Market Sell-off Following Hawkish Fed Statement - Does it Make Sense?

Following the FOMC statement yesterday, in which the Fed stated that it will consider reducing the quantitative easing this year and stopping it altogether next year, the global market dropped significantly and bond yield surged. Let's dig deeper and see if there is any opportunities in light of the sell-off.

The Fed is considering stopping the quantitative easing because the US economy is slowly getting stronger and the downside risks to the economy and labor market are diminishing. The Fed lowered the unemployment forecast for 2013 and 2014, suggesting that the labor market is improving.

The strengthening of the economy is actually good news but the market only focused on the fact that tapering would cause interest rate to go up and we will be back to the "normal" market situation sooner than expected. I think that the market is too bogged down to details - it really doesn't make a huge difference whether the Fed will begin tapering in Q4 this year or Q1 next year, or whether it will start lifting interest rates in late 2014 or early 2015. In addition, quantitative easing was a desperate action took by the Fed in hopes of kick-starting the economy; very few people expected the program to run for so long (from November 2008) when the Fed began to purchase securities.

The improvement in the economy will likely drive inflation up, which is actually beneficial to the equities market in the long run as people are more likely to consume in an inflationary environment.

However, for fixed income and commodities, the implication is more complex.

It is pretty certain that the very impressive run over the past few years for fixed income return will end as rates start going up. The credit spread for fixed income had been squeezing so much when investors looked for yield and continued to purchase riskier bonds as yields continued to go down. I believe this trend will be reversed and in fact this is already happening.

For commodities such as gold and silver where investors purchase it as a store of value, because the commodities generates no return (actually it has negative yield taking into account storage fee etc.), investors will see them to be less attractive when yield increases. Right now, there is virtually no opportunity cost of holding gold because the safe alternative (treasury note) is also generating close to zero return. However, it will not be the case when yield rises. Therefore, I think that commodities will at best stay at the current range in the next few years.

So in conclusion, I believe it is wise to reduce the exposure in bonds and commodities and purchase equities in light of the sell-off.

Is Gold Attractive After the Selloff?

Gold experienced the biggest decline in history, dropping US$210/oz or 13.7% over two days. Is gold an attractive investment at the current price level?

To answer the question we need to first understand why gold price dropped in the first place. The news about central banks dumping gold triggered the market to rethink gold as an investment vehicle. This is a reversal of the trend in the past few years, when central banks purchased more and more gold as reserve.

The spectacular rise in gold price in the past few years was mainly due to the belief that it is better to hold onto real assets like gold amid the current expansive monetary environment. Many investors, such as John Paulson, do not believe that printing money by central banks is going to solve all the problems  - hence they decided to bet on gold instead. The sudden drop in gold value reminded investors that investing in gold can be risky too. With price dropping 13% in two days, gold is no longer considered a safe haven.

Finally, gold is only worth what the market thinks its worth. Gold is different from other commodities in that the majority of people purchase gold as a storage of value. There is a limited industrial application of gold compared to other commodities such as silver or bronze. Gold doesn't produce any earnings or cash flow; in fact, it would cost you money to store it if you hold physical gold so it has a negative yield. Without limited real application any produces no cash flow, gold is a type of assets that is difficult to value. Some can argue that the floor price of gold is the cost of production, but if the higher cost gold producers don't find it worthwhile to produce gold, they can simply shut the mine down.

With the market now realizes that there is a lot of volatility in gold price, I don't see it going back up to the $1,700 range. Therefore, even though current gold price dropped a lot, I still don't think it is an attractive investment.

Focus on the Long Term

Investors should remind themselves from time to time that they should invest for the long term and ignore some of the daily news that are unlikely to have long-term consequences.

In the past two weeks, all eyes were on Cyprus to see how would its financial crisis play out. However, as Larry Fink, CEO of Blackrock, stated last week, Cyprus is a US$10 billion dollar problem and is unlikely to be a major economic issue. The sum Cyprus was seeking is trivial compared to the US$85 billion printed every month by the US Government for its asset purchase program.

I attended a presentation by Bill Ackman, portfolio manager of hedge fund Pershing Square. He is a fundamental, research-intensive value investor who seeks to realize value from investments through an activist approach. His short-selling against Herbalife led to a live debate on CNBC with Carl Icahn, a supporter of Herbalife. He is not particularly concerned about the short-term prices of securities. Rather, he looks at the long term viability and profitability of the company when he decides to make the investment. This strategy paid off as the hedge fund he manages beat the market consistently, including a decline of only 13% in 2008.

