The crisis which erupted in August last year is now generating a full-blown domino effect on the “real” US economy and half a year after things have developed sufficiently for me to make an informed opinion on the state of affairs so far and how things could go from here.
Firstly, a confession to make. Although my mental analysis framework was pointing to a reduction in equities allocation as the problems in the US led to one hole after another in its economic fabric, I instead shifted my allocation to more defensive themes and stocks well-supported by NTA (net tangible assets), but ultimately it turned out everything was hit anyway. So the lesson of the day was not to ignore the tide, especially when it had a fundamental basis.
Two qualitative analysis frameworks work well here (which I sadly discounted). Firstly, that the general market is driven by three factors: fundamentals, liquidity and sentiment, and that one should watch out if the first two look to be declining or when the last factor is peakish. That credit creation (and hence liquidity) would be affected was clear, while the fundamental situation seemed mixed for a while as the US employment situation remained strong until December. Sentiment was mixed. It was a time to be careful. The second analysis framework was described in an earlier article: “The financial statement as an analysis framework“. It showed a systematic way of thinking about revenues, costs, profits and how they eventually filtered through to stock valuations via P/E ratios, which were a function of liquidity. As liquidity declined, as did sentiment, there was a P/E de-rating, which is essentially what has happened over the last few months, especially for the small/mid caps and China stocks in particular. It remains to be seen whether the E will be affected in the coming months, in which case there could be another round of downward pressure on stock prices.