Financial Ruminations

George Soros CEU lectures

2010-07-19T09:16:00.002+05:30

Was reading George Soros CEU lecture series during the weekend and would like to share his deep reflection on financial markets with all of you ( see below). You can watch the video or read the full transcript by clicking here.

“Let me state the two cardinal principles of my conceptual framework as it applies to the financial markets. First, market prices always distort the underlying fundamentals. The degree of distortion may range from the negligible to the significant. This is in direct contradiction to the efficient market hypothesis, which maintains that market prices accurately reflect all the available information.

Second, instead of playing a purely passive role in reflecting an underlying reality, financial markets also have an active role: they can affect the so-called fundamentals they are supposed to reflect. That is the point that behavioral economics is missing. It focuses only on one half of a reflexive process: the mispricing of financial assets; it does not concern itself with the impact of the mispricing on the so-called fundamentals.

There are various feedback mechanisms at work which may validate the mispricing of financial assets, at least for a while. This may give the impression that markets are often right, but the mechanism at work is very different from the one proposed by the prevailing paradigm. I claim that financial markets have ways of altering the fundamentals and that may bring about a closer correspondence between market prices and the underlying fundamentals. Contrast that with the efficient market hypothesis, which claims that markets always accurately reflect reality and automatically tend towards equilibrium. There are various pathways by which the mispricing of financial assets can affect the so-called fundamentals. The most widely travelled are those which involve the use of leverage—both debt and equity leveraging. These pathways deserve a lot more research.

My two propositions focus attention on the reflexive feedback loops that characterize financial markets. There are two kinds of feedback: negative and positive. Negative feedback is self-correcting; positive feedback is self-reinforcing. Thus, negative feedback sets up a tendency toward equilibrium, while positive feedback produces dynamic disequilibrium. Positive feedback loops are more interesting because they can cause big moves, both in market prices and in the underlying fundamentals. A positive feedback process that runs its full course is initially self reinforcing, but eventually it is liable to reach a climax or reversal point, after which it becomes self reinforcing in the opposite direction. But positive feedback processes do not necessarily run their full course; they may be aborted at any time by negative feedback.

I have developed a theory about boom-bust processes, or bubbles, along these lines. Every bubble has two components: an underlying trend that prevails in reality and a misconception relating to that trend. A boom-bust process is set in motion when a trend and a misconception positively reinforce each other. The process is liable to be tested by negative feedback along the way. If the trend is strong enough to survive the test, both the trend and the misconception will be further reinforced. Eventually, market expectations become so far removed from reality that people are forced to recognize that a misconception is involved. A twilight period ensues during which doubts grow, and more people loose faith, but the prevailing trend is sustained by inertia. As Chuck Prince, former head of Citigroup said: we must continue dancing until the music stops. Eventually a point is reached when the trend is reversed; it then becomes self reinforcing in the opposite direction.

To go back to my original example, the conglomerate boom of the late 1960s: the underlying trend is represented by earnings per share, the expectations relating to that trend by stock prices. Conglomerates improved their earnings per share by acquiring other companies. Inflated expectations allowed them to improve their earnings performance, but eventually reality could not keep up with expectations. After a twilight period the price trend was reversed. All the problems that had been swept under the carpet surfaced, and earnings collapsed. As the president of one of the conglomerates, Ogden Corporation, told me at the time: I have no audience to play to.

Typically, bubbles have an asymmetric shape. The boom is long and drawn out: slow to start, it accelerates gradually until it flattens out during the twilight period. The bust is short and steep because it is reinforced by the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis.

Bubbles that conform to this pattern go through distinct stages: inception; a period of acceleration, interrupted and reinforced by successful tests; a twilight period; and the reversal point or climax, followed by acceleration on the downside culminating in a financial crisis. The length and strength of each stage is unpredictable, but there is an internal logic to the sequence of stages. So the sequence is predictable—but even that can be terminated by government intervention or some other form of negative feedback.

…………………………………… ……………………..It will be useful to distinguish between near equilibrium conditions, which are characterized by random fluctuations, and far-from-equilibrium situations where a bubble predominates. Near equilibrium is characterized by humdrum, everyday events which are repetitive and lend themselves to statistical generalizations. Far-from-equilibrium conditions give rise to unique, historical events where outcomes are generally uncertain but have the capacity to disrupt the statistical generalizations based on everyday events. The rules that can guide decisions in near equilibrium conditions do not apply in far-from-equilibrium situations. The recent financial crisis is a case in point. ……………………………….
I have gained some new insights into far-from-equilibrium conditions during the recent financial crisis. As a participant I had to act under immense time pressure, and I could not gather all of the information that would have been available—and the same applied to the regulatory authorities in charge. That is how far-from-equilibrium situations can spin out of control. This is not confined to financial markets. I experienced it, for instance, during the collapse of the Soviet Union. The fact that the participant’s thinking is time-bound instead of timeless is left out of the account by rational expectations theory.

I was aware of the uncertainty associated with reflexivity, but even I was taken by surprise by the extent of the uncertainty in 2008. It cost me dearly. I got the general direction of the markets right, but I did not allow for the volatility. As a consequence, I took on positions that were too big to withstand the swings caused by volatility, and several times I was forced to reduce my positions at the wrong time in order to limit my risk. I would have done better if I had taken smaller positions and stuck with them. I learned the hard way that the range of uncertainty is also uncertain and at times it can become practically infinite. Uncertainty finds expression in volatility. Increased volatility requires a reduction in risk exposure. This leads to what Keynes calls increased liquidity preference. This is an additional factor in the forced liquidation of positions that characterize financial crises. When the crisis abates and the range of uncertainty is reduced, it leads to an almost automatic rebound in the stock market as the liquidity preference stops rising and eventually falls. That is another lesson I have learned recently.”

The power & perils of intuition

2010-03-30T13:36:00.001+05:30

Below are excerpts from an interview of Daniel Kahneman and Gary Klein on the power & perils of intuition (Mckinsey Quarterly). You can read the full interview from here. I think the interview is as relevant for corporate personnel as it is for a stock researcher. Key points worth remembering are:

1. Don’t become overconfident: Look for information which does not support your thesis. If you’re starting with a hypothesis and planning to collect information to support the thesis, then you are doomed.

2. Learn the “The premortem technique”: It is a sneaky way to get people to do contrarian, devil’s advocate thinking without encountering resistance. Before a project starts, we should say, “We’re looking in a crystal ball, and this project has failed; it’s a fiasco. Now, everybody, take two minutes and write down all the reasons why you think the project failed.”. The logic is that instead of showing people that you are smart because you can come up with a good plan, you show you’re smart by thinking of insightful reasons why this project might go south. If you make it part of your corporate culture, then you create an interesting competition: “I want to come up with some possible problem that other people haven’t even thought of.” The whole dynamic changes from trying to avoid anything that might disrupt harmony to trying to surface potential problems.

3. Use “Checklists”: The checklist doesn’t guarantee that you won’t make errors when the situation is uncertain. But it may prevent you from being overconfident. The problem is that people don’t really like checklists; there’s resistance to them. So you have to turn them into a standard operating procedure—for example, at the stage of due diligence, when board members go through a checklist before they approve a decision. A checklist like that would be about process, not content. I don’t think you can have checklists and quality control all over the place, but in a few strategic environments, I think they are worth trying.

4. Avoid “Correlated errors”: There’s a classic experiment where you ask people to estimate how many coins there are in a transparent jar. When people do that independently, the accuracy of the judgment rises with the number of estimates, when they are averaged. But if people hear each other make estimates, the first one influences the second, which influences the third, and so on. That’s what I call a correlated error. Frankly, I’m surprised that when you have a reasonably well-informed group—say, they have read all the background materials—that it isn’t more common to begin by having everyone write their conclusions on a slip of paper. If you don’t do that, the discussion will create an enormous amount of conformity that reduces the quality of the judgment.

5. Postpone intuition as much as possible: Take the example of an acquisition. Ultimately, you are going to end up with a number—what the target company will cost you. If you get to specific numbers too early, you will anchor on those numbers, and they’ll get much more weight than they actually deserve. You do as much homework as possible beforehand so that the intuition is as informed as it can be.

Identifying Speculative Manias and Financial Crises

2010-03-28T11:53:00.001+05:30

Edward Chancellor’s (GMO) latest white paper, “China’s Red Flags”, is a must read. Edward highlights 10 common characteristic of past manias and financial crises and then points to China’s current vulnerability. Top ten aspects of great bubbles over the past three centuries are:
1. Great investment debacles generally start out with a compelling growth story.
2. A blind faith in the competence of the authorities is another typical feature of a classic mania.
3. A general increase in investment is another leading indicator of financial distress.
4. Great booms are invariably accompanied by a surge in corruption.
5. Strong growth in the money supply is another robust leading indicator of financial fragility.
6. Fixed currency regimes often produce inappropriately low interest rates, which are liable to feed booms and end in busts.
7. Crises generally follow a period of rampant credit growth.
8. Moral hazard is another common feature of great speculative manias.
9. A rising stock of debt is not the only cause for concern. The economist Hyman Minsky observed that during periods of prosperity, financial structures become precarious.
10. Dodgy loans are generally secured against collateral, most commonly real estate. Thus, a combination of strong credit growth and rapidly rising property prices are a reliable leading indicator of very painful busts.

“In summary, researchers find that rapid credit growth is the most important leading indicator of financial instability. The presence of an asset price bubble is the second most reliable crisis indicator. Low interest rates and strong money growth are also good warning signs. Real estate busts often produce severe and long-lasting economic downturns, while investment booms may result in a misallocation of capital. Classic manias have often been accompanied by a compelling growth story and an uncritical faith in the competence of the authorities. They are exacerbated by moral hazard and accompanied by rampant corruption.”

Growth- Is it good or bad for markets?

2009-12-06T12:21:00.002+05:30

"Even in such a time of madness as the late twenties, a great many men on Wall Street remained quite sane. But they also remained very quiet. The sense of responsibility in the financial community for the community as a whole is not small. It is nearly nil. Perhaps this is inherent. In a community where the primary concern is making money, one of the necessary rules is to live and let live. To speak out against madness may be to ruin those who have succumb to it. So the wise in Wall Street are nearly always silent. The foolish thus have the field to themselves.”-John K Galbraith

“It follows that once the investor pays a substantial amount for the growth factor, he is inevitably assuming certain kinds of risks; viz., that the growth will be less than he anticipates, that over the long pull he will have paid too much for what he gets, that for a considerate period the market will value the stock less optimistically than he does.”- Benjamin Graham and David Dodd

India’s 3Q09 GDP growth came in at 7.9%, better than expectation. Growth in good, but it comes at a price. Monetary tightening is a certainty, sooner rather than later, which puts upward pressure on rupee (look out for export oriented companies!) and downward pressure on markets. However it is highly unlikely that the EM rally will fizzle out soon. As developed world continue to slug through subpar growth (loose monetary and fiscal conditions will continue to remain benign in developed market) and as EM growth profile improves, EM asset class will continue to do well led by low rates globally, the dollar carry trade will be alive & kicking and even the EM central banks will be more constrained in raising rates. Global investors will be willing to pay more for any growth visibility and will look for returns and growth in Asia. The biggest risk to the aforesaid scenario, both on an absolute and a relative basis, will be if growth in the US or more broadly, OECD surprises on the upside, and monetary and quantitative tightening is faster than currently envisaged. Thus, it is very important to know and analyse what we are asking for.

Dr. John Hussman writes in his latest article to investors about Reckless Myopia and says that in his estimate, there is still close to an 80% probability (Bayes' Rule) that a second market plunge and economic downturn will unfold during the coming year. Also, Gluskin Sheff chief economist David Rosenberg noted last week, “Even if the recession is over, the historical record shows that downturns induced by asset deflation and credit contraction are different than a garden-variety recession induced by Fed tightening and excessive manufacturing inventories since the former typically induce a secular shift in behavior and attitudes towards debt, asset allocation, savings, discretionary spending and homeownership. The latter fades more quickly.”

Thus, the gloom and doom scenario, in OECD, as outlined by Hussman, David Rosenberg, Roubini, et al, ( through various articles) looks to be good for EM market asset class, as was discussed above.

Other important points from Hussman article worth exploring, “I should have assumed that Wall Street's tendency toward reckless myopia – ingrained over the past decade – would return at the first sign of even temporary stability. The eagerness of investors to chase prevailing trends, and their unwillingness to concern themselves with predictable longer-term risks, drove a successive series of speculative advances and crashes during the past decade – the dot-com bubble, the tech bubble, the mortgage bubble, the private-equity bubble, and the commodities bubble. And here we are again………Whether or not I have focused too much on probable “second-wave” credit risks is something we will find out in the quarters ahead – my record of economic analysis is strong enough that a “miss” on that front would be an outlier. What I do think is that over the past decade, investors (including people who hold themselves out as investment professionals) have become far more susceptible to reckless myopia than I would have liked to believe. They have become speculators up to the point of disaster…………Frankly, I've come to believe that the markets are no longer reliable or sound discounting mechanisms. The repeated cycle of bubbles and predictable crashes over the recent decade makes that clear. Rather, investors appear to respond to emerging risks no more than about three months ahead of time. Worse, far too many analysts and strategists appear to discount the future only in the most pedestrian way, by taking year-ahead earnings estimates at face value, and mindlessly applying some arbitrary and historically inconsistent multiple to them. This is utterly different from true discounting – which does not rely on multiples, but instead carefully traces out the likely path of future revenues, profit margins, cash flows and earnings over time, and explicitly discounts expected payouts and probable terminal values back at an appropriate rate of return. That's what we actually do here. Talking in terms of multiples can make the process easier to explain, and can be a reasonable approach to the market as a whole if earnings are normalized properly, but ultimately, an investment security is a claim to a long-term stream of cash flows. It is not simply a blind multiple to the latest analyst estimate. Fortunately, the evidence suggests that the long-term returns to a careful discounting approach tend to be strong even if investors repeatedly behave in speculative and short-sighted ways. This is because long-term returns are fully determined by the stream of cash flows actually received by investors over time, and because inappropriate valuations ultimately tend to mean-revert. In the face of speculative noise, the long-term returns from a proper discounting approach may not capture as much speculative return as might be possible, but over time, many of those speculative swings tend to wash out anyway.”

The dollar carry trade route is pumping up the stock, real estate and commodity markets all over the world. Also, the money being printed by various central banks all over the world to ensure that the value of their currency doesn't shoot up too much against the dollar (example-Swiss, China, HK, et al) is also at some level getting diverted for speculation purposes. A fascinating article on the aforementioned two points can be read from here.

Happy Reading!!

The “inside” view and the “outside” view

2009-11-23T18:51:00.002+05:30

“The human brain is incapable of conceptualizing something vastly different from what it is today. But the big-money ideas are those where the changes are far beyond what you can conceive today. The closer you can get to conceiving those types of changes and the higher the probability they might happen, the more likely you are to find big winners.” - Lisa Rapuano, Matador Capital Management, Value Investor Insight– September 28, 2005.

Bill Miller’s 3Q commentary is a must read. Miller highlights Michael Mauboussin’s new book, Think Twice, to explain the concept of “inside” view and “outside” view in investing. The inside view considers a problem by focusing on the specific task and by using information that is close at hand. The outside view asks if there are similar situations that can provide a statistical basis for making a decision. The outside view wants to know if others have faced comparable problems, and if so, what happened. It’s an unnatural way to think because it forces people to set aside the information they have gathered.