Sometimes financial journals magnify every piece of news because that is how they draw readership. However, ask yourself what are the long-term consequences of the news before getting bogged down in every bits of details.

ASEAN Equity Fund Purchased

I purchased a mutual fund focusing on equities in the ASEAN region just before CNY. The followings are the reasons for the purchase:

• Despite the rapid appreciation of equity value, the valuation for ASEAN equities is still around average compared to historical average.
• The global economy is starting to recover as evidenced by recent economic indicators in the US and Asia. Tail risks have also fallen, therefore the downside risks for equities have reduced significantly.
• ASEAN economies are well positioned to benefit from the recovery in global economy as more companies shift their production factories from China to countries like Indonesia and Vietnam due to lower production cost (even after factoring in the difference in productivity, workers in Southeast Asia are still much cheaper than China now, and the productivity gap is only going to narrow over time).
• As more foreign investments are made into these countries, currencies for ASEAN countries may appreciate against the USD. The foreign exchange rates for ASEAN countries against USD are still below the pre-Asian Financial Crisis level in 1997.

I should have made this purchase a while ago but due to certain compliance requirements I can finally make the investment now after some delay. Since equity prices have increased so much in the past three months, I don't expect the investment to have a very high return but the risk/reward still looks attractive.

Real Estate Investment - Positive Carry or not?

Many investors are bullish on properties because they provide "positive carry", that is, the rental income exceeds other expenses (including management fee, mortgage payment, etc.). However, they are only half right - they should only count the interest expense portion of mortgage payment instead of the entire principal plus interest payment.

Why? The interest payment is an actual expense to the investor; he doesn't get anything in return. However, when you pay off the principal portion of the mortgage, you are increasing the equity of the property. For example, you have a 20-year mortgage attached to an investment property and the property gives you zero cash flow (the rental income offsets the mortgage payments and all other cash outflow for maintaining the property). After 20 years, even if the property does not appreciate in value and you receive no cash flow from the investment, the mortgage is paid off and your equity is increased by the amount of the original mortgage amount.

Accordingly, even though some property investments cannot provide a positive cash flow, as long as the cash outflow is less than the mortgage principal repayment amount, you are still increasing the equity of the property which you can tap in any time (you can sell the property or refinance to take out extra cash).

Human Capital

I recently read a publication by Goldman Sachs (GS) about its 2013 investment outlook. What I find interesting is that GS is very confident in the US economy and equities, despite many investors' concerns on political issues. In fact, GS has been bullish on US equities since the financial crisis and the call has been correct -  US equities outperformed all other major equity markets since the financial crisis in 2008/09.

GS argues that the US has structural advantages in four categories: economic, institutional, human capital, and geopolitical. I tend to agree with GS's view and would like to expand on the human capital argument. US has the strongest education in the world, as seen by the number of top universities in the US. If you take a look at any rankings of top universities in the world, schools from the US dominate the list. Hence, many top talents are attracted to student and eventually work in the US. This is at a sharp contrast to many European countries, where the troubled economy and high unemployment rate force people to leave the country and work elsewhere.

In this information age where innovation drives economic growth, I believe the US is more resilient than many investors who are bearish on the US economy due to its fiscal problems.

2012 Year in Review

Equities: We have some equity investments during the year but the amount was not significant. Satisfactory gains were made and all equity investments were sold prior to year end.

Property: Our self-use property rose in value in line with the market. There is a 20-year mortgage attached to the property and we are two years into the mortgage. Because of the low mortgage rate (Hibor + 0.7%), principal repayments represent around 80% of mortgage payments.

Savings: Our cash position rose significantly because (1) equity investments were sold in November; and (2) gifts were received from our wedding. Right now we have an excessive cash balance.

Our family net worth rose by 76% in 2012, mainly due to the rise in property value and savings from salary income. We are only four years out of university so we don't have a significant amount saved up, and the salaries from my wife and me represent a significant amount of our net worth.

What to do in 2013: Look for investment opportunities and lower the cash level. Right now, our only major investment is the self-use property, and we are looking to add other investments to diversify.

As (1) the global economy is seeing signs of improvement; (2) tail risks have eased after the US reached a compromise to avoid the fiscal cliff; and (3) equity valuation is still reasonable (13x P/E for S&P 500 and 11x P/E for HSCEI), I think it is a good time to add investments in equities.