inefficient market that Malaysia had and contrary to US findings where convergence results deteriorated as time went by.

Some of the industries in Malaysia and their appropriate value drivers for valuation models are shown below:



In summary, forward earnings and book values are appropriate models to use in equity valuation. EV/EBITDA and EV/Sales which were highly revered by some researchers in the past appeared to be poor valuation models to use. P/CF and P/S also might not contribute much to equity valuations in Malaysia. Hmmm…..The results are quite in line with the valuation models that are commonly used among research analysts. Perhaps the popularity of PER and PBV among research analysts could have caused the results to favor these two, as this might be a self-fulfilling prophesy as investors use these models to bring the market values towards the fair values computed by these models.

Firm-specific value drivers of stock returns:
This could be useful for deciding which firms to invest should the firms have similar upside based on their fair values. Several value drivers are tested, such as beta, book-to-market (inverse of PBV), earnings yield (inverse of PER), dividend yield, net gearing and market capitalization. Multivariate analysis using panel data regression tests is used to determine the explanatory powers and significance of these value drivers. All in all, book-to-market and market capitalization had the most significant impact on stock returns, followed by net gearing and beta. Earnings yield and dividend yield appeared insignificant in most of the industries. Book-to-market, market capitalization and dividend yield are negatively correlated to stock returns whereas net gearing, earnings yield and beta are positively correlated to stock returns. Surprisingly, beta appeared to be not so significant in affecting stock returns, rendering the application of CAPM in Malaysia rather pointless :P On the other hand, higher net gearing in fact favor stock prices, of course provided that the borrowings do not bring the firms close to default risks. This could be due to greater efficiency in the capital structure where higher borrowings could bring in tax savings and at the same time allow greater expansion of business operation. Most of the industries have more or less similar results as the overall market, except for agricultural products (Mainly oil palm companies) which had net gearing as the most significant driver, and construction firms of which dividend yield was significant in the negative direction to stock returns. Banks and industrial conglomerates (like Sime Darby) are not affected by net gearing at all.
In summary, lower market capitalization, lower book-to-market ratio and higher net gearing favor higher stock returns. 

Summary: 
GICS provides the best industry classification of firms

Most appropriate valuation models: Market value multiples based on forward values of earnings and book values performed the best. Enterprise value-based models coupled with sales, cash flow and EBITDA multiples performed poorly.

Lower book-to-market, lower market capitalization and higher net gearing significantly affect stock returns in the positive direction.

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