Says Miller, “……Think Twice, the opening chapter tells the story of Big Brown, the super looking colt who’d won such impressive victories in the Kentucky Derby and the Preakness, the first two legs of racing’s Triple Crown. This is a story with a lesson that directly relates to investing, and to understanding the kind of recovery that appears to be getting underway in the U.S. economy. After winning all 5 of his starts by a combined total of almost 40 lengths, Big Brown was a 3-10 favorite to win the Belmont Stakes and become the first horse in 30 years to win the Triple Crown. Those odds indicated the “wisdom of crowds” putting a 77% probability on Big Brown’s winning the race and making horse racing history. Part of that was right: he did make horse racing history — by being the only horse to win the first two legs of the Triple Crown and finish last in the Belmont. That so many were so sure of Big Brown’s success was due to a common analytical error that manifests itself in investing as well as horse racing. That error is the neglect of base rates. Psychologists call it the “inside” view, in contrast to the “outside” view. In the case of Big Brown, taking the outside view would be to see how many horses in the past had won the first two legs of the Triple Crown and then went on to win the third. The inside view focused on Big Brown, his history, the competition he faced, the tracks he ran on and their condition, his time between races, and so on.

The outside view revealed that 29 horses had won the first two races of the Triple Crown in the 130 years it had been run, with 11 of those horses going on to win the third race. Parsing the data a little more finely showed a remarkable divergence in winning percentages. Before 1950, 8 of the 9 horses that had a shot at the Triple Crown won it. After 1950, only 3 of 20 were successful. Moreover, when Big Brown’s speed ratings were compared to the most recent 6 Triple Crown contenders (and not just to his competition in the race), he was the slowest by a wide margin. If those who were betting on the Belmont had used the outside view instead of the inside view, no one would have believed what everyone did believe, that Big Brown had a nearly 80% chance to win the Belmont.

Investors are faced with these sorts of problems constantly: if I put my money in bonds now, what rate of return should I expect over the next 5 or 10 years? What is the outlook for stocks over the next 12 months? What are the chances of a significant rise in inflation over the next few years? What kind of economic recovery will we have? Should I fire my active money manager and replace him with a passive index product? What are the chances we have a “double-dip” recession? And on and on. Faced with these sorts of questions, most people default to the inside view, and then augment its flaws with the usual assortment of behavioral biases long known to psychologists: they anchor on the most recent experience, they assume instances are representative of deeper patterns, they give more weight to vivid examples or dramatic outcomes, they place twice the weight on a dollar lost as on a dollar gained, etc. The financial crisis that is now abating has created a near perfect environment for the admixture of all of the above, and that is perhaps why what Nobel winning economist Ken Arrow called the “clouds of vagueness” seem particularly thick and forbidding just now. Taking the outside view on some of the issues facing investors won’t make an inherently unknowable future predictable, but it can improve the odds of getting things right, or getting fewer things wrong.”

An intriguing post in Moneycontrol board is worth a read and re-read, “If your money doubles every five years, the compounded return that you are earning on your investment is somewhere close to 15%. Similarly, if it is doubling in every four years, the compounded return is in the vicinity of 19%. Have you ever wondered how long it will take to double your money if the interest rate is as low as 0.01%? Well, you don’t have to do the math. We will save you the effort and let you know that it will take all of 6,932 years! Yes, you’ve read that right. It will take a mammoth 6,932 years to double your money if you are earning a return of 0.01%.While this may seem like a joke to you, people invested in the US money market instruments currently are earning just that, a paltry return of 0.01%. Bill Gross, who runs the world’s biggest bond fund at PIMCO, believes that it is the measly return in the US that is driving investors towards higher yielding asset classes like gold and emerging markets. But can the US Fed continue maintaining short term interest rates at such low levels, especially given the fact that the specter of bubbles is being raised in most high yielding asset classes? Indeed, says Bill Gross. According to him, Fed’s foremost worry is the recovery of the US economy. Unless the US economy recovers and its employment scenario improves dramatically, Fed will continue to hold interest rates close to zero, asset bubbles or no asset bubbles. Gross is also of the opinion that once China starts letting its currency appreciate, which it would in about six months time, asset prices might come down and hence, the US Fed should not be hasty in its decision to tighten monetary policies and put the fledgling recovery under further pressure.”

If you want to read the Chinese argument on not letting the Yuan appreciate this year and why it will allow the currency to appreciate next year, read the latest Economist article here. “…….Beijing rejects the accusation that its exchange-rate policy has given it an unfair advantage. It is true that other emerging-market currencies have risen sharply this year, but this ignores the full picture. Last year China held its currency steady against the dollar throughout the global financial crisis, while others tumbled. Since the start of 2008, the yuan has actually risen against every currency except the yen……….Nevertheless, in the long run, a stronger yuan would benefit China’s economy—and the world’s—by helping shift growth from investment and exports towards consumption. It would boost consumers’ purchasing power and squeeze corporate profits, which have accounted for most of the increase in China’s excessive domestic saving in recent years. China will probably allow the yuan to start rising again early next year. This will not be the result of foreign lobbying—indeed, China is more likely to change its policy if foreign policymakers shut up. But by early next year China’s exports should be growing again, its year-on-year GDP growth could be close to 10%, and its inflation rate will have turned positive. The arguments in favour of revaluation will then loom much larger.”

Another interesting article in Economist asks the recurrent question-- central banks are wrong to keep rates low, or markets are wrong to expect recovery? “LIKE a truck rolling downhill, the rally in risky assets is proving hard to stop. Good economic news causes share prices to rise because it indicates the recovery is robust; bad economic news also causes prices to rise because it signals that central banks will keep interest rates near zero. Those low interest rates have probably been the main driver of the rally, encouraging investors to put their cash to work in search of higher returns. But other factors have been at play. Forecasts for corporate profits have been revised steadily upwards as analysts anticipate the benefits of economic recovery…Instead, the main threat to the rally seems likely to be disappointing growth, at least in the developed world…..At some point, the central dilemma at the heart of this rally will have to be resolved. Low interest rates seem like good news for investors. But why are central banks holding rates so low? Either they are correct in assessing that the economy is still fragile, in which case corporate profits will ultimately disappoint. Or they are underestimating the strength of the recovery, in which case inflationary pressures will start to emerge (and bond yields will rise sharply). Markets will have a tricky time navigating between this Scylla and Charybdis in 2010.”

George Cooper, author of ‘The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy’ interview in DnaIndia can be read from here. Coopers says that Central banks are not genuinely independent. They are in effect slaves to the developments in the markets. “Central banks say they must ignore asset prices and change in asset prices. If that is correct, why do they act when asset prices fall? They didn’t know that they were wrong to start with — they can’t know when the prices fall. The practical aspect as to why they do it is effectively the same answer as the previous question. They respond to falling asset prices because that leads to contracting credit, contracting economic activity, higher unemployment and intense political pressure. So central banks are acting, or trying, to continuously push credit into economies for political reasons. But of course the result of that if they are successful, they push the economy to get over-indebted, which is exactly what they shouldn’t be doing. It’s essentially a war between politics and good central banking……….. What I am saying is that we have now become so indebted in the West, that were we to try to pay off the debt in the conventional manner, the degree of economic contraction would be so severe that we would find ourselves in a situation like the 1930s, the Great Depression. The alternative is that we go into something like that 1970s, when we technically monetised the debt away to create inflation. Both of those scenarios are very bad. But the 1970s scenario is less bad than the 1930s. What concerns me, however, is that if we are going through that option, it is very important that we recognise the mistakes that led up to it. We must reform the system so we do not make the same mistakes again. And that’s basically why I wrote the book. My concern is that we are going into the endgame of monetising the debt without ever admitting to ourselves that’s how we got into the problem in the first place. So we will repeat the mistake again.”

Other good articles worth exploring are:

What if a Recovery Is All in Your Head?-Robert Shiller
The Phantom Menace-Paul Krugman

Liquidity- its benefits and pitfalls

2009-11-10T18:43:00.004+05:30

Excess liquidity, its benefits and pitfalls, continue to remain at the centre-stage of debate amongst most intellectual illuminati, especially in the field of economics and finance. Below are highlighted two articles on the topic, one from Paul McCulley of PIMCO and other from Ruchir Sharma of Morgan Stanley. Happy Reading!

Paul McCulley’s (PIMCO) latest article is a must read. It will immediately struck a cord with those grounded in deep fundamental analysis. Mr. McCulley highlights the contradiction between what equity markets is currently discounting (V-shaped recovery) and treasury bond markets (U or W-shaped recovery) and explains that, although seemingly irrational, the tie that binds them is the Fed’s policy of "exceptionally low levels of the Federal funds rate for an extended period." Mr. McCulley also highlights that markets can stray quite far from "fundamentally justified" values if Fed maintains it current ultra-loose policies for an extended period and, ironically, the strongest case for risk assets holding their ground is that the big-V doesn't unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed.

Says Mr. MaCulley, “But, you retort, this can't go on forever – at some point, risk assets will have to capitulate to reality if the big-V does not unfold, no? Yes, but it is not quite as simple as that. Without the big-V, Treasuries will tend to bull flatten, soothed by rational expectations of an extended period of the Fed funds rate pinched against zero. In turn, such a path for Treasuries would provide valuation support for risk assets. How so? All risk asset prices are analytically the Net Present Value of expected growth in cash flows, discounted by the appropriate-duration risk-free rate plus a risk premium. Thus, expectations of a friendly-for-longer Fed policy would be supportive of risk assets, as they (1) tend to pull down long-duration risk-free rates, while also (2) pulling down the market-required risk premium (which moves inversely with investors' animal-spirited risk appetite, which moves inversely with fears of Fed tightening). To be sure, this fundamental valuation framework – known as the Gordon Model – also implies that in real terms, the positive P/E effect of low long-term risk-free rates is moderated to the extent that the non-big-V scenario also implies lower growth in real profits. There are no free lunches. But since real long-term Treasury rates trade in real time, while "new-normalized" real growth rates are uncertain, subject to animal-spirited conjecture, friendly real long-term interest rates will tend to dominate the formulation of P/Es. Thus, ironically, the biggest intermediate-term risk for risk assets is not that the big-V doesn't unfold, but that it does, inciting the Fed to bring the extended period of a near-zero policy rate to a close. But again, you retort, doesn't that imply that in the absence of the big-V, risk asset prices could levitate into bubble valuation space? Yes, it does mean that. And that is a very, very uncomfortable proposition for those grounded in fundamental analysis, as I am.”

Ruchir Sharma’s latest article in ET is worth pondering over as he talks how excess liquidity heading towards unproductive assets could derail the current market momentum. How? Mr. Sharma points out the significant increase in commodity price and explains that prices are unusual high at this stage of the economic cycle given that the underlying demand and supply fundamentals are still so weak. Thus, if Oil and other commodities (especially food items) continue their relentless march upwards led by liquidity rather than fundamentals, then we could see the Central Bankers tightening before current market expectation, which could be negative for equity markets. The aforesaid point once again reminds us that there is no point in chasing risky assets from current valuation levels.

Other key points from McCulley’s article that’s worth noting are:

• Thus, as we look forward, a huge amount of humility is warranted in projecting asset returns on the basis of tight bands around what "fundamentals" suggest constitute fair value. Yes, there is no substitute for fundamental analysis; it remains at the core of investment management. But asset values can stray far, very far, away from their putative "fair" levels, much, much further than was the case during the middle-aged years of the Great Moderation. The efficient market hypothesis may not be dead, but it is most assuredly in retreat.
• And the envelope between those two modes of theorizing is the fact that the future is inherently uncertain. That might not sound like a profound assertion, and it isn't. We all intuitively know that. But the efficient market hypothesis conveniently assumes away that reality, in what is technically called the "ergodic axiom" – that past and current relationships between variables are reliable predictors of future relationships between variables. This assumption holds in astronomy, which is why astronomers can forecast with incredible accuracy when the next lunar eclipse will unfold. This assumption also holds in calculating the risk of any given hand in a defined card game – there are 52 cards in the deck and it is quite possible to calculate with great precision the odds of winning the game, such as Blackjack or Poker. That doesn't mean that you can know with precision whether you will win, simply that you can forecast the odds of any given player winning, given the cards in their hands and other players' hands, in the context of what cards are left in the deck. Indeed, I find it amusing when television shows broadcasting such games flash up the odds of any player winning after each card is dealt. There is risk, but not uncertainty – we know there are 52 cards in the game and we know what constitutes a winning hand. The ergodic axiom holds. In investment markets, however, the ergodic axiom doesn't hold, even though it is implicitly assumed in the efficient market hypothesis (but ironically, not in the legal disclaimers of all investment presentations, which state that past results are not necessarily indicative of future results!). In investment markets, genuine uncertainty exists: We can't assume that we know how many cards will be in the future deck or what will constitute a winning hand. That's not risk, but rather uncertainty.
• And how do we deal with it? "Certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. How then are these highly significant daily, even hourly, revaluations of existing investments carried out in practice? In practice, we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – though it does not, of course, work out so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not really mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance; errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads us to absurdities. We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematically expectation. In point of fact, all sorts of considerations enter into market valuations which are in no way relevant to the prospective yield.
• Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention. For if there exist organized investment markets and if we can rely on maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence. Thus investment becomes reasonably 'safe' for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are 'fixed' for the community are thus made 'liquid' for the individual." Those few paragraphs, my friends, are the foundation of modern behavioral economics and finance. Human beings, including investment managers, face both risk and uncertainty, and deal with uncertainty by resorting to conventions, notably that yesterday is the best predictor of today, and that today is the best predictor of tomorrow. George Soros calls it reflexivity.
• But when that comforting convention is overwhelmed by a new reality, all hell breaks loose. Uncertainty can no longer be simply assumed away. And when that happens, human beings tend to disengage, eschewing investment in favor of building up cash reserves. And if this proclivity becomes both widespread and profound, we find ourselves in Keynes' Liquidity Trap – there is plenty of money around, but risk-averse investors, infected with uncertainty, refuse to "put it to work" – on either Wall Street or Main Street. Such was the case a year ago, following the fateful decision to let Lehman Brothers fall into a watery grave.
• We here at PIMCO think it will, but only in a muted way, not a big-V way. We also recognize, however, that markets can stray quite far from "fundamentally justified" values, if there is a strong belief in a friendly convention, one with staying power. And right now, that convention is a strong belief in a very friendly Fed for an extended period. Thus, the strongest case for risk assets holding their ground is, ironically, that the big-V doesn't unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed. Simply put, big-V'ers should be wary of what they wish for. U'ers, meanwhile, must be mindful of just how bubbly risk asset valuations can get, as long as non-big-V data unfold, keeping the Fed friendly. But that's no reason, in our view, to chase risk assets from currently lofty valuations. To the contrary, the time has come to begin paring exposure to risk assets, and if their prices continue to rise, paring at an accelerated pace.

