Vad's Best Ideas

"Pick battles big enough to matter, small enough to win"

I am a big believer in sector and style rotation. The reason for that is pure and simple- economic business cycles always repeat themselves. Despite the simplicity behind the logic of the business cycles you can always hear people here and there saying something like "This time is different" or "It's a New Deal that does not be fit inside the usual business cycle". My advice in this case is very clear- as soon as you hear someone say something like that- simply put him into your "ignore his/her investment advice" list.

The truth of the matter is that business cycles embody human nature of fear and greed, and as long as this world economy is governed by people rather than emotionless machines, business cycles will continue to repeat themselves. Once the demand equilibrium for one good/stock is out of balance- human greed will continue to push for more supply until the balance tilts the other way.

Certainly someone might ask why can't the market's supply/demand balance in the long term- and the answer again lies in the human psychology- regardless of what the conventional economic theory assumes- people are irrational creatures- they are always too greedy at market top and too fearful at market bottom. As many behavioral studies have shown, it is simply a normal part of human nature- to shun regret and to accumulate pride. People quickly forget the mistakes and only remember their successes.

Otherwise how would we explain that most of the individual investors under perform the market, but keep investing thinking that they can do it better next time ...? What's more recent studies show that after some time passes by, these same investors believe that they actually have done better than the market, even though the data clear contradicts it.

Same is true with most of the professional money managers. It has always been a puzzle to me how ignorant Wall Street is to business cycles- I guess the greed is in action again-"after the spring bonus is cashed- the past year results are irrelevant". Sub prime fiasco was not something that happened overnight, it took several years for the fear to finally outweigh the greed and here are we are now...

It is hard to describe the current situation with some of the emerging market equities and super hot high fliers in the US in any other way than the "irrational exuberance" all over again. I mean, come one, some time during last week market cap of PetroChina has exceeded the market cap of GE (we are talking of the most valuable company in the world outside of the Exxon Mobil, the icon of the US economy). Or here is another one-market cap of ICBC (Industrial and Commercial Bank of China) is now higher than that of both BofA and Citi. And we are talking about the bank, that to be cleaned by the regulators with a significant capital injection just a little while ago, the bank whose loan quality is at best questionable and the bank with a significant chunk of earnings coming from investment gains in other irrationally priced Chinese securities... Don't get wrong not everything in Shanghai is overpriced but we are getting awfully close...

It seems like everything that has a word China in its name has gone through the roof recently. You don't really need to have earnings history or even a legitimate business strategy- it seems like you can just slap some numbers together and feed it to investors, they will readily buy it at any price, even if does not make sense whatsoever.

As you know after the Fed Rate Cut I tilted my portfolio heavily towards emerging markets with Chinese stocks being featured prominently. I tried hard to pick only stocks that made enough money and had "good enough" growth potential to justify the higher risk/return return I believe the prudent investors should require from such an unstable developing economy.

But as the headline of this post indicates, I try to only to fight the battles that I can win. I certainly don't expect the Shanghai or Hon Kong markets to suddenly adjust to a more reasonable valuation level. There are many factors that led to the current euphoria that include US investors current hunger for growth, combined with Fed induced dollar weakness and the inefficiency of the Chinese capital markets in general... But I think we are getting dangerously close to a tipping point were many investors could suffer severe losses, because in the momentum game of musical chairs someone is always left behind.

I certainly don't try to predict the date and time when this will occur, but the truth is it is very likely that it will. The Chinese economy is definitely on steroids today, but it going to slow down, it always does... How much of the current booming investment capital has been fueled into unproductive areas of the economy that will never produce return is not clear at this time. I am also not sure that any kind of major correction will unravel prior to next year's Olympics, so I guess one might ague that we can play musical chairs for a little while longer, but it is certainly not something I am personally eager to do...

Hopefully the aftermath of this correction will be less severe than that of Japan and Taiwan at the close of the last century, but if I had to make a bet today, I would say than when the time comes, China might make the previous boom/bust cycles seem very minor...

But the key here is to stay positive. It's not all doom and gloom out there. As I said before, I believe that all events out there, even the most negative ones are could and should be transformed into opportunities .My strategy for investing is simple- don't try to fight the windmills but rather pick opportunities that could benefit from the events that should unfold in the aftermath. I have sold my last shares in CHNG, ACH and CEO and moved money into what I think could be lower risk stocks- NVO, GILD, GEOY, BCPC, EMC, SAIA... By reducing my risk profile, I certainly open myself to a potential underperformance against the "on steroids" portfolios of some of my closest competitors, but I believe that this is a prudent move and that while timing the market consistently over the long haul is close to impossible, one should certainly preserve some gains when it makes sense, while staying a 100% invested just in case if he/she were wrong...

In the next post I will try to explain why the IT sector in US and large cap growth stocks in general have been doing so well and why I think this trend will continue...

Trade safe and cheers,
Vad

Comments: View Comments |  Wednesday October 17, 2007