Fighting paralysis in a market meltdown

Having an anchor on where asset prices should be gives us the conviction to fight in face of fear

Back during the dark days of the Asian financial crisis, the sell-down of the Straits Times Index (STI) and other regional bourses was relentless. Investors watched in horror as the value of their portfolios got smaller and smaller with each passing day.

When the STI hit 800 points on Sept 4, 1998 - from 1,700 just six months earlier - a panic-stricken remisier went up to his head of equities research, and said: "Oh no! We have only eight days to go before we hit zero!"

The logic was that, if the STI continued to fall by 100 points a day, there would be only eight days left for the market.

It sounds funny now when the story is recounted. But at that time, that was a very real fear of investors and market participants alike. The numbers on the screens represented one's wealth. Every point of decline in the index would translate into a loss in the value of one's portfolio.

The thing is, when we are too absorbed in the violent market actions of the day, we lose sight of reality. If we were to step back and view the market with a cool head, we would realise that there was no way the stock market would hit zero. Why?


Construction workers in the Central Business District. The stock market represents real businesses with real assets. Even if a company is not profitable, it still owns assets like buildings and machinery which have a value. ST PHOTO: JOYCE FANG

One, the stock market represents real businesses with real assets. It represents the real economy. The stock you own gives you a stake in a company that makes money by selling a service or a product. Even if it is not profitable, it still owns assets like buildings and machinery which have a value and a price in the real marketplace. If one can buy the shares of a listed company that owns a drinks bottling plant at half the price of building one, nobody would build a new plant. Those with money would just buy up the existing plants via the stock market.

This will drive up the stock prices of drinks factories. When the stock prices rise to such a level that it may be cheaper to build a new plant, a new set of entrepreneurs will come in to build new plants. This will mark the end of the "up" cycle in the stock prices of drinks factories.

Given that the companies in the STI own a substantial amount of assets in Singapore and derive a significant sum of their income from Singapore which itself is a very open economy, it may be instructive to peg the movements of the STI to the GDP to get a sense of where the stock index should be.

Similarly, stock market prices cannot go so high as to defy market realities. Say, you can install fibre-optic cables for just $1 but you can sell the completed network to investors in the stock market for a whopping $10. On that basis, you could guarantee that many people would want to do that.

This would result in overbuilding and prices for the use of fibre-optic cables would plunge. And when listed companies that own these networks cannot make money, their stock prices would fall. This was exactly what happened in 2001 and 2002.

Two, the productive capacity of the economy (or the company) comes from the skills and size of the workforce and the country's (or the company's) accumulated intellectual and physical capital.

"If gross domestic product (GDP) were to fall by 5 per cent, it would not be because our ability to produce goods and services had fallen by 5 per cent, but because aggregate demand for those goods and services had fallen. When the demand returns, the economy will be able to ramp up production quite quickly," Mr Ben Inker, asset management firm GMO's director of asset allocation, wrote in a paper entitled Valuing Equities In Economic Crisis.

The Great Depression caused the United States' GDP to fall by 25 per cent from 1929 to 1933. But that fall, as extraordinary as it was, was a fall in demand relative to potential GDP. It was not a fall in the economy's productive capacity. The economy eventually got back to its previous growth trend as if the depression had never happened.

Equities are long-duration assets - that is, they are valued based on the assumption that they will generate perpetual streams of income. So even if the economy is going to be horrible for the next five years and dividends are going to be cut by 50 per cent, the present value of the stock theoretically should be reduced by 5 per cent. A 10-year slump would wipe out only 10 per cent of the stock's value.

"To us, the true value of the stock market changes very slowly and smoothly. It is the myopia of investors that causes market prices to vary so wildly," he wrote.

Of course, demand for a company's product or service may never come back after a slump if it can no longer produce things that the market wants, or at a price that the customers are willing to pay. Still, it would own assets like buildings and factories that another competitor may find value in.

There is one drastic scenario where demand would fall significantly and large swathes of industries would be affected - that would be a near complete destruction of the earth with more than half of the world's population being wiped out.

Barring the above scenario, the economic activities of the human race are unlikely to cease.

Where is the bottom for STI?

The markets all over the world have been in turmoil since the start of 2016. It's partly a continuation of the episode we had in August last year, plus renewed fears of a global slowdown in demand and the helplessness of central banks and governments to do anything about it.

As investors are gripped by fear and horror watching the daily meltdown in the local market, it is timely to be reminded of the two points above: that companies own real assets and that the productive capacity of the economy (the company) comes from the skills and size of the workforce and the country's (company's) accumulated intellectual and physical capital.

Given that the companies in the STI own a substantial amount of assets in Singapore and derive a significant sum of their income from Singapore which itself is a very open economy, it may be instructive to peg the movements of the STI to the GDP to get a sense of where the stock index should be.

Let us examine this relationship by setting the STI at 100 points when the market was at its lowest during the Asian financial crisis in the second quarter of 1998. That was crisis-level valuation. We also set the Singapore GDP at 100 points from then onwards. We then track how the two have moved since.

The GDP seems to act as the floor for stock prices. From 2000 to 2003, three major negative events - the burst of the dot.com bubble, the terrorists attacks in the US, followed by the Sars outbreak - halved the value of STI stocks from its peak in end 1999 to a level just 17 per cent above the Asian financial crisis. From 1998 until 2003, GDP grew by about 11 per cent, and the stock prices did not go below the support provided by the GDP.

During the global financial crisis, prices did go slightly below the GDP support, but the rebound came soon after.

Given the level of Singapore's GDP today, the crisis valuation for the STI based on this simple relationship is 2,510 points. If the GDP were to fall by 5 per cent, the crisis- level valuation for the STI is 2,355 points. Admittedly, we are not facing a systemic crisis like that of the Asian financial crisis or the global financial crisis - at least for now.

Having an anchor on where asset prices should be gives us the conviction to fight against our paralysis in the face of fear.

•The writer is a partner in Aggregate Asset Management, manager of a no-management-fee Asia value fund, and author of Show Me The Money - Fighting Paralysis In A Market Meltdown.

A version of this article appeared in the print edition of The Sunday Times on February 21, 2016, with the headline 'Fighting paralysis in a market meltdown'. Print Edition | Subscribe