Other key points from Mr. Sharma’s article that’s worth noting are:

• Oil and agricultural commodity prices typically tend to rise sharply during the late stages of an expansion when supply becomes tight following strong demand for many years. Commodity bulls spin the story that prices are rising due to relatively better growth prospects of China and other commodity-consuming emerging economies. Hard numbers just don’t back that claim: inventories for many commodities from aluminium to zinc are at multi-decade highs. Massive inflows of financial capital are propelling commodity prices higher as investors and speculators buy the asset class to just make an anti-dollar play or because cheap money has their speculative juices flowing.
• The US dollar and commodity prices have shared a very high degree of inverse correlation ever since the Fed started easing monetary policy in the second half of 2007 when global economic activity was at its peak as was the associated oil demand. The price of oil at that time was trading at around $70 a barrel. Oil prices then doubled between August 2007 and June 2008 due largely to speculation and the resultant monetary tightening by several central banks in developing economies arguably contributed to the global recession last year. It is incredible that oil and many other commodity prices are now trading well above the average price that prevailed during the 2003-07 economic boom even though demand is yet to recover. Global spare capacity is currently running at 8% and in the past, oil prices have only risen when spare capacity was below 5%. Indeed, world oil demand is set to contract in 2009 for the first time since 1983.
• A commodity price rally during the initial stages of the economic recovery was not in the script of policymakers. Food and energy prices — the biggest contributors to inflation in many countries — usually remain relatively low so early in an economic upturn. Central banks then do not have to worry about inflation until the recovery is well entrenched.
• During previous expansion phases in the US dating back to 1970, the stock market on an average rose 30% six months after hitting a bottom while commodity prices were more or less flat over that period. This time around, prices of metals and oil have risen by almost the same magnitude as the already outsized 50% jump in the US stock market from its March lows.
• Nearly $35 billion has flown into commodity Exchange Traded Funds or ETFs that are a popular way for investors to gain exposure to commodities. The number of commodity ETFs outstanding has surged to 12 million securities compared to just three million in February this year. Speculative turnover in the commodity markets is also huge. Estimates put the daily trading volume of futures contracts in the energy space at a staggering 15 times underlying demand. The norm, just five years ago, for trading volumes of various commodities was four to five times actual demand.
• It is remarkable to see how emboldened speculators in commodities have become all over again just a year after the rout they faced when the bubble burst. ‘Echo bubbles’ are hardly uncommon in history. In several instances bubbles in the same asset class have resurfaced shortly after the original boom-bust cycle as it takes a long time for an idea to die and easy money conditions created to deal with the slump often end up reflating the same old notion. However, echo bubbles typically tend to be of a lesser magnitude as the original bubble. While both policymakers and market participants are slow to learn lessons from their previous mistakes, they do not completely forget the painful consequences of the previous boom-bust experience, suggesting the current run up in commodity prices will not be anywhere as large as the move seen during the 2003-07 bubble phase. In addition, any surge in commodities has to be self-limiting.
• If the easy money-driven economic recovery rolls on in its present form then oil prices will soon be back at close to $100 a barrel. Such a price shock will be too much for the global economy to handle; oil close to $100 a barrel will have the same debilitating effect on consumer balance sheets as oil at $150 a barrel had last year. Consumer incomes in many economies have shrunk from when oil traded close to $150 a barrel; at $80 a barrel now, oil is already draining away more resources from consumer wallets than at most points in history and offsetting much of benefit from the stimulus plans. Food and energy account for one-third of the consumer basket in developing countries and with prices of various agricultural commodities from vegetables to sugar also joining the commodity party, inflation worries are surfacing rather prematurely in the economic recovery cycle.
• The concerted and vigorous actions of policymakers across the world to revive the global economy are now doing more to reflate asset prices rather than lift economic growth. The realisation that easy money alone cannot create economic growth and the adverse consequences of just pumping liquidity into the system are likely to dawn upon investors and policymakers alike in the months ahead.

Mother of all Carry Trades Faces an Inevitable Bust

2009-11-03T21:06:00.002+05:30

In a must read article in FT Dr. Nouriel Roubini explains how the combined effect of the Fed policy of a zero Fed funds rate (through carry trade) + quantitative easing + massive purchase of long-term debt instruments is fuelling the current market rally. But when will the bubble burst?

Dr. Roubini explains, “if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments. Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed. This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.”

V. Anantha Nageswaran writes on the same topic in his weekly article in Mint today. Says Nageswaran, “That might become the more pressing objective of the two goals that the US would be pursuing in the coming years: asset price reflation and preserving its hegemonic status in global affairs. Unfortunately, both cannot be pursued simultaneously at all times, although that would be preferable. Now, after a few trillion dollars of last year’s losses have been clawed back in the asset markets in the last seven months, the US can and would likely switch priorities. The persistence of the gold price above $1,000 per ounce and in excess of its high earlier in the year would be unwelcome at the US Federal Reserve board. Hence, some increase in risk aversion, stability to slight recovery in the dollar and reduction in the bond yield might be the Fed’s prescription for the hour. Whether financial markets would deliver on this combination remains to be seen. Well, if the Fed could deliver a 60% rise in US stocks at a time when nearly three million jobs were lost, it could make this happen too—provided, of course, that this is its immediate goal.”

As per Mr. Nageswaran article, Fed should bring in some increase in risk aversion + stability to slight recovery in the dollar + reduction in the bond yield. If this happens then as per Dr. Roubini a stampede could occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts will trigger a co-ordinated collapse of all those risky assets. Macro investors should keenly monitor this issue as this could impact their returns substantially.

However, for all those in the bottoms-up camp, the great guru (Warren Buffett) advice should be of utmost importance during volatile times, “Price is what you pay, value is what you get” + “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” + “We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely.”

Happy Reading!!

The Echo Bubble

2009-10-31T20:01:00.003+05:30

Post the result reason it was refreshing to read some good articles couple of which I will highlight here.

The first article is written by Jerry Guo in Newsweek, titled The Echo Bubble. The article questions the current market rally and calls it an echo bubble, which is defined as “…… the smaller bubbles that follow on the heels of major ones, usually after the authorities helicopter in loads of cash to patch up the first round of damage, setting the stage for a second round of easy-money-driven speculation. The phenomenon has been observed throughout history, from the British railway bubble of 1830 to the Saudi stock bubble of 2005. Edward Chancellor, author of Devil Take the Hindmost: A History of Financial Speculation, says, "Echo bubbles tend to be smaller and fade away faster than the first bubble." On average, they reach about 30 to 40 percent of the size of the original before bursting and sending market values back down to where they should have been all along, wiping out the gains of the echo, but generally not dipping back to the previous low. That implies a Dow falling to 7000 or 8000.”

Jerry quotes Mr. Ruchir Sharma from Morgan Stanley and PIMCO’s CEO Mohamed El-Erian to prove that the story of emerging markets is a dream that dies hard. An example from Behavioural finance is also given to prove the irrationality of the markets, “……….. In one recent experiment done by Smith, participants were asked to trade an imaginary security, of which the underlying real value was understood. The experimental traders started out underbidding the security but slowly bid it up into a bubble, which then burst. They were subsequently asked to trade the same security again, knowing full well what happened last time around. Nothing changed—except the velocity at which the bubble was created; it happened much faster in the second round. Only in the third round did some participants finally learn their lesson. "We think we can beat the crowd," says Smith with a laugh. "But we are the crowd." It's true not only for the little guy, but also for the world's most sophisticated investors.”

Ride the bubble as long as you stay on the right side of them ( only if you can you time the markets!). “This echo bubble, like those past, is fueled by the fact that there is still a lot of money desperately seeking big returns in global markets. The total amount of financial assets worldwide has fallen from its all-time high of $194 trillion in 2007 to $178 trillion today, according to the McKinsey Global Institute. That $16 trillion in losses is larger than the U.S. economy. But the remaining $178 trillion is still a lot of money, and nearly 60 percent more than the 2000 total of $112 trillion. With interest rates so universally low, investors feel pressured to put that money somewhere. In China, the credit boom has resulted in massive speculation in equity and property markets…………………….. No matter: bubbles are inherently illogical, and the timing and scale of their highs and lows are nearly impossible to predict. One thing that history does tell us about echo bubbles is that they always crash and lead to a new cycle of creative destruction, only after which real and sustained growth can once again emerge…………………………………This rally is not driven by giddy investors convinced they are grabbing a piece of the future, but by wary buyers trying to make back their losses, hoping to profit from a government-subsidized gravy train that they know will come to a halt sooner rather than later. "I think the key distinguishing feature between this period and 1999 is memory. Back then, the previous crash was far away. Now you'd have to be an amnesiac not to remember, and that creates a different psychology," says University of Maryland professor Carmen Reinhart. Still, the rally may yet have some legs. Its length will depend on things like the speed with which central bankers start pulling back the stimulus bucks, the possibility of a Chinese banking blow-up, and whether we start to see currency crises resulting from all the new government debt (as some experts, like Harvard professor Kenneth Rogoff and Reinhart, predict). Rogoff and Reinhart, who re-cently published a book titled This Time Is Different: Eight Centuries of Financial Folly, say if that happens, it could well be emerging markets—today's darlings—that will be the victims. If there is any bubble truism to remember, perhaps it's this: the faster they rise, the harder they fall.”

William Bonner & Addison Wiggin, authors of, Empire of Debt - The Rise of an Epic Financial Crisis, interview in DNAINDIA is a must read. Click here. The author says, “We have run out of enemies so we will have to figure out a way to destroy ourselves. We are collapsing under our own weight. Another way of phrasing it is that we are sort of victims of our own success. We have gotten used to getting our way for a long enough period of time. But you know, all things rise and all things fall. And I think that is natural for nations as well. After the Second World War, the dollar became the reserve currency of the world, which took the coalescence of power in Washington and distributed it globally. We are still looking at the end of that era now. The question is, how are we going to wean ourselves off the dollar as the standard currency or the reserve currency of the world because so many countries India, China, South Korea and Japan hold massive amounts of dollars, and pretty much universally? Even Americans agree that it is not a good idea to hold them anymore. But there is no alternative (TINA) yet. The rise of the empire has been an interesting story, but like all empires, we have outlived our utility to most of the people that we do business with………… Every dollar that is printed cheapens the ones before it. Even in normal times, the Fed's target is 2% inflation rate, which means that the dollar loses value by 2% per year. But with all the printing that is going on, you can expect inflation down the road to be much more aggressive. The interesting tension is that they are fighting against the deflationary cycle, a credit bust, which requires all this cash to be poured in. So we don't see inflation on the horizon just yet, but that will be the interesting story to be done.”

Three points from Jeremy Grantham third quarter newsletter that I would once again highlight are, (1) “Notwithstanding this concern, I believe we are well on the way to my “emerging emerging bubble” described 18 months ago (1Q 2008 Quarterly Letter). I would recommend to institutional investors, including my colleagues, to give emerging equities the benefit of value doubts when you can. For once in my miserable life, I would like to participate in a bubble if only for a little piece of it instead of getting out two years too soon. Riding a bubble up is a guilty pleasure totally denied to value managers who typically pay a high price to the God of Investment Discipline (Thor?) for being so painfully early. I think the first 15 percentage points over fair value would satisfy me.” (2) “The lessons, if any, are that low rates and generous liquidity are, if anything, a little more powerful than we thought, which is a high hurdle because we have respected their power for years.” And what we thought were powerful and painful investment lessons on the dangers of taking risk too casually turned out to be less memorable than we expected. Risk-taking has come roaring back” and, (3) “Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment”

RBI latest monetary policy review gave a clear indication that the monetary policy reversal is beginning. It also highlights the policy dilemma that most central bankers are currently facing. RBI noted, "the challenge for the Reserve Bank is to support the recovery process without compromising on price stability. This calls for a careful management of trade-offs. Growth drivers warrant a delayed exit, while inflation concerns call for an early exit. Premature exit will derail the fragile growth, but a delayed exit can potentially engender inflation expectations." It is widely expected that RBI will lift policy rates by 25bp in January 2010. Hopefully by then, the RBI should have had adequate comfort in the pace of recovery. Also, at present the money markets are expecting the federal funds rate to rise by 100bps by the end of next year and the Bank of England to raise rates by 150bps by the end of 2010. Greed and fear in his latest note highlights, “…But if the S&P500 does turn around and “melts up” to the 1,200 level into year end, it can be confidently assumed that these rate hike expectations will increase further, an assumption which macro traders should be prepared to bet aggressively against. GREED & fear remains of the view that neither the Fed nor the Bank of England will raise rates at all next year. GREED & fear also remains of the view that neither will abandon completely so-called unorthodox policies in 2010.” This is one important thing to watch out for and any premature tightening (or aggressive) vs. current expectation could spook the markets and vice versa.

Other good articles worth reading are (click on the link):
· Akash Prakash: The capital inflow conundrum
· The Gold Standard
· Morgan Stanley GEF
· Hussman Funds

Happy Reading!!

Jeremy Grantham--Just Deserts and Markets Being Silly Again

2009-10-28T11:23:00.003+05:30

Jeremy Grantham third quarter newsletter can be read from here. Key learnings from the newsletter are:

The Last Hurrah and Markets Being Silly Again: “The idea behind my forecast six months ago was that regardless of the fundamentals, there would be a sharp rally.1 After a very large decline and a period of somewhat blind panic, it is simply the nature of the beast..……... After the sharp decline in the fall of 1929, the S&P 500 rallied 46% from its low in November to the rally high of April 12, 1930. It then, of course, fell by over 80%. But on April 12 it was once again overpriced; it was down only 18% from its peak and was back to the level of June 1929. But what a difference there was in the outlook between June 1929 and April 1930! In June, the economic outlook was a candidate for the brightest in history with effectively no unemployment, 5% productivity, and over 16% year-over-year gain in industrial output. By April 1930, unemployment had doubled and industrial production had dropped from +16% to -9% in 5 months, which may be the world record in economic deterioration. Worse, in 1930 there was no extra liquidity flowing around and absolutely no moral hazard. “Liquidate the labor, liquidate the stocks, liquidate the farmers” was their version. Yet the market rose 46%. How could it do this in the face of a world going to hell?

My theory is that the market always displayed a belief in a type of primitive market efficiency decades before the academics took it up. It is a belief that if the market once sold much higher, it must mean something. And in the case of 1930, hadn’t Irving Fisher, arguably the greatest American economist of the century, said that the 1929 highs were completely justified and that it was the decline that was hysterical pessimism? Hadn’t E.L. Smith also explained in his Common Stocks as Long Term Investments (1924) – a startling precursor to Jeremy Siegel’s dangerous book Stocks for the Long Run (1994) – that stocks would always beat bonds by divine right? And there is always someone of the “Dow 36,000” persuasion to reinforce our need to believe that as markets decline, higher prices in previous peaks must surely have meant something, and not merely have been unjustified bubbly bursts of enthusiasm and momentum. Today there has been so much more varied encouragement for a rally than existed in 1930. The higher prices preceding this crash (that were far above both trend and fair value) had lasted for many years; from 1996 through 2001 and from 2003 through mid-2008. This time, we also saw history’s greatest stimulus program, desperate bailouts, and clear promises of years of low rates.

As mentioned six months ago, in the third year of the Presidential Cycle, a tiny fraction of the current level of moral hazard and easy money has done its typically great
job of driving equity markets and speculation higher. In total, therefore, it should be no surprise to historians that this rally has handsomely beaten 46%, and would probably have done so whether the actual economic recovery was deemed a pleasant surprise or not. Looking at previous “last hurrahs,” it should also have been expected that any rally this time would be tilted toward risk-taking and, the more stimulus and moral hazard, the bigger the tilt. I must say, though, that I never expected such an extreme tilt to risk-taking: it’s practically a cliff! Never mess with the Fed, I guess. Although, looking at the record, these dramatic short-term resuscitations do seem to breed severe problems down the road. So, probably, we will continue to live in exciting times, which is not all bad in our business.”

