Stock markets in the ‘yin phase’

BUSINESS COMMENT

Carl Stick

ACCORDING to Chinese philosophy, yin (shadow) and yang (light) are complementary energies that form a universe. It is a convenient mythology that has, over time, been used to help smooth the many paradoxes associated with modern life.

In recent years, it has been applied to understanding of the nature of economic and business cycles. The conclusions may have implications for how we, as investors, steer through torrid times.

The main proponent of this theory is Mr Richard Koo, chief economist of the Nomura Research Institute, and well known for his examination of "Japan's Great Recession", from 1990 to 2005.

Mr Koo believes economies and companies operate within yin and yang phases. During "lighter" yang phases, both focus on growth and "profit maximisation" (driving up the share price); in "darker" yin phases, this emphasis shifts to "debt minimisation" (reducing debt levels), at which point the economy falls into a "balance sheet recession". Under these conditions, asset prices plummet, pushing corporate and personal balance sheets underwater — this is where we find ourselves today.

Mr Koo's theory is contentious because it challenges conventional wisdom about recessions and how to tackle them. It states that monetary and fiscal stimuli are ineffectual if used at the wrong point in the cycle.

Mr Koo proposes more fiscal stimuli are required during a yin phase, when borrowers are few, and looser monetary policy during a yang phase, when borrowers are abundant. Any contortion and the cycle collapses.

Mr Koo's depiction of Japan's recession is one derived from a balance-sheet recession perspective. He argues that the lesson to be learnt from this period is the redundancy of monetary policy.

His conclusion, that governments must spend their way out of recession and worry about budgetary imbalances later is contentious. Nevertheless, if we are suffering from a global variant of this asset crunch, we must all view leverage more critically.

A balance sheet recession occurs when asset prices plunge, leaving indebted entities technically bankrupt. On a corporate level, this transforms the indebted business from its normal function of profit maximisation to one where its overarching strategy is paying down debt and diverting cash flows away from future growth.

In monetary terms, if the business opts to pay debt rather than increase borrowing, cash remains within the banking system, and looser monetary policy has a negligible impact. It does not matter how low the cost of borrowing becomes if there remains a falling demand for debt.

We are seeing evidence of this today. Central bank money supply has grown, but broader money supply — money created through loans — is lagging. In other words, the "multiplier effect" — the expansion of commercial bank money into the real world — is modest and reflects the banks' desire to hoard capital. This is the essence of Mr Koo's warning.

We believe this warning has not been heeded by the market, as evidenced by the equity rally from the fearful lows in March.

Despite the shift in sentiment, it is unlikely that our willingness to spend will be maintained as unemployment rises, and we choose, instead, to repair our personal balance sheets.

Recently, American investor Jeremy Grantham presented the future as a "long, boring period where making fortunes is harder, and investors value safety and steady gains rather than razzle-dazzle".

The spring bounce looks more "dazzle" than steady. He does, however, hit upon the key for investing now: We should be investing in the reliable entities that have consistently generated equity returns, without resorting to debt to maximise results.

Cash-rich businesses do not have the dilemmas of their indebted brethren; they can invest the money they earn back into the business, compounding earnings growth, year–on-year. In a yin environment, this represents a crucial advantage.

The yin part of the cycle can take years to work through.

There is an evolutionary aspect to Mr Koo's theory, however. Human ego ultimately dictates the fear associated with the yin phase, and the overconfidence that will induce the bubbles in the yang. These precepts are nothing new, but identifying this particular cyclicality should help investors tailor their strategies.

The best investment returns of tomorrow will be generated by businesses with the strongest balance sheets today — in this respect, cash is king. Such investments remain our focus.

Carl Stick manages the Rathbone Income Fund and is a director of Rathbone Unit Trust Management. This article was published in The Daily Telegraph on Friday.

From TODAY, Business – Monday, 01-Jun-2009

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