Monday, December 31, 2007

SMOKE & MIRRORS 2008 ! !

2008 can be best described as the year of Smoke & Mirrors.
Reassuring comments and massive liquidity infusions from central bankers, never-ending losses at investment banks, rising inflation and slowing global growth: 2008 will keep you guessing. It will be an ongoing game of hide and seek, cover ups, assurances, lies and blame games, in the US election year

“Smoke and mirrors is a metaphor for a deceptive, fraudulent or insubstantial explanation or description. The source of the name is based on magicians' illusions, where magicians use smoke and mirrors to accomplish illusions such as making objects disappear, when they really don't disappear at all. The expression may have a connotation of virtuosity or cleverness in carrying out such a deception.” (Source: wikipedia)


A cautious approach to investing in 2008 is best advised. The world’s equity markets are near their recent highs, despite turmoil in the credit markets, record high oil prices and food prices, large write downs in the US financial sector, and a rapidly slowing US economy.

In a bid to build confidence in the system, Central Banks around the world have continued to pump liquidity into the markets, in an attempt to revive a frozen credit market and illiquid derivative market. Banks are refusing to lend against asset backed securities including mortgage backed securities as confidence is low, and no one is sure of the asset quality on the counterparty’s books; with banks still unwilling to disclose the full extent of their losses.

The credit crisis of July and August this year has still not abated and continues to haunt world markets. 2008 will see more write-offs, bailouts, fund infusions and maybe takeovers of large US and European financial companies, by investors from the Middle East and Asia.

Outrageous bonuses paid to investment bankers and CEOs at financial institutions are going to be questioned. Their short term oriented decisions and dangerous underestimation of risk have resulted in large losses that have eroded the capital of such banks.


  • Crisis in the housing market: An inventory glut, rising mortgage payments and increasing defaults
  • Cutbacks in US Consumer spending & Falling consumer confidence: Layoffs in the manufacturing sector as well as high profile jobs in the financial sector will affect both consumer consumption and the housing market.
    As a result of heavy discounting at US retailers November sales were better than expected. 2008 will be a difficult year for US retailers.
  • Credit crunch arising from the sub prime crisis & risks of increasing defaults in 2008.
    Wall Street is demanding FED rate cuts. The Fed is caught between a rock and a hard place, with rising inflation, slowing growth and a declining US Dollar.
  • Resetting of mortgages poses another risk to the default rate, even as the US government is coming up with all kinds of schemes to freeze mortgage resetting, ahead of an election year.
  • The ill-conceived SIV Bailout conduit appears to be a non starter, with many banks moving SIVs back onto their own balance sheets.
  • Write downs and write offs in the US financial sector, are spreading to financial Institutions around the world. European & Japanese banks and large Insurance companies may be holding a lot of junk paper.

  • Large Bond Insurers in the US, face losing their AAA ratings, due to potential subprime and CDO losses. Bond Insurers have ventured beyond the usual municipal securities into structured finance such as collateralized debt obligations, guaranteeing about $1.2 trillion of structured finance debt. Caught up in the subprime mess, they will need to raise additional capital to meet regulatory capital adequacy requirements.
    Bankruptcies and loss of AAA ratings at Large bond insurers will affect the credibility of the bond market as a whole, something the market is refusing to acknowledge at the moment.

Avoiding a global slowdown
Net US exports have grown due to a strong global economy. In the event of a US slowdown/ recession, the world market will struggle to decouple from the US.
Any slowdown / cutback in US consumer spending will hurt Asian economies that are large exporters to the US. As a result, Asian demand for exports from the US will fall sharply.
These Asian exporters in turn have been importers of industrial commodities and raw materials from South America, Australia and Africa, and Crude oil mainly from the Middle East.
The Decoupling theory will not work, if the US goes into recession.


The best strategy for 2008 is to maintain liquidity in ones portfolio. Fresh buying in equities may be delayed, but booking profit in overvalued sectors would be advisable.


I expect GOLD to outperform. Gold can be bought on declines, which will occur when Equity markets correct, as gold is liquidated to meet margin calls. Rising inflation and a falling USD are very gold positive. December 2007 marks the first time that gold has made a monthly and annual closing above $ 800.


The US Dollar will face strong headwinds, and this should be positive for Non- USD currencies. The USD may strengthen in the short term, when world equity markets correct, as investors exit foreign currencies and return to the USD. Longer term the USD will continue to decline.

I continue to be cautious on the Euro and the GBP. Though they will continue to strengthen, a strong Euro is hurting European exporters (e.g.: Airbus, B.M.W) while the recent slowdown in UK growth rates, high debt levels & a weakening housing market may force rate cuts in the UK. Political intervention cannot be ruled out.

Carry trade currencies such as the Swiss Franc and the Japanese Yen will strengthen if the markets crash/correct sharply.

‘Commodity’ currencies such as the Brazilian Real, South African Rand, Canadian Dollar and Australian Dollar, will react negatively to news of slowdown in consumption of Industrial Commodities and Oil.

The Oil producing nations of the Middle East may be forced to unpeg their currencies from the US Dollar if local inflation rates rise further, and the USD continues to decline.

Other currencies that should do well against the USD will be the Singapore Dollar and the Swedish Kroner.


Oil prices will be very volatile. A weakening USD is oil positive, but a slowing world economy will reduce oil consumption. The US is the world’s largest oil consumer. A US slowdown would be oil negative.


Markets around the world appear to be ignoring all of the above mentioned risks and concerns. I am bearish on the US Stock markets. Valuations are not cheap and expectations are far too optimistic given the problems the US is currently facing.
Tightening of global liquidity and lack of depth in Asian and emerging stock markets can result in sharp corrections in these markets, which have seen a phenomenal run up over the last five years.
While I am buying select Indian Equities, I continue to book profit in many long term holdings. If you are entering into a new position today, make sure that valuations are reasonable and that you are ready to adopt a long term buy on declines and hold strategy. Avoid buying into popular sectors that are overvalued and leave you with no margin of safety as an investor.

I will put up a detailed note on Indian Equities soon.

Invest wisely and safely in 2008. Heres wishing everyone a very Happy New Year!

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