Economic and Financial Fundamentals and the Stock Market Outlook: “The good news is that we have not fallen off into another Great Depression. With the degree of stimulus there seemed little chance of that, and we have consistently expected a global economic recovery by late this year or early next year. The operating ratio for industrial production reached its lowest level in decades. It should bounce back and, if it moves up from 68 to 80 over three to five years, will provide a good kicker to that part of the economy. Inventories, I believe, will also recover.

In short, the normal tendency of an economy to recover is nearly irresistible and needs coordinated incompetence to offset it – like the 1930 Smoot-Hawley Tariff Act, which helped to precipitate a global trade war. But this does not mean that everything is fine longer term. It still seems a safe bet that seven lean years await us. Corporate ex-financials profit margins remain above average and, if I am right about the coming seven lean years, we will soon enough look back nostalgically at such high profits. Price/earnings ratios, adjusted for even normal margins, are also significantly above fair value after the rally. Fair value on the S&P is now about 860 (fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smoldering embers). This places today’s market (October 19) at almost 25% overpriced, and on a seven-year horizon would move our normal forecast of 5.7% real down by more than 3% a year. Doesn’t it seem odd that we would be measurably overpriced once again, given that we face a seven-year future that almost everyone agrees will be tougher than normal?

Major imbalances are unlikely to be quick or easy to work through. For example, we must eventually consume less, pay down debt, and realign our lives to being less capital-rich. Global trade imbalances must also readjust. To repeat my earlier forecast, I expect developed markets to grow moderately less fast – about 2.25% – for the next chunk of time, and to look pretty anemic compared to emerging countries growing at twice that rate. We are nervous about the possibility of a major shock to Chinese growth. (My personal view of a major China stumble in the next three years or so is that it is maybe only a one in three chance, but is still the most likely important unpleasant surprise of the fundamental economic variety.)

Notwithstanding this concern, I believe we are well on the way to my “emerging emerging bubble” described 18 months ago (1Q 2008 Quarterly Letter). I would recommend to institutional investors, including my colleagues, to give emerging equities the benefit of value doubts when you can. For once in my miserable life, I would like to participate in a bubble if only for a little piece of it instead of getting out two years too soon. Riding a bubble up is a guilty pleasure totally denied to value managers who typically pay a high price to the God of Investment Discipline (Thor?) for being so painfully early. I think the first 15 percentage points over fair value would satisfy me. If I’m right, the first 15% will be a small fraction of the eventual bubble premium. So in a sense, we would be early once again. We believed from the start that this market rally and any outperformance of risk would have very little to do with any dividend discount model concept of value, so it is pointless to “ooh and ah” too much at how far and how fast it has traveled. The lessons, if any, are that low rates and generous liquidity are, if anything, a little more powerful than we thought, which is a high hurdle because we have respected their power for years. And what we thought were powerful and painful investment lessons on the dangers of taking risk too casually turned out to be less memorable than we expected. Risk-taking has come roaring back.

Value, it must be admitted, is seldom a powerful force in the short term. The Fed’s weapons of low rates, plenty of money, and the promise of future help if necessary seem stronger than value over a few quarters. And the forces of herding and momentum are also helping to push prices up, with the market apparently quite unrepentant of recent crimes and willing to be silly once again. We said in July that we would sit and wait for the market to be silly again. This has been a very quick response although, as real silliness goes, I suppose it is not really trying yet. In soccer terminology, for the last six months it is Voting Machine 10, Weighing Machine nil!

Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment………………………”

So, back to timing. “It is hard for me to see what will stop the charge to risk-taking this year. With the near universality of the feeling of being left behind in reinvesting, it is nerve-wracking for us prudent investors to contemplate the odds of the market rushing past my earlier prediction of 1100. It can certainly happen. Conversely, I have some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again. I would still guess (a well-informed guess, I hope) that before next year is out, the market will drop painfully from current levels. “Painfully” is arbitrarily deemed by me to start at -15%. My guess, though, is that the U.S. market will drop below fair value, which is a 22% decline (from the S&P 500 level of 1098 on October 19).

Unlike the really tough bears, though, I see no need for a new low. I think the history books will be happy enough with the 666 of last February. Of course, they would probably be slightly happier with, say, 550. The point is that this is not a situation like 2005, 2006, and 2007 when for the first time a great bubble – 2000 – had not yet broken back through its trend. I described that reversal as a near certainty. I love historical consistency, and with 32 bubbles completely broken, the single one outstanding – the S&P 500 – was a source of nagging pain. But that was all comfortably resolved by a substantial new low for the S&P 500 last year. This cycle, in contrast, has already established a perfectly respectable S&P low at 666, well below trend, and can officially please itself from here. A new low (or not) will look compatible with history, which makes the prediction business less easy.”

Micheal Mauboussin's new book-Think Twice, Mohnish Pabrai interview in Dnaindia and Economics!!

2009-10-21T12:15:00.000+05:30

I follow Micheal Mauboussin from Legg Mason very closely and his new book “Think Twice” is now on stands. You can buy his book in India from here. Mr. Mauboussin is a thought leader and his books will help improve on our latticework of mental models- a though process framework which will help in our investment & day-to-day endeavours. I will try and highlight some of the key points from his book in a later post.

Mohnish Pabrai interview in Dnaindia is a must read for all Value investors (although I believe that growth investors too can have value bias thereby blurring the line between value and growth). You can read the full interview here. He has also written a book on investing, The Dhandho Investor: The Low-Risk Value Method to High Returns.

Pabrai was at his best in the interview when he said, “An investor should think of himself as a gentleman of leisure. Don’t think that you are in some profession. You just think that you are a person who is focused on enjoying and living life well. If you focus on yourself as a gentleman of leisure what is going to happen is that you do not feel any compelling reason to act. It has been several months since I have bought any new stock. And that is not a problem because we went through a period in December when we bought ten stocks. The first thing is that we are in a profession were you don’t pay for activity, you get paid for being right. So there should be no compelling reason to act. Basically, the thing you do is you take out the reason to act…..The second thing you do is you focus on acquiring worldly wisdom. I read an enormous amount of stuff and relate to what different investment managers who I respect are saying. So, at times, things become no brainers………...…………………………………………………………………………………..I would say that we will never see another Warren Buffett. Just like we will never see any Albert Einstein or another Mahatma Gandhi. Buffett is a very unique individual. His skillsets outside of investment are phenomenal but they get dwarfed by his investing skills. The main thing that makes Warren Buffett Warren Buffett is that he is a learning machine who has worked really hard for, let’s us say seventy years, and is continuously learning every day. So the thing is if you want to be like Buffett, there is no short cut. First of all, you have to be deeply interested in investing and you have to be very willing spending tens of hours, hundreds of hours, reading the minutiae. There is a very famous value investor called Seth Klarman. He is into horse racing. And his famous horse is called Read the Footnotes.”

Moving on from Value investing to Economics. Another article in Dnaindia provides data of how China can’t get enough of US treasuries. As highlighted in an earlier post, the dollar debasement trade will most likely drive the final down leg in the 2000-14 equity bear market, as per Russell Napier. However, some economist suggests “China's total holdings of US securities were $1.44 trillion at the end of August, or about $34 billion more than suggested by monthly TICS data. In fact, during the July-September quarter of 2009, China's reserves increased by $141 billion, compared to a gain of $177.9 billion in the second quarter….. Significantly, China's purchase of US securities continues to show a bias towards longer-dated Treasuries for the third straight month. The average yield differential between the 10-year Treasuries and 3-month bills was 3.42% in August, compared to 3.38% in July.” This is an important data to watch out for if one is a macro investor and is interested in making money on dollar debasement trade.

Happy reading!!

Markets needs “Goldilocks scenario” to maintain the momentum

2009-10-09T13:36:00.004+05:30

The debate on “to tighten, or not to tighten” is gaining thrust. Australian central bank (CB) was the first to tighten rates thereby eliminating the “moral hazard” of other CBs who did not want to be seen as the first to start the tightening process (since the risks of policy mistakes are high). As the world cleans up after the U.S. housing debacle, central bankers are already fretting over how to tackle the next bubble, which may not be too far off as super-easy monetary policies worldwide leave financial markets flush with cash.

With CBs in a flux, markets are caught in a Catch-22 situation. Akash Prakash writes in his recent article, “If economic growth does bounce back with a vengeance, as some of the bulls think, it will force the hands of policy-makers to quickly pull back the emergency measures, which will ultimately be a strong negative for equity returns. It is unlikely that equity markets can continue their manic rise in the face of tightening liquidity conditions. Markets will probably do better if growth is slow enough to not force tightening. Yet, given the market reaction to the recent weak economic data, equities do not seem to be able to digest sub-par economic numbers, implying that an element of growth is already priced in. Markets seem to need incoming data to continue surprising positively to sustain the uptrend….Equities are only cheap if you believe in a strong earnings recovery. However, to get a strong earnings recovery, you need robust economic growth. As it is unlikely that corporate houses can do much more cost cutting, we now need top line growth. If we get a robust economic recovery (as earnings estimates imply), policy-makers will reverse the emergency fiscal and monetary measures, which will tend to be a drag on price-to-earnings (PE) multiples………… Thus, unless we get a perfect “Goldilocks scenario”, where growth is strong enough to deliver earnings, but slow enough to not force policy-makers’ hands, equities are going to have a choppy few months as the countervailing forces of economic acceleration and liquidity withdrawal fight each other. It is not clear who will triumph.”

Mr. Prakash continues, “Even in the Indian context, we need to worry about RBI beginning a new tightening cycle and rising interest rates. This tightening cycle will be a negative as RBI is not raising rates because the economy is overheating. The central bank is doing so because of inflation concerns in the face of spiking agricultural prices. G-sec yields are rising, hence, ultimately, interest rates will rise system-wide because of a huge government borrowing programme. In fact, bankers talk of a lack of credit demand from good quality borrowers. If interest rates were rising because of strong economic growth and an overheating economy, very strong corporate earnings would have compensated for the impact of rising rates on valuation multiples. However, rising rates will only damage multiples now, with no earnings offset. A strengthening rupee will further tighten financial conditions and damage profitability. We are also yet to see any credible plan from the government to put the fiscal in order. We all seem to be betting on growth to bail out government finances. Unless we find a path to bring the fiscal under control, at the first signs of strong credit demand from corporate India, rates will spike further and we will be hugely dependent on global capital flows to sustain growth………………………………………….….. Thus, while we may have a bit of a hiccup, if we can hold on and live through some short-term volatility and price declines, gains are likely. A correction is quite a possibility, which may even be severe but nothing like 2008.”

In another article Ruchir Sharma lucidly points out that the current synchronous global recovery has reached its mature stage and the extremely “high correlations are a symptom of a global boom-bust environment. Hopefully, after the tech and credit boom-bust cycles, it will be a while before the same mistakes are repeated and a relatively dull environment should prevail for the next few quarters. In such a scenario, it will be key to focus more on secular themes and less on cyclical movements…………..At the sectoral level, fortunes of sectors such as materials and energy will remain tied to global macro variables, but consumer stocks (both discretionary and staples) with exposure to emerging markets should show steady growth through cycles given the relatively low leverage of the consumer in many developing countries…….. Of course, the risk persists of the global economy suffering a major double-dip or conversely of a policy-induced synchronous melt-up in growth rates after the meltdown of last year. Either event will make the world continue to behave as just one market. However, the odds do not favour another extreme outcome and the markets are therefore likely to go horizontal after being vertical and highly correlated in the recent past. The time for taking aggressive oneway directional bets is probably behind us and the case for differentiation based on local influences is strong. The nature of markets is, in fact, to let new factors take on the reins just when everyone is convinced about the prevalence of a particular regime”

John Hussman writes in his column, “Probably my clearest drawback as an investment manager is that I have too often assumed that investors should recognize what seemed to me to be patently obvious dangers (the predictable collapse of the dot-com bubble, the tech bubble, the housing bubble, the oil and commodities bubble, etc) with a longer lead-time. Unfortunately, we inevitably experience a period of frustration – at least temporarily – for assuming such foresight…….the most important lesson I keep having to re-learn is how utterly myopic investors can be when there’s an uptrend to be played….…. Since I have no plans to risk the financial security of our shareholders on securities that are not worth their price, or premises that I believe are dangerously false or irrational, I can’t say that learning this lesson will make us strikingly more responsive to speculative runs in the future. But there may be some middle ground that we can exploit.”

Finally, Macroman writes thus, “Markets might be screaming “you suck!” to Macro Man, but trust him: the feeling is mutual.”

Happy reading!!

To tighten, or not to tighten: that is the question:

2009-09-17T12:15:00.000+05:30

The deep dilemma of central bankers, pertaining to exit strategy (from the recent massive monetary easing + fiscal stimulus), reminds me of Shakespeare’s Hamlet. Below is the soliloquy from Hamlet where the protagonist (played by the eponymous character) is musing on the comparison between the pain of life, which he sees as inevitable (the sea of troubles - the slings and arrows - the heart-ache - the thousand natural shocks) and the fear of the uncertainty of death and of possible damnation of suicide.

“To be, or not to be: that is the question:
Whether 'tis nobler in the mind to suffer
The slings and arrows of outrageous fortune,
Or to take arms against a sea of troubles,
And by opposing end them? To die: to sleep;
No more; and by a sleep to say we end
The heart-ache and the thousand natural shocks
That flesh is heir to, 'tis a consummation
Devoutly to be wish'd. To die, to sleep;
To sleep: perchance to dream: ay, there's the rub;
For in that sleep of death what dreams may come
When we have shuffled off this mortal coil,
Must give us pause: there's the respect
That makes calamity of so long life;
For who would bear the whips and scorns of time,
The oppressor's wrong, the proud man's contumely,
The pangs of despised love, the law's delay,
The insolence of office and the spurns
That patient merit of the unworthy takes,
When he himself might his quietus make
With a bare bodkin? who would fardels bear,
To grunt and sweat under a weary life,
But that the dread of something after death,
The undiscover'd country from whose bourn
No traveller returns, puzzles the will
And makes us rather bear those ills we have
Than fly to others that we know not of?
Thus conscience does make cowards of us all;
And thus the native hue of resolution
Is sicklied o'er with the pale cast of thought,
And enterprises of great pith and moment
With this regard their currents turn awry,
And lose the name of action. - Soft you now!
The fair Ophelia! Nymph, in thy orisons
Be all my sins remember'd.”

The aforesaid speech is a subtle and profound examining of 'life is bad, but death might be worse'. Similarly, for central bankers, ‘too much liquidity is bad, but chocking it prematurely is worse’. The key emerging issue for policymakers is to decide when to mop up the excess liquidity and normalize policy rates—and when to raise taxes and cut government spending. The biggest policy risk is that the exit strategy from monetary and fiscal easing is somehow botched, because policymakers are damned if they do and damned if they don’t. If they have built up large, monetized fiscal deficits, they should raise taxes, reduce spending and mop up excess liquidity sooner rather than later. The problem is that most economies are now barely bottoming out, so reversing the fiscal and monetary stimulus too soon—before private demand has recovered more robustly—could tip these economies back into deflation and recession. Japan made that mistake in 1998-2000, just as the US did in 1937-39. But if governments maintain large budget deficits and continue to monetize them as they have been doing, at some point—after the current deflationary forces become more subdued—bond markets will revolt. When that happens, inflationary expectations will mount, long-term government bond yields will rise, mortgage rates and private market rates will increase, and one would end up with stagflation. Thus, central bankers need to maintain a very delicate balancing act.

What is the implication of the central bankers’ dilemma on equity markets? A period of subdued growth or “double-dip” scenario (which is the most likely base case, at present) could actually be good for equity markets as central bankers decides to keep the liquidity tap on “full throttle”, in effect accepting higher asset prices to compensate for the very weak transmission of monetary policy. Also, as the risk of policy mistake is high, it could lead officials to postpone tough choices about unsustainable fiscal deficits.

Do find below opinion of three eminent thought leaders on the aforementioned topic.

Mr. Akash Prakash from Amansa Capital in his latest article writes, “the reality is that central banks have an exceedingly tricky task ahead in deciding how and when to calibrate their exit strategies from the emergency policy actions of 2008…….. If asset prices keep moving higher, and the central banks decide to do nothing, in effect accepting higher asset prices to compensate for the very weak transmission of monetary policy through the interest rate and credit channels, then we are setting the stage for another bubble in asset prices. It would be ironic if the policy solutions to the current crisis set us up for another bust down the road. No central bank willingly wants to go down this road, but there may be no choice. On the other hand, learning from the last 18 months, if they target the building asset bubble, while the other monetary transmission mechanisms are still weak, the authorities could jeopardise the whole economic recovery, by causing a premature tightening of policy. This would seemingly go against the emerging consensus coming out of the G-20 meeting. Having come so close to economic collapse, no policymaker wants to risk another economic downdraft. Thus the central banks have a real dilemma, and one fraught with political risks. The structural nature of the problems confronting consumers in the US seems to preclude a vibrant recovery in the other channels of monetary transmission. An overleveraged consumer and financial system will not correct its imbalances overnight. Central banks may have no choice but to willingly let loose another asset bubble, and this time emerging market assets are a prime candidate to be at the centre of this growing frenzy.”

Dr. Abheek Barua latest article talks about RBI preparing for recovery, “The “double-dip” scenario is a contingency we must be prepared for from the policy perspective. Thus it would be foolhardy at this stage to extrapolate the future path of growth from current data, however encouraging they may seem. The finance ministry has clearly decided to wait and watch before withdrawing some of the fiscal stimuli and that seems eminently sensible. The RBI may be extremely concerned about inflation but it is unlikely to put an end to monetary accommodation abruptly. As I have argued before, the first round of monetary tightening is likely only in January. By that time we will hopefully have a better sense on where the global economy and the domestic economy are headed…. We must also prepare for a scenario in which the current recovery in the global economy and markets sustains and ramps up risk appetite further. Were that to happen, there is every chance that global capital will flood economies like India that are growing much faster than the rest of the world. This has implications both for the rupee and money supply and we perhaps need to think out a clear strategy to handle this………. Both the prospects of sustained recovery and downturn are equally challenging for policymakers. The right formula might be to stick to what has worked best in the past and let prudence, not dogma, guide policy.”

Dr. Roubini in his latest project syndicate op-ed gives his suggestions for exit strategy, “First, different countries have different capacities to sustain public debt, depending on their initial deficit levels, existing debt burden, payment history and policy credibility. Smaller economies—such as some in Europe—that have large deficits, growing public debt, and banks that are too big to fail and too big to be saved may need fiscal adjustment sooner to avoid failed auctions, rating downgrades and the risk of a public finance crisis. Second, if policymakers credibly commit—soon—to raise taxes and reduce public spending (especially entitlement spending), say, in 2011 and beyond, when the economic recovery is more resilient, the gain in markets’ confidence would allow a looser fiscal policy to support recovery in the short run. Third, monetary policy authorities should specify the criteria that they will use to decide when to reverse quantitative easing, and when and how fast to normalize policy rates. Even if monetary easing is phased out later rather than sooner—when the economic recovery is more robust—markets and investors need clarity in advance on the parameters that will determine the timing and speed of the exit. Avoiding another asset and credit bubble from arising by including the price of assets such as housing in the determination of monetary policy is also important. Getting the exit strategy right is crucial: Serious policy mistakes would significantly heighten the threat of a double-dip recession. Moreover, the risk of such a policy mistake is high, because the political economy of countries such as the US may lead officials to postpone tough choices about unsustainable fiscal deficits…….”

Happy reading!!

Time in the market is more important than timing the market

2009-09-15T14:33:00.000+05:30

Ramesh Damani, one of the most erudite investors in the India stock market talks to CNBC on the perils of timing the market and, post the recent run-up, how he gone back to the basics of investing—bottoms-up approach with little focus on market timing. Mr. Damani’s interview clearly highlights the predicament of investors who missed the recent run-up because they wanted to perfectly time the market. Key learning: (a) Look for price-value variance of individual stocks rather then focus on broad market prediction. Sit through some of the short-term pain (in case what you buy goes down) if you are confident of the long-term value of the stock. Bill Miller said, “……….It is trying to invest long-term in a short-term world, and being contrarian when conformity is more comfortable, and being willing to court controversy and be wrong, that has helped us outperform”, (b) Time in the market is more important than timing the market. Warren Buffett said, “Only buy something that you'd be perfectly happy to hold if the market shut down for 10 years” and, (c) Learn from your mistake. “The best advice is to learn from mistakes and move on. If every shot you hit in golf was a hole-in-one, you’d lose interest,” Warren Buffett.

Interview of Ramesh Damani in CNBC-TV18:
Q: Bull or bear?
A: There is an old saying that if the bird talks like a duck, walks like a duck and quacks like a duck, then it is a duck and I think all the readings that I see in the market sound bullish. I mean the market is climbing its proverbial wall of worry. You know the bear markets don’t correct so much. The screen tells you a completely bullish story. There has been a gradual increase, people are being able to trade and the volumes take place, so I think the intellectual fit that I am trying to describe myself, it would be correct to say that I was very bearish when the markets were going down. Perhaps this was not a bull or a bear market. This was perhaps a very severe correction in an ongoing bull market that we experienced. It was maybe a 70% correction but a bear market by definition cannot snap back on a V-shaped recovery, the fact that the market has snapped back suggests that we were in a very severe correction of a bull market.
Q: At what point did you relook at your basic core hypothesis that we are in a bear market and this is just a bull market rally? When were you convinced first because we spoke about three-four months back and you were still quite hesitant to say that the bear market is over, what convinced you?
A: I think after the elections, the market made a 20% gap as you famously know and it has held that gap and that is almost impossible for a major market, a trillion dollar economy, a 17-18% gap to hold that and the market has held that for almost 100 days after that and you know the corporate results have come on and globally the market have recovered, maybe it is liquidity but it may be that India is putting a different story, maybe it is once in a generation thing that we are seeing and we are so unfamiliar with that kind of history. I will take you back to an example I quote frequently of the Japanese bull market, which extended the duration of 25 years and in 1987 when the global markets crashed across the world, the Japanese markets crashed too but it was one of the first to recover and continued to make new highs for a long time to come. So maybe in that kind of stage, in the evolution of the Indian economy as you go from a trillion dollar economy to a 20 trillion dollar economy over a period of 20 years and what we saw was a very sharp correction but the game is to stay invested in good stocks and perhaps the markets are telling us that.
Q: What are the odds that as the skeptics still point out that this is just the liquidity talking and very soon we will have a massive fall once again, so don’t trust it?
A: I think invariably we are going to have a fall sometime soon. If you look at the US employment data that came out, 9.7% and if you look at the aggregate employment, people are looking for jobs and people are looking part time jobs, there are 25 million people in US who are unemployed, so there is no case to be extraordinary bullish but there is another saying that you cannot fight city haul, if the government wants to promote liquidity, it is going to do that and it has just been gushing around. In India there is appetite, growth and hunger for stocks and so we could have a setback during the way but I think that the worst of the prices is behind us now.
Q: Does you think that we will see 12,000 again in the next couple of years?
A: It could happen, it is very hard. I don’t think that anyone would have predicted almost exactly one year ago what would happen to Lehman Brothers or Fannie Mae and Freddie Mac or a Bernie Madoff, the best minds were following these businesses. So you never know the global markets. This could happen — within this there have been just corrections — but I think that the long term trend perhaps still remains bullish.
Q: So how do you position yourself, buy every dip in the market again?
A: I have gone back to the basics. As you've always known that timing the market has been an extremely hard business and we just don’t know, there are so many factors confusing the markets but it is easier to take the bottoms-up approach that I have always done in my life, which is take a bottoms-up approach, sit through some of the pain which you are invariably going to see as being a long-term investor. Let me give you an example what Jim Rogers says, he says that trying to sell China is like trying to sell America in the 1950s. You knew that the Korean War took place and the Vietnam War took place and the race riots took place and the index kept plodding higher over periods of time and if you bought the right companies at that time, you made an enormous amount of fortune by the time 2000 came around. So maybe we will see a lot of corrections during this way, riots in India, slippages and liquidity crisis but if you invest in the right kind of companies and the right kind of stocks, then probably there is a pot at the end of the rainbow that is waiting for investors. So my sense is — at least what I am doing is — more of a bottom-up approach rather than doing a macro view because I have been unsuccessful in the last six months in terms of trying to call the market in terms of timing it.
Q: Intellectually was it a difficult transition because you got it right for a year and then the market suddenly turned and there was a lot of disbelievers were on the wayside? Was it a difficult intellectual adjustment to say no, I need to follow the market, cannot fight it?
A: It is painful and it makes you go home and cry sometimes, it is very painful, but it is to just time the market. I watch a lot of people and listen to a lot of people and there maybe a very few people who got it right. Jeremy Grantham got the top and the bottom right, some people got the top and some got the bottom right. To get both these extremes, I don’t find too many people who got it right. So it has been very painful.
Unfortunately you read a lot and you tend to get carried away about what happened in the 1930s in America and what happened in the Nifty 50 stocks in the 1970s in America or in any other markets in the way that the bear markets are really grueling processes, which absolutely kill the appetite for equity but I think that India, at the end of the day, is a compelling story and we always knew that and if I try to time the market, it was my mistake. I think at the end of the day when you think a stock is overvalued, you sell it and when you think that the stock is deeply undervalued — there is no question it was on 8,000 — you are trying to say that will you get more undervalued? I think you have made a mistake and I think people paid the price for that because markets are really philanthropic and give you a chance to get back on their. So the lows have been seen and the rebound suggests that those who have bought when the perceived risk was greatest but the actual risk was the least actually did very well. But having said that the markets are long-term stories and so you have to climb it back on the trade, very painful but it is nice to be back on the trade.
Q: It still is good that we got away lucky with just one and half years of severe price damage but in terms of time it could have been much worse?
A: It could have been. Of course, we are still not out of the woods, we still might see a market going sideways for many years as we saw in the Dow — it hit 1,000 for the first time in 1968, it didn’t cross it till 1982. This was against a backdrop of economy growing at 4-4.5% gross domestic product (GDP) and America already at the top of the world.
So yes, I think all bull markets begin with some sort of intellectual hypothesis and go back in history and say what was the 90s bull market in India? It foreshadowed liberalisation that was going to take place; the 2000s: that India would become a technological superpower, although Japan’s bull market said that Japan will become the largest economy in the world, a member of the G5.
This bull market in terms of how well it bounces back from lows is suggesting that there is something going on that is extraordinary in India and we are actually in the process of taking India from a trillion-dollar economy to — not a 2-trillion dollar or a 3-trillion dollar economy as even the bulls are suggesting but — something far greater. Maybe in a generation, we will take a population from affliction to affluence, from poverty to prosperity, maybe we would go from 100 million people in the middle class right now to a billion people in the middle class and the profound investment implications for that over investment horizons.
So it is very hard to point out what is going to happen in the next quarter, next year. Yes, there will be correction, the stocks that you bought will probably go down but if you believe this intellectual hypothesis and I am increasingly beginning to believe that then this is not a garden variety bear-bull market. This could be a long-term story, an intellectual hypothesis that is unfolding of a country that is in the wave of transformation. The first time countries like China, India are transforming the world, that we are going to go from a middle class of 100 million to a billion and there are important investment conclusions to reach from there.
Q: If this is true then you should not be sideways for many years like you were talking about, you can see a high pretty soon?
A: On that, I am not so sure. This could be a 20-year bull market for which five years go sideways, and there are two-three years I don’t think it’s going to make a new high in a hurry. The first I think as the market goes up, the tap of paper — whether it will be initial public offerings (IPOs), qualified institutional placements (QIPs) or public sector undertaking (PSU) disinvestments though there is an appetite for it — will suck out money and go back to the primary market.
Second point is we look at the composition of the index. It’s hard to see some of the stocks, which were rightly beaten out, coming back to the January ‘08 levels. I don’t want to name those companies but it is hard to see those companies go up five times, eight times from these prices. The composition of the index makes it possible and secondly the markets could be three-four years in the range, but as bottom-up stock picking, you will do fine. This market has proved already that you could have done really well bottom-up picking.
Q: So you won’t bet on more than 21,000 levels in 2010 at all?
A: I would say it is unlikely. Could it happen? Yes, it could. I would say 21,000 seems unlikely to me but the market remains fine. If you are going out picking stocks, making a living, you will do just fine.
Q: You spoke about largecap names in the index struggling to get back to 2008 highs. What about midcaps, they are 60-70% off their highs even now?
A: There is always a sense that when the market collapses, recall that all analysts said avoid the midcaps, they are decimated, no one will invest in them. The basic mistake is that we say that what a good stock pick does is that it always try to find the discrepancy between price and value and I have never seen anything in my life like what happened in 2008.
I have made a portfolio with a lot of care, lot of construct and which has beaten down to 90% and at some point you just threw in the towel like I did myself saying maybe I don’t understand this, maybe this is a once-in-a-kind global depression that we don’t understand — that cash will be usually important. I think that was a mistake.
I think that I made a mistake along with a lot of other analysts that ultimately you try to find the discrepancy between price and value and if it gets to be too extreme that you understand the companies are doing fine and the fundamentals are doing fine, you just step in and buy on the bridge.
So I think you will find and as long as you keep finding these discrepancies whether they are midcaps or largecaps, I would be a buyer. I am not particularly biased towards index stocks or midcap stocks.
Q: Have you been buying since the election results came in?
A: I had to reiterate myself and think just because I missed the lows, I don’t want to miss now. You know, you could have bought Infosys at Rs 500, it went to Rs 1,000, if you could have bought it at Rs 1,000, it went to Rs 2,000. Markets tend to work like that — so the sooner you drive looking at the front-view mirror rather than the rearview mirror, the better off you are.
At some point, I had to bite the bullet and say whatever has happened has happened. I am going to remain invested. Let us look at a scenario that happens in the world where money, which is flooded in the system, will lead to inflation. If it does happen, you want to own a piece of business. That will appreciate in terms of value over a period of time as opposed to holding cash. I think the governments have decided central banks must have made it midnight and decide that anyone who holds cash will be punished. So there is a huge and brutal punishment for holding cash. So rather just sitting on some cash, you need to move into some assets that will protect you in an inflation environment or if there is a benign environment where interest rates and inflation remain low, will be value accretive over a periods of time. I am certainly not going out in gushing and saying buy an index fund or just buy any stocks. Any old thing will do fine, but you certainly have to move back to equities because you just cannot make money otherwise.
Q: So the feeling that you should not be terribly overweight equities in you portfolio, that has changed now? You would say that it is the place to be for the next few years?
A: I have always been a 0:1 kind of guy, either be in equities or in cash and I don’t look at anything beyond that. Jewellery, real estate, bonds aren’t my area of competence.
Q: Did you give gold a thought then?
A: Gold is good. I will still recommend it and say that it is possible that in the next year, we see huge global currency prices, that magnitude of which we are aware of led by the US dollar somewhere. As a percentage of a portfolio, maybe 1-2%, I would recommend an exposure to gold because it is an insurance, I would not look at it as an investment for someone or for price appreciation but I would look at it as an insurance.
Q: So now is it 1 for equities or somewhere in between?
A: It is, I still have cash and I am willing to deploy it. I tend to be more careful as an investor, it is not in my nature to invest in one go but I am actively looking for aggregates where I find opportunities and I am investing.
Q: Is there a niggling concern at the back of your mind or something in your gut, which is telling you that I had to change my mind because of the screen but something could still go terribly wrong?
A: Absolutely, I chew my nails every time. Look what the global markets are telling us is that no matter what the excesses are committed and no matter what happens in this world, the government is going to pump in money and everything is going to be alright after that. Capitalism is not so simple and there has to be a punishment at the end of the day for the people who abuse the system.
Q: So intellectually, you are not convinced yet?
A: If I was in the US I might have looked at the markets differently. I am looking at India where I see the excesses were committed in terms of the stock market valuations but not in terms of the real economy. We are seeing a good growth story unfolding out here and I see good companies, which have seen good visibility, good prospects down the road and I am basing it on its intellectual hypothesis that we are in the process of transforming our country from a trillion dollar economy to a factor of n.
In that case, say, if you are looking back at the 1950s in America and you foresaw what is going to happen in America including the Korean War and the Vietnam War but you held on to Johnson & Johnson, Proctor & Gamble (P&G) and some of the great names out there, I think you would have done just fine despite all the crisis.
Q: What is the general feeling you get when you talk to the smart set in the market? Have people participated or are they rubbing their eyes in disbelief and the markets just ran past?
A: You were the only person who kissed the screen when the market was up 17% that day. I didn’t see any one jubilant person on the Dalal Street per se. Clearly, there were people on the other side of the trade but to be honest the smart money was caught napping this time, even the most bullish people were cautious at some point in time. I think some people who I know got the bottom right out there but they also did not believe that the market could rally as sharply as it did. It does beg the question: what is going on in the Indian market, is it something extraordinary that is going on and it is hard to disapprove that after you have seen this kind of revert back.
Bear market rallies don’t go on like this, at some point it gets silly and after it crossed 12,700 as I told you earlier, you just would have to take a re-look at things and I think that people are beginning to realise that those lows are gone and you are not going to see those prices again. Will there be a retest of that time? I doubt it somehow.
Q: So what are the themes that you are betting on, you have been fan of themes like consumer, aviation, logistics. Nacking the same things or some other themes have come to the fore?
A: Liquid themes, liquor, beer, tea, oil. As groups, I think there will be good picking among the PSU stocks over the next few years because the government is determined to do that.
Q: But National Hydroelectric Power Corporation (NHPC) did not do too well.
A: Let us take Oil India, for example. NHPC is something that you would look five years down the road to make it valuable, the idea that there is a God-given right to make money on appreciation on listing in PSUs, I don’t know where that comes from. Life cannot be so simple that you double your money on listing. People are stupid if they expect that.
Q: Did you buy NHPC?
A: No, I didn’t. But something like Oil India that is coming up and everyone says it is 10 times earnings but is going to be: why not buy Oil & Natural Gas Corportaion (ONGC)? But it’s just the sheer factor of listing that brings accountability to these companies. I think now that they know that they are in the public, margins will improve. We have seen time and time again after PSUs get listed that it brings accountability. They are sleepy companies. Telefonos de Mexico in Mexico when it got listed, management made a single change that if you want to pick up a pay cheque, come and sign for it and, they saved 3,000 pay cheques. I mean that is what accountability brings to the system.
So I think they will do well and as a group, the next 10-20 years that you are looking for in this investment horizon, you would want to bet on individual groups that will do well and I would submit that you take a look at Godrej group, it has been there for the 100 years and it is going to be there for the next 20 years and it has interesting portfolio businesses and I think the crown jewel is Godrej Properties. They seem to be doing a lot of things right and the next generation is ready. So whether it is soaps, properties or oil, I think that they will do well over a period of time.
Q: So just buy one of the stocks, which has exposure in all or you look at individually all?
A: They have two listed companies which is Godrej Consumer and Godrej Industries. As a full disclosure, I have interest in both the companies and I would like to buy into both the companies because if India is going to get to a billion middle class it is hard to believe that you won’t be bullish on fast moving consumer goods (FMCG) companies but I think the crown jewel in that whole business is Godrej Properties, which I think over a period of time will add extraordinary value to the shares.
Q: They will have an IPO out soon?
A: I think this September-October they will have an IPO coming out or maybe November.
Q: So have you turned bullish on real estate?
A: On an individual stock price basis, maybe yes because if you go through the model of these companies that we do, if it is a land bank model then I am not bullish, because a land bank prices keep going up but I think that the sheer model that they have on Godrej Properties is something that needs to be studied and I am bullish on the particular model that they have.
Q: Any other theme that you have spotted without going into the stock, any other bracket which you like?
A: You look at the beer and the spirits market, the per capita consumption of beer per person in India has to go up. Everywhere the beer sells more than spirits so these stocks look very expensive on a PE basis but I would submit that you look at it on a marketcap basis, these companies are very cheap if you compare them to the global peers in terms of the marketcap and in terms of the size of the opportunity wherever, so I would say the FMCG stokes and I would say the beer companies and I would take contrarian bet on aviation.
Q: You are still sticking with that contrarian call?
A: Warren Buffet says never buy an aviation company but the fact of the matter is that Warren Buffet never said buy a railroad company and he had bought one 100 years later because he found value in there.
It is always between price and value and it is not only about Indian aviation companies but I think globally they are going to do well, so if you ask me for a pair trade as an intellectual exercise, I would say, go short telecom and buy aviation because there is a real threat to the telecom companies not just in India but overseas from what is called the Google voice that is coming on and it is practically free and the international calls are a cent per minute or 2 cents per minute and you know how Google works. They just try to go in there by stealth and just dominate the market and there is a real threat that the voice and data will just become USD 10 per month or USD 20 per month or some sort of cheap figure like that.
So there is a technological threat to the telecom companies and at the same time I see that in the airlines capacity going down and the pricing power returning and getting more intelligent in just the way they price it. So if you ask me for a pair trade over a few years that is the one I would suggest as an intellectual exercise.
Q: Short telecom, long aviation?
A: Yes.
Q: We asked you many months back on what would make you change your mind on the bear hypothesis and you said let the index cross 12,700 and I will change my mind or I will re-look at it at least. What will you change your mind on if the market were to fall that you were right not to be bullish?
A: I have realised the folly of my ways in terms of timing the market and by no means I am trying to time this market. I am just giving you two things of where I stand that first I am beginning to believe that there is an intellectual hypothesis of what is going on in this country. Secondly I am doing up bottom-up stock picking. So in a correction like this, they will all fall but at the end of the day given the environment that we are going to face a few years down the road, I want to own a piece of the business, cash is not helping me at this point. So I am doing bottom-up stock-picking and owning a piece of the business. I fully expect there to be a severe correction in the US in the next two years or so and I think that India will be able to survive that and move on ahead if my hypothesis on India is correct.
Q: So you have turned a medium-term bull again?
A: I am investing.
Q: Your money is where your mouth is?
A: My money is where my mouth is.

Investing-Learn from your mistakes

2009-09-01T18:09:00.003+05:30

A must read article below from equitymaster, ‘Investing-learn from your mistakes’ (click here), which gives practical solution on how to learn from one’s own investment mistakes. Also see some good related quotes below. Happy Reading!!

“One of our strategies for maintaining rational thinking at all times is to attempt to avoid the extreme stresses that lead to poor decision-making. We have often described our techniques for accomplishing this: willingness to hold cash in the absence of compelling investment opportunity, a strong sell discipline, significant hedging activity, and avoidance of recourse leverage, among others.”-Seth Klarman, Value Investor Insight

“We think shorting makes us better analysts. Charlie Munger says you really understand a company when you can articulate the negative scenario better than the person on the other side of the trade. We also think that from a business standpoint, if you’ve done all the work and conclude the negative scenario is most likely to play out, it makes a lot of sense to be able to short.”-Ric Dillon, Value Investor Insight

“Becoming a better investor has always struck me as a process of self-education – you read everything you can and learn through trial and error. My finance degree, except for having to take some accounting courses, was worthless.” -Aaron Edelheit, Value Investor Insight

Investing: Learn from your mistakes: (source equitymaster.com)

Investing is a knowledge intensive activity. Being a successful investor requires life long acquisition of knowledge, i.e. learning. Especially learning from one’s own mistakes. But it is easier said than done. We often fail to admit that we have made a mistake, let alone learn from it. Why is it so? How can we correct this tendency? We shall examine these issues in this article.

Why we are blind to our mistakes
There are at least four behavioral stumbling blocks why we fail to recognize our own mistakes. They are self-attribution bias, hindsight bias, the illusion of control and feedback distortion. Self attribution bias is the tendency to attributing all our positive results to our own skill and the bad outcomes to bad luck. Hindsight bias is the tendency to believe after an event has taken place that we knew all along that it would take place. The illusion of control is the tendency to ascribe results to our actions when in fact, they are caused by other reasons. Feedback distortion is the tendency to twist facts to fit our beliefs. Or as Charles Munger, Vice Chairman of Berkshire Hathaway puts it, “torturing reality so that it fits our mental models of the world”.

How to rectify this tendency?

Admit: The first step in dealing with biases is to admit their presence.
Keep records: Writing down one’s decisions and the reasoning behind them helps keep a check against self-attribution bias. It also helps counter the hindsight bias, especially if one has written down the various alternative results possible. In fact, even Warren Buffett recommends this method. He says, “Write down the reason you are buying a stock before your purchase. Write down ‘I am buying Microsoft @ US $300 bn because…’ Force yourself to write this down. It clarifies your mind and discipline. This exercise makes you more rational.”
Check if you are really in control: The illusion of control is particularly strong when there are lots of choices (like lottery tickets), there is a large amount of information (relevant or irrelevant) and there is personal involvement. In investment, the equivalents of these factors are large portfolios, high turnover and short time horizons. Hence, the most effective remedy for the illusion of control is long term investing in select stocks.
Seek the bad news: We should create mechanisms at the personal and the organizational level that records and speeds up the delivery of bad news. The exact opposite of ‘shooting the messenger’. When we check for results, we should actively look for negative outcomes, instead of only seeking positive results.

V-shaped recovery is negative for equities!!

2009-08-28T14:39:00.000+05:30

Is V-shaped global economic recovery actually negative for equities? Yes, says Mr. Akash Prakash, in a brilliant article in Business Standard. Says Mr. Prakash, “While the bears may be right about growth coming out of this recession being a disappointment, is such an economic outcome necessarily negative for equities? One can easily make the case that the best environment for equities is one of subdued growth, and not the V-shaped recovery bears fear the market is pricing in. A subdued and halting economic recovery will allow equities to remain in the sweet spot of easy liquidity, low inflation but improving economic and corporate fundamentals. This is the point in the economic cycle where policymakers are still totally focussed on stimulating growth, and inflation is not yet an immediate concern, but the beginnings of growth are visible. On the other hand, a sharp V-shaped recovery will in all probability force the hand of central bankers and we will see a shift in policy to exit the current super-stimulative policy regime. Such a policy shift will in all likelihood have a serious negative impact on equity markets. Given the trading pattern of the last few months, markets seem hypersensitive to even discussions of policy shift on the part of the central banks. Thus the bears may be right about the upcoming economic recovery in the US and Europe being far more anaemic than the market is thinking, but ironically such a scenario may only go to extend this cyclical bull rally. This rally may still have some legs given that the most likely cause for a short circuit — viz a change in policy stance so as to roll back liquidity, fiscal stimulus and quantitative easing — seems to be still some distance away.”

Mr. Prakash thinks that given that sharp run-up, it is the right time to buy protection through either buying options or building cash levels, given that 10-15% correction could be round the corner. He reasons, “We are, first of all, entering a seasonally very tough period for equities. The months of September and October have normally not been kind to equity markets, and historically one has seen many sell-offs in these months. Secondly, the cost of protection has come down globally, with the VIX index having fallen by 67 per cent over the last nine months. Risk aversion has clearly reduced. Contrarian sentiment indicators measuring the bullishness of retail investors and fund managers also indicate much more complacency towards equity risk. The performance of Chinese equities is also a cause for concern, given that these markets have been leading indicators for global markets over the past 18 months. At one stage last week, they were down 20 per cent. The continued decline of the Baltic dry bulk index, despite the stabilisation of the Chinese equity markets, is also a worrying divergence. Trading volumes and breadth, at least in the US, do not give comfort on the short-term sustainability of this rally……….. The case for buying protection is even greater in the case of India. Our markets have been among the best performing large markets this year. Despite this huge run-up, protection has rarely been cheaper, as volatility skews have flattened…………………………… In the case of India, due to the weak monsoons, we are seeing cuts in growth forecasts for 2010. Along with lower growth, serious risks in the form of a surge in food prices and inflation exist. Chances are that the fiscal situation will only worsen as the government has to engage in drought relief and ramp up food subsidies. Interest rates have already started creeping up, despite enormous liquidity in the system and the next move of the RBI is to hike. A combination of factors — cuts in GDP growth rates, rising interest rates and stress in rural India — does not equate with corporate earnings upgrades. Commodity prices have also risen in the last six months, which will offset much of the margin expansion we have seen in corporate India in the last quarter. The market is also not particularly cheap……………. While we do expect a correction, any fall will be a buying opportunity, as I still believe India will be a very exciting investment destination over the coming years. There is still so much low-hanging fruit on the policy side, which can keep markets enthused and ensure strong growth. There still exists the strong possibility that this whole cycle will ultimately end with a bubble in emerging market stocks. India will be a major beneficiary of any such rush of liquidity into the asset class. Given the magnitude of the returns we have seen this year, I think it is more prudent to try and protect these returns to the extent possible as opposed to trying to make the last 10 per cent. One will get a chance to buy stocks cheaper, it is only a matter of time.”

Irrational Exuberance?

2009-08-27T13:46:00.000+05:30

Interesting to note that a company’s CFO calls brokers “Irrationally Exuberant”. Yesterday two big brokerage house upgraded Infosys to a BUY (peak cycle multiple given!!). Look what liquidity and anchoring bias can do to us analysts. Please click here for Infy CFO’s interview. Enjoy!!

Think through!!

2009-08-27T11:45:00.002+05:30

Given that liquidity and macro have taken prominence, atleast in the near-term, over micro, it has been interesting to read (some articles/books) and contemplate, on the aforesaid issue, over the past few days. Key questions that emerge are (a) have we learnt anything from the on-going crisis, (b) should be take a dip into the liquidity created by central bankers, (c) is the risk-reward ratio currently favourable, (d) given the backdrop of current crisis, are central bankers conscious of not creating/supporting another asset bubble, (e) when will central bankers begin the tightening process, (f) what else could spook the markets, (g) will the present CB easing support a ‘V’ shaped recovery, (h) does chance play a big role on our business and our lives?

The answers (lets think of it independently), to the aforementioned questions, will certainly improve our thought process. Happy reading on what some stalwarts think on the issues.

Jeremy Grantham, “When asked by Barron’s on October 13th if we would learn anything from this ongoing crisis, I answered, “We will learn an enormous amount in a very short time, quite a bit in the medium term, and absolutely nothing in the long term. That would be the historical precedent.”

Dance with Chance, the four domains that are critical to most people: heath, wealth, success and happiness. Very often people assume much more control than they actually have. Chance and randomness play a significant role in business and in our lives…….. The point is not that the world is hopeless and we shouldn’t do anything, it’s just that we should do a more careful assessment of what we can predict and what we can’t predict. And where we can’t predict then the effort and the resources are better spent on planning. Given the uncertainties facing most businesses now, it’s very difficult to focus and very difficult to predict when the current downturn will end. Could things get much worse? Would things start to get better in the first quarter of 2010 or would it take another three years or would it become more like what happened in Japan? These things are very, very hard to predict. So instead of trying to predict this, which we actually cannot, we are better off spending our resources and effort on planning for various contingencies.” And when it comes to managing risk in investing, the pillars of wisdom are: “Be average. Be patient. Be risk aware. Be balanced.”

Ruchir Sharma, “However, the cyclical bull camp holds that any rally will start to fade in 2010 once the effects of the stimulus begin to wear off in the US and policymakers in developing countries start to withdraw liquidity as they become wary of asset bubbles forming in their domestic markets. In short, the current economic momentum inspired by government stimulus efforts will likely keep financial markets well bid for much of 2009 but the environment will be more challenging next year………All three camps share the common feature of a macroeconomic forecast lying at the heart of each thought process. Valuations and sentiment from a contrarian standpoint are not presently an issue — as those variables tend to matter only at extremes and not when they are stacked in the middle. ………..But we all need to retain the flexibility to switch camps at the slightest sign of incremental change, especially with many financial market indices back at the pre-Lehman levels. For markets to move higher hereon, economic data needs to keep surprising on the upside for as goes the global economy, so go the markets.”

BCA Research (www.bcaresearch.com), "By mid-1936, the Federal Reserve lifted bank reserve requirements, in an attempt to soak up liquidity and prevent speculation from returning to Wall Street. However, the banking system was still too fragile and in need of capital. Consequently, both narrow and broad money growth plunged from a healthy clip back into negative territory. To make conditions worse, by 1937 fiscal stimulus programs ended and social security taxes were collected for the first time. The federal deficit shrank rapidly from -5.4% to -1.2% of GDP, creating significant contractionary forces…………..Obviously the economic relapse in the 1930s is an extreme example. Nonetheless, it does highlight the risks of authorities exiting prematurely before the economy and banking system are ready (even after an extended period of healthy growth). Currently, U.S. and U.K. money multipliers are still impaired, although aggressive easing has allowed some liquidity to flow through to the real economy. A decline in U.S. M2 growth would be a major warning sign. U.K. broad money growth has plunged in recent months, presenting a significant threat to the economy.” Bottom line: Policymakers will need to continue to curb investor expectations for an early exit in order to allow a sustainable recovery to materialize. It will likely be at least until the end of next year before growth conditions in the U.S. and U.K. are robust enough to withstand a reduction in stimulus."

Manoj Pradhan (Morgan Stanley) on keeping a watch for the beginning of monetary tightening, “Even before the dust settles on the monetary easing cycle, markets have started a watch for the beginning of monetary tightening. Unlike past cycles where the focus was solely on policy rates, the unconventional element of monetary easing means that the assets and liabilities of central banks are key variables in the tightening equation. Central bank balance sheets will undoubtedly be observed as closely as indications of policy rate hikes. But we caution investors against equating a contracting balance sheet with a withdrawal of monetary expansion. Instead, we provide a laundry list of measures that would constitute monetary tightening. None of these measures indicate that tightening is imminent any time soon.”

Manoj Pradhan on ‘V’ shaped recover, “The rally in risky assets has gone from strength to strength - from relief that the worst is behind us to pricing in a ‘V-for-Vigorous' recovery. And while our US, euro area and UK teams point out significant upside risks to output in the short term, the medium-term outlook does not show such a rosy picture. Markets are pricing in a first 25bp rate hike by January for the Fed and the BoE and February for the ECB. This is not unreasonable if we get a large-sized economic bounce in 2H09. However, we believe that market expectations of a steady tightening campaign that takes rates higher at a rapid clip are unlikely to be realised. The weaker medium-term outlook for the economy and the complicated process of unwinding QE will act as headwinds to a rapid increase in policy rates, in our view.”

Manoj Pradhan on Central bankers finding themselves in ‘Between a Rock and a Hard Place’, “Monetary policy usually finds traction in the real economy through different 'channels of monetary transmission', working through falling interest rates, increasing asset prices and increased lending by banks. These translate into more consumer and business spending, which boosts economic growth. During this cycle, however, interest rates that matter for borrowers have fallen only very slowly while the flow of credit to the private sector is likely to be weaker than usual due to financial sector deleveraging. Only risky asset prices have been roaring forward since the rally began in March. This imbalance between the various channels creates complications for the prospects of returning monetary policy to neutral. If central banks decide to tolerate higher asset prices in order to compensate for the weaker impact of both the interest rate and the credit channel, they risk inflating another asset bubble. If they respond to rapidly rising asset prices while the other transmission mechanisms have only played a weak role, they risk tightening policy into a weak economic recovery. Turning away from the inflation-targeting (IT) regime that is now conventional wisdom to perhaps a price level-targeting (PT) regime or even explicitly accounting for asset prices may give central banks much-needed flexibility.”

Dr. John Hussman, “That said, I can only describe our investment stance here as “uncomfortably defensive.” ………………….. “It's a lot like watching people scale across a tenuously secured rope bridge and get a nice meal at the center. You'd like to climb across and join them, but you know that too many things aren't right with the bridge, and it's not clear that the people who are eating will ultimately survive.”

Jeremy Grantham, “……….When markets sell at normal prices, life for us becomes much harder, perhaps 10 times harder. Predicting movements away from rational prices in an irrational world should not be easy, and indeed it is not. Our one and only effort at predicting a bubble – in emerging markets – is likely to stay just that. Only U.S. quality feels (and measures) to us like a real outlier. If you feel yourself becoming overconfident about anything, take a cold shower and start again. Just be patient. In our strange markets, you usually don’t have to wait too long for something really bizarre to show up.”

Is liquidity the single biggest factor that is going to fuel the market direction and what could pop the liquidity bubble?

2009-08-26T12:32:00.000+05:30

Arvind Sanger, Managing Partner, Geosphere Capital recent interview in CNBC is thought provoking. You can read the full interview here. Sanger focuses a lot on liquidity and its impact on worldwide equity/commodity markets. Says Sanger, “ But my view is that this is a global liquidity led rally and it has come a lot further, a lot faster than almost any observer would have imagined a few months ago. But as far as the liquidity – it is still very much alive. I don’t think any of the major Central Banks whether it is the US Fed or even with all the news or noise that comes out of China, whether the Chinese regulators and the banking systems are really to clamp down on liquidity and as long as liquidity is there then any signs of negative news like for instance in India’s case the monsoon or its effect, there are always good reasons why it won’t matter so much and liquidity finds reasons for any near-term negative fundamentals to be overlooked. This is not to say that there are no positive fundamentals. But I think liquidity is the single biggest factor that is going to continue to fuel market direction. My sense is that barring any external shocks, markets should continue to trend high…………………………….I guess bubbles - if one would use that term – can go a lot longer, a lot further than any of us imagined. ………………………………………………………..So, I think one of the challenges is we don’t have similar historical parameters to judge some of the factors that are driving this recovery because you have never had such a loose fiscal and monetary response on a global basis ever before to compare with. So, I am not sure that I am at all ready to call any kind of an end to the bubble. I think there are short-term speed-bumps in the road. We are about to go through a global seasonal swine flu season, which you had a little bit of experience of that in the last few weeks in India. But I think that is globally going to be probably a bit of a scare over the next month or two. But I don’t think it is that major issue. I think liquidity at the end of the day could affect fundamentals enough to where there might not be a real pop in some of these commodity bubbles, they may stabilize, they may pullback a little bit. But I don’t think I would be calling any bubble pops anytime soon as long as that liquidity is around………………………………...I think the US is not in a position to tighten anytime soon or lesser recovery to start to take off much more powerfully than anything that we have seen in the US so far. I think the big concern will have to come back again whether it is China or on a global basis. Certainly, India is probably going to be the first one that’s going to face that is inflation. When you face that inflation concern as we did in late 2007 and 2008, you have to tighten. My concern is this time whether we will enjoy three-four years of prosperity before we have to deal with the inflation because this easily liquidity could lead to again with commodity prices being driven up by that by another inflation scare, again people are still not willing to give up the ghost of deflation scare. So, as long as we are still questioning growth maybe we don’t have to worry about it. But sometime in 2010 if the growth does continue to come along in increasing proportions from a global basis then that will be the scare. I am not sure if US is going to lead this the way in terms of tightening first or whether China and other emerging markets which are much more even sensitive to any inflation scare what have to do for some - my sense would be that’s where the initial risk will come in. I think that’s the issue. But I don’t see anything that suggests that’s something we have to eminently worry about in the next six months. India certainly is an exception but even if the Reserve Bank of India (RBI) is tightening in India, I am not sure whether the global liquidity flows will not overwhelm any moderate tightening here to keep the markets from going down too much.”

Happy Reading!!

Ramesh Damani, Sanjoy Bhattacharyya and Chetan Parikh----on various behavioural fallacies which leads to sub-optimal investment returns

2009-08-13T15:59:00.005+05:30

Ramesh Damani’s CNBC-TV18 show RD 360 interviews Sanjoy Bhattacharyya and Chetan Parikh on various behavioural fallacies that investors regularly indulge in. The full interview (see below or click here) is a must read for all investors. Chetan Parikh summed up the interview very nicely, “….Buffett also said that investing is not a game where a guy with 160 IQ beats the guy with 130 IQ. What is crucially important is to be able to have that temperament to control the urges that get people into trouble and I think that is where behavioural investing comes in.”

Happy Reading!!

Q: Yogi Berra used to say we met the enemy and enemy is us. Are investors their own worst enemies?
Bhattacharyya: Absolutely right. What we do very often is we rely on a set of assumptions and beliefs that have gained ground overtime. To give you a simple example, one of the beliefs that all of us have, and particularly economists, is that when human beings take economic actions they always act in a way to maximize their own gains and they behave rationally. We all know that isn’t right. I will give you a simple illustration, you go abroad on a holiday, you go to a restaurant you probably never going to visit it again your life, you tip at the end of the meal why would you do that?

Q: Because you are never going to come back again?
Bhattacharyya: Absolutely right, and if you wanted to tip I would suggest you tip before the meal starts to get good service rather at the end of the meal. So I think that illustrates exactly what you said that we believe in certain things. We refuse to move away from those assumptions and our actions reflect the mistaken assumptions and beliefs.

Q: We do not want ugly Indian abroad but Chetan in terms of ugliness in stock market say, markets swings in a pendulums from fear to greed from greed to fear, how can investors profit from there and what is behavioral finance tell us about it?
Parikh: Essentially humans are not just irrational but they are predictably rational. There are certain biases, errors that we follow as a result of trying to take mental shortcuts, which lead us to sort of extrapolate patterns. Say, for instance, prices are falling down if markets are coming down you extrapolate that pattern. You are also got this entire loss of version circuitry working in your mind with the result that you go ahead you probably sell at the wrong time. When markets are going up there is euphoria, there is over confidence and there is this belief that prices are going to continue rising because we are used to seeing patterns.
This is what the way the mind evolves, this is the way the brain circuitry evolved. So essentially you go ahead and you extrapolate that trend out and probably make a mistake of not selling. So you oscillate between greed and fear and you do not take rational decisions, which is a price versus a value decision.

Q: Let us go to one of the axiom of behaviour of finance which it stands on is that bureau of finance believes that all money is equal, that all rupees are equal but people do not believe to that – they do mental accounting.
Bhattacharyya: Right. The reason for that is very simple. It relates to how you receive that money. A rupee earned by working 12 hours in an office is very different from your grandmother leaving you inheritance of the same amount. That is why governments round the world persist with lotteries though they realize that perhaps it does not have the best social outcome. Simple example to make the point, if you are given a free ticket for a music concert as opposed to paying for a music concert and, let us say, a Michael Jackson concert, the concert gets cancelled, your response to the cancellation of the concert is very different, because when it is a free ticket you couldn’t care less because you are not bothered about the money coming back to you but when you paid for the ticket you are incredibly concerned about what the organizers are going to do.

Q: And whether Michael Jackson comes or not you probably go there?
Bhattacharyya: Right.

Q: Because you paid the money?
Bhattacharyya: Because the money is gone.

Q: In terms of the mental accounting, people use credit card money different than taking it out from their pockets and that leads to bad decisions?
Parikh: Yes because you are putting it into different mental pockets. You go ahead and spend and you say that this is not money that is due immediately. It is not visibly going out and with the result that you go ahead and you over spend.

Q: How do you protect your self against this: are SIP plans a good amount because then you treat that as serious money?
Bhattacharyya: That is a good way to do it. As always very practical solution, The problem with SIP though is that this is not going to make me friends in the mutual fund industry is that you should be doing SIPs with valuations built as an overlay on it so if you say that I am only going to do SIPs when the market trades at less than 14 times earnings that is great because you do not want to be systematically putting in money when the market is expensive. Ofcourse the mutual fund industry does not encourage this.

Q: Or in a debt fund for example?
Bhattacharyya: Same idea. If you believe that yields are going to go higher you got to be careful because you are going to see value erosion in the NAV so SIP is a great idea to come back to this belief but need to be handled with care and thought.

Q: But the principle behind this mental accounting that investors should profit from is what?
Bhattacharyya: That all rupees count equal. The buying power of what you have is exactly the same irrespective of how it has come to you. That is what you need to keep at the back of our minds. Once that idea is rooted in your head, I think what Chetan spoke about the irrationality with how you spend or how you allocate will automatically diminish.

Q: Let me give you and example of another axiom and you tell me how investors respond: I bought a stock, Reliance, for Rs 50,000 it is worth Rs 1 lakh now and I bought the same amount of Infosys for Rs 2 lakh it is worth Rs 1 lakh now so one I had a loss and a profit both are worth Rs 1 lakh I need to raise Rs 1 lakh to pay my son’s tuitions. What would most investors do?
Parikh: Most investors would go ahead and sell the profit making company, which is that they would go ahead and they would sell Reliance and they would hold on to Infosys because there is a loss over there.

