Written by Michael Waring

This has been a very challenging time for everyone involved in capital markets and as we all know, there has been no place to hide in recent weeks. Selling of stocks and the rush to cash has been unrelenting. At a time like this, it is difficult to offer any definitive answers as to what is happening. However, as fundamental based investors, we would make the following observations.

With respect to the ‘bail-out’ plan or TARP (Troubled Asset Relief Plan), we are concerned that it fails to address the need to recapitalize U.S. financial institutions that are badly undercapitalized. Rather than a purchase of toxic assets, we would have preferred to have seen an injection of capital via preferred shares or a conversion of unsecured debt into equity. Although the bail-out plan will help the system, we are of the view that these other measures would be more effective. Perhaps that is why the market response thus far has been negative.

We would also highlight the relentless selling pressure on anything commodity related. The pundits are quick to ascribe this as signs of a significant global downturn. However, we believe that it is too soon to make that determination. Remember that, until this past summer, the trade in vogue among hedge funds was to short the U.S. dollar, U.S. financials and go long commodity stocks. Now we are witnessing the great un-wind as hedge funds scramble to the exits to reduce their excessive leverage. Good stocks, bad stocks, any stocks that had gone up earlier this year have been hit. The selling has been indiscriminate and any stock that had a bid has been taken down. When we gaze at our quote screen, we are not sure that it is telling us anything except that there are a lot of desperate folks trying to unwind their positions.

Our experience has taught us that, when we see this sort of manic behaviour, we are typically close to a bottom in markets, at least temporarily. How far the deleveraging has to go is anyone’s guess. However, it will come to an end and only then will we have a more accurate picture as to actual supply and demand.

It would seem to us that we are approaching a major inflection point. Either we are entering a full-blown global recession/depression or stocks are now becoming very attractive from a valuation standpoint. While far from being experts on this subject, we simply do not see the parallels of today with 1929. Today’s global economy is much broader and deeper than in 1929 and communication is virtually instant. A global slowdown? Yes! A depression? We think not.

A brief word on one of our favourite subjects, China. Yes the Chinese economy is slowing; New car sales have slowed, air travel has dropped, real estate markets have weakened and growth in electrical power demand has declined. Much of this has to do with a significant downturn in exports to the U.S. and Europe which should come as no surprise. However, while exports have dropped, Chinese domestic consumption is up sharply and will help to mitigate the slowdown from abroad (See Chart One).

Chart One: China, More Consumption, Less Exports

Chinese inflation has dropped sharply in the past few months (led by declines in food prices) from 7.8% in Q2 to 4.9% year over year in August. (See Charts Two and Three)

          Chart Two: Food Price inflation is coming                   Chart Three:…led by quick stabilization                              off sharply                                                                         of pork prices.

After doubling in the last twelve months, pork prices have finally stabilized. Pork Prices have been the single largest factor in Chinese inflation in the past year. We have seen forecasts suggesting Chinese inflation will drop from 6.4% in 2008, to 4.3% (or lower) in 2009. This will give the Chinese monetary authorities more room to react to any slowing in the economy. To wit, China cut interest rates mid September for the first time in six years and we suspect more cuts in interest rates are coming. Additionally, unlike 1998, corporate debt/equity ratios in China and other emerging countries are simply not that levered. (See Chart Four).

Chart Four: Gearing Ratios, Corporate net debt/equity ratio (%)

                                                           Source: UBS Equity Strategy

At the moment, we believe that growth in Chinese GDP will slow to 8.5-9.0% in 2009 down from 11.5% in 2007. The cause being lower exports to U.S. and Europe. However, in our view the momentum in the Chinese economy will remain strong, driven in part by pent-up domestic demand and the on going need for infrastructure build.

On another note, despite the headlines, we do not believe that conditions are as bad as the press would have us believe. This is not to belittle the severity of the challenges we face, but remember, the news media has to sell papers and engage eyeballs. Of course, nothing sells like bad news! The nature of this crisis makes for great headlines; stock market down by 7%, 100 year old brokerage firm goes into liquidation! We suspect the odds are that the current situation has been blown way out of proportion compared to actual reality. That’s exactly what the press does at economic tops and bottoms.

One final thought, speed. A major evolution we have observed in our years of managing portfolios is that the rate at which events unfold in the economy and the market has drastically increased. It is simply astounding to watch how quickly events occur today versus twenty years ago. Whether it’s the advent of the internet, cell phone, laptops, we don’t know . We do know that market events and responses have never been faster. So we believe that we will actually get through this crisis sooner than most experts predict. This is not to suggest that we will be out of the woods shortly. Since we are faced with long work-outs on mortgages and other related problems. However, the resolution of these challenges and the market’s ability to discount may happen on a shorter time frame than currently expected.

Wishful thinking on our part? Perhaps. However, we are trying to avoid running with the herd. We are never happy or comfortable there. Nor should you be.

What do we need to see?

Our wish list:

1. A stabilization in U.S. housing prices. Prices do not need to go up, just stop going down. U.S. home builders need to stop building houses!

2. We need a return of confidence in the system and for banks to begin lending to one another again.

3. Credit spreads need to narrow as a sign that confidence has returned.

Disclaimer:
This report is intended for clients of Galileo Global Equity Advisors Inc. Galileo Global Equity Advisors Inc. invests on behalf of its clients in the issuers mentioned in this report. Employees of Galileo Global Equity Advisors Inc. may own shares. This document is not intended to sell or promote securities.

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