Q: The principle in that being?
Bhattacharyya: The amount of pain that we take when we make a loss is much greater for an equivalent number of amounts than the amount of pleasure that we experience when we book a profit so that is something that we call risk aversion. This actually comes to haunt most of the behavioural finance because we do not treat loses and gains equally.
Parikh: Basically, as Sanjoy put it, there is any symmetry between gains and losses. The disutility of a loss is far greater than an equivalent amount of gain, the utility of an equivalent amount of gain. This has a lot to do with – as Charlie Munger said that this is what is the loss of possessed reward or an almost possessed reward – this is what he calls deprival super-reaction. It is the way that you go ahead and the way you frame, you are framing yourself and saying that I made a loss so over here I made a gain over there. You have not looked at the probabilities, you have gone ahead and framed it in terms of losses.

Q: If you frame it differently you would come to different conclusion?
Parikh: You would come to different conclusions. And again, as I said, the way you frame it is going to impact the way you process it in your brain. There is entire neuroscience behind it.

Q: My Rs 1 lakh loss for example, a 30% tax rate means a Rs 30,000 gain if I sell it – you could look at that way to do it better?
Parikh: Yes.

Q: Let me ask you another question on sunk cost fallacy. What is that?
Bhattacharyya: You have already invested certain amount in a stock and the stock has gone down below the price at which you purchased it. Now you recognize that you have made a error of judgment but the amount of money that you have invested is already there so for many people this way out is to buy more of the stock to reduce their average price but that is to a pure logic because if you made an error of judgment what the smart person will do is to recognize the error, sell the stock an get out of it. Very few of us can bring ourselves to do it because the loss that it entails so you let the sunk cost remain and in fact pump good money after bad to give yourself the physiological illusion that you are now behaving smartly.

Q: Is Air India a good example of sunk cost fallacy?
Parikh: There is plenty of. Actually even the example that I have is Subhiksha: one example of a person being committed to something, which is loss making but I guess that this is the whole thing that has got to do with commitment. It is a fact that once you have made a commitment to something you want to be consistent with it and you will look for everything. In fact believing is seeing you are going to look for everything. Any information that comes that contradicts what you feel you are going to ignore it, you are going to throw it out and that is a human mind is.
Bhattacharyya: The smart investor is just the reverse. He always hunts after he has made in investment or even before he makes an investment. For the reason that he actually contradicts his thesis so that he does not fall into the trap of doing something stupid, which he may not have thought about so disconfirming is really the hallmark of the smart investor.
Parikh: Progress is made from contradictions and not from confirmations.

Q: We talked about behaviour of finance, number numbness, and numerical illiteracy. Talk to me about it?
Bhattacharyya: I think the way people buy lottery tickets is a good illustration of this. We know there are of a million lottery tickets sold, one number is going to win and the odds that any six digit number is going to be the winning number is equal. Yet there is the belief in people’s mind that certain numbers recover more frequently than others. You see this at the poker table, ruler table. Let me give you an extension of what you just said, which is very interesting and all of us can relate to it.
We are all great cricket fans in this country. You have a batsman: last five innings that he has played, he has scored four fifties and a century, right. The team is batting first innings score is 89 for 5. Let us say the batsman with the hot hands — the guy has got four half centuries — and let’s say Dhoni, the guy who should come in at number 7 is another batsman with a career average, which is far superior to the guy who has hit four fifties and a hundred. The captain will promote the guy with the hot hands in the belief that this inning is going to be another half century and the team needs it more.

Q: So that means get out of a hot performing mutual funds and get into low performing – surely you are not suggesting that?
Bhattacharyya: There is actually some statistical evidence that suggest that mean reversion is a very powerful factor in anticipating future returns.

Q: You say mean regression, I say Warren Buffet?
Bhattacharyya: Correct, it is the same thing. That is absolutely right but you must recognize that for every 10 million people on this planet there is one Warren Buffet so back to the lottery mistake.

Q: What is money illusion in behaviour of finance?
Parikh: Money illusion is basically the fact that you do not consider that there is a factor of inflation so you may have normal increases in asset prices or for that matter in any price index but you are not considering the impact of inflation. Over long periods of time, it makes a big difference. For instance, if you see that over a ten-year period you have made a normal gain of a thousand percent but if the price index has gone up a thousand two hundred percent, you have not done too well at all.

Q: People look in absolute terms not in the relative terms?
Parikh: People look at absolute terms they do not consider the impact of…

Q: Is there a business bias in behaviour of finance that you are aware of or misunderstanding the odds to people who misplace their odds?
Parikh: Misunderstanding of odd is certainly because if for instance you have a very vivid event that has happened, it may be of a very low probability even, you could have a 9/11 and people will stop traveling by airplanes because of what happened. You mis-calibrate probabilities especially low probabilities events when there is a lot of news flow or a lot of coverage after that particular event. You find out the number of people who have died of shark attacks - so the same thing that Sanjoy was saying you must look at the base rates. If you do not know what the base rates, if the base rates are very low and some event has happened the chances of even you put a very high probability up over there you are probably making a big mistake.

Q: It is like inspecting another crash after a crash?
Bhattacharyya: Absolutely right. It is called another word for this in a different context the resensing effect. You are most vividly impacted by what you have been exposed to most recently. Very low probability events, which have tremendous impact and can do much greater damage than people think, it is not just about the probabilities of the event, It is about the impact of the event will have. So we have got to consider expected value as oppose to just the probability of the event. If you have low probability event which can do tremendous damage, you have got to try and visualize these to stay out of trouble.

Q: And plan for that always? That is what the recent meltdown showed us.
Bhattacharyya: That is why the entire financial crisis and all of Wall Street has flawed thinking because value at risk impact does not deal with that last one percent which is where the maximum damage is done.

Q: 99% probability is not good enough sometimes?
Bhattacharyya: So risk management needs to deal if it is going to be practical and help you to save money in the worst possible time with that low probability high impact event.

Q: The other fixation that investors fall into is the anchor investing. Take a particular set of number and base their beliefs around it – talk about that?
Parikh: Essentially in the stock market if probably the purchase price or some 52-week high or low or the recent last week price so whatever you have seen on media that could be one price. The point is that the human mind will anchor on any meaningless number or any meaningless data. It is just there on which to compare and which to have a reference. So in the markets you are going to have anchoring on pretty much user spaces. What should really matter is: what is the value? Is there a price value discrepancy when you are going ahead and buying or not. Benjamin Graham said that value standards do not determine market prices in fact market prices determine value standards.

Q: In terms of anchor fixing?
Bhattacharyya: It is a very interesting thing. It happened to me all the time it happens to all investors except, I suspect, you Ramesh. Here is the broker, he rings you up and he says you know this stock just three months ago was selling at Rs 500 it is Rs 240 now. It is a real bargain and what he is doing implicitly trying to affect the way your mind works by using exactly this effect, that anchoring effect because the nature of the business has not changed, the earning power has not changed. The fact that it was at Rs 500 three months ago does not mean that at Rs 240 it is cheap. It may just have had a hugely inflated price because of sequence of events round the world. So that is I think a daily sort of trap that we face, all of us as investors because people try to make you relate to something that actually does not have something to do with the value of what you are buying.

Q: So in a bubble stocks can fall 50% and fall 50% from that price and 50% form that price and if you are not aware of it you are going to?
Parikh: You are going to go ahead and make big mistakes.
Bhattacharyya: Lose big money, lose your shirt.

Q: Another way you can lose money according to behaviour of finance is following the trend or herd investing?
Bhattacharyya: Yes and that goes back to something that you spoke about earlier because you are absolutely like a rabbit in the headlights and you want to respond to situations of extreme euphoria or to extreme panic because what is the emotion that is driving you — greed and fear — and as a famous economist said, you rather be wrong with whole crowd around you than be the one guy who is by himself.
So the real issue is when you are wrong you want to be where every one is , no one wants to stick out like a sore thumb when things turn out badly and that response actually leads people to herd and investment managers sadly, my troupe are the worst possible example of this because they do the maximum damage.

Q: Because investors force them to do that because investors say markets up, you are not up, you are doing a bad job?
Parikh: That is because there is that very short-term focus, there is that intense myopia of looking at measurement, trying to measure on short-term basis, which again this is an inadequate time period in which to gauge performance, your sample period is very low. The point is worldly wisdom teaches you fail conventionally rather than succeed unconventionally.

Q: But behavioural finance, people who study that are optimist, human behaviour can be changed?
Bhattacharyya: Human behaviour I think can move towards recognizing that there are lot of things that we don’t know and if we come to that conclusion that we don’t have capabilities and understanding and assimilating certain ideas or assumptions. We cannot comprehend them then we are protected by the knowledge that we don’t know. The fact that we know what we don’t know is a huge plus in investing because the bulk of the money lost in behavioural finance goes back to the idea of over confidence. People act, if you ask someone, let me ask you this: what does a Boeing 747 weigh?

Q: 330,000 pounds?
Bhattacharyya: It is a wonderful answer because it straight away tells you that there are many things about which you don’t have a clue but if someone asked you a question on the street you would instantly have an answer and your answer should be: I don’t know. So the recognition that you don’t know is absolutely fundamental to changing behaviour, the acceptance.
Parikh: Essentially I think you have to know your circle of competence. Buffett had used this word: Circle of competence. What you don’t know is more important than what you do know and alienating that is more important. Buffett also said that investing is not a game where a guy with 160 IQ beats the guy with 130 IQ. What is crucially important is to be able to have that temperament to control the urges that get people into trouble and I think that is where behavioural investing comes in.

Expectation Investing by Micheal Mauboussin

2009-08-11T11:00:00.001+05:30

Recently re-read Expectation Investing by Micheal Mauboussin and thoroughly enjoyed the same. Micheal is the CIO of Legg Mason Fund and is a highly regarded investment professional. Micheal practice what he preaches and Legg Mason is amongst the top performing fund in US (remember Bill Miller). The theme of the book is that the key to successful investing is to estimate the level of expected performance embedded in the current stock price and then to assess the likelihood of a revision in expectations. Investors who properly read the market expectations and anticipate revisions increase their odds of achieving superior investment results.

Steven Crist, “Crist on Value,” summarises the aforementioned approach, “The issue is not which horse in the race is the most likely winner, but which horse or horses are offering odds that exceed their actual chances of victory . . . This may sound elementary, and many players may think that they are following this principle, but few actually do. Under this mindset, everything but the odds fades from view. There is no such thing as “liking” a horse to win a race, only an attractive discrepancy between his chances and his price.”

The book describes how “value drivers” and “value factors” work to affect shareholder value. While, for example, sales growth will drive shareholder value, it is the value factors such as volume and pricing that affect sales growth. So by starting with the stock price and working backwards we can infer what the market seems to expect to happen to volume and pricing. At this point we can ask ourselves if these expectations seem reasonable and also if we should expect the market’s expectations to ever change.

In the Indian space, there are numerous recent examples where investors failed to capture the long-term cash-flow expectations implied by the stock price and have eventually failed. This was because of (a) too much focus on outcome rather than the process of investment, (b) Not thinking in terms of probability, (c) availability bias (accounting vs. economic focus), (d) recency bias (betting on what has worked) and (e) diversity breakdowns (expectations gaps).

The book talks about several concepts like CAP (competitive advantage period), focus on ROIC>WACC, value drivers, et al, which should be an ideal toolkit for any investment manager. I would reiterate that I loved reading the book and would recommend it to all investors.

The best advice I ever got

2009-08-07T17:33:00.002+05:30

Mohamed El-Erian (CEO and co-chief investment officer, PIMCO) talks about the best advice he has every got. Click here for the full article. He says, “We were living in Paris, back when my father was Egypt's ambassador to France. Each day we used to get at least four daily newspapers, from Le Figaro on the right side of the political spectrum to L'Humanité, which was the newspaper of the Communist Party. I remember asking my father, Why do we need four newspapers? He said to me, "Unless you read different points of view, your mind will eventually close, and you'll become a prisoner to a certain point of view that you'll never question."

Reading widely is particularly important right now. Most of the market research these days asks the same question: Is this the market bottom? To answer that question, they look at historical valuations and try to extrapolate from them. And most of the time that is the correct approach. However, right now we are going through major and unpredictable changes in the financial landscape. As a result, "Is this the bottom?" is the wrong question. But you have to read other people like [New York University economics professor Nouriel] Roubini, like [The Black Swan author] Nassim Taleb, and some of the behavioral-finance guys to understand why the question is wrong. The question we should be asking is, In this new world how do the historical variables morph, and what are the unintended consequences of government policy? There's a tendency for everyone to operate in a comfort zone and to want to read what is familiar to them. But if you are just used to following one person or one newspaper, you will miss these big shifts.”

Facets of Bubble Analysis

2009-08-07T17:15:00.000+05:30

Excerpts from Doug Noland bubble bulletin (the article is worth pondering over) is given below. You can read the full article here.

“Months back I posited that a Government Finance Bubble had emerged from the smoking ashes of the Wall Street/mortgage finance Bubble. I understand why some might see me as a dreary hammer out searching for nails. All the same, the backdrop merits further discussion of facets of Bubble analysis. ………………..Many see Bubbles in terms of an unsustainable overvaluation of asset prices. And many would view today’s “post-Bubble” landscape and find my ongoing Bubble premise borderline ridiculous. But I’ve always viewed Bubbles as a Credit phenomenon. Inflating assets prices are actually only one of many consequences of an overexpansion of Credit. Rapid asset inflation is almost a sure sign of underlying Credit excess, though analysts should downplay asset prices while focusing keenly on underlying Credit and speculative dynamics. Huge Credit growth, market price distortions (especially the under-pricing of risk), highly speculative markets, and prolonged asset inflation are inevitably indicative of some underlying monetary/Credit disorder. ……….…………..Again, Bubbles are first and foremost a Credit phenomenon. Fundamental to the nature of Credit, expansion generally fosters more expansion. Credit excess begets only greater Credit excess. And Credit excess notoriously begets speculative excesses. Importantly, Credit is inherently self-reinforcing – both on the upswing and downswing. In today’s “system” of unrestrained Credit, rising demand for borrowings does not dictate an increasing price for this Credit. Indeed, an unlimited supply of Credit will tend to satisfy rising demand at a lower price. And this gets right to the heart of a huge Bubble – and policymaking - dilemma. ……………..The bottom line is that unrestrained Credit is inherently unstable, and few seem to appreciate the unique nature of today’s unfettered global Credit environment. There is no international gold monetary regime for which to discipline lenders, central banks, governments or economies. The dollar reserve system self-destructed over decades of undisciplined Credit expansion. And the breakdown of U.S. discipline – and the resulting massive dollar devaluation – has unleashed domestic Credit systems from China to Brazil. Never have “developing” Credit systems (and currencies) enjoyed such freedom to inflate financial claims……………It’s with this backdrop in mind that I contemplate the likelihood that we have entered an especially dangerous period of Credit excess and attendant Bubbles. Fundamentally, the massive intrusion of the Treasury and Federal Reserve into the marketplace has only further distorted the pricing of finance throughout our economy - as well as globally. Despite record debt issuance, the market will lend the Treasury three-month money at about 11 basis points. Two-year borrowings come at cost of about 100 bps. The price of Treasury notes and bonds inflates in spite of enormous deficits as far as the eye can see. Moreover, the marketplace is happy to lend to Fannie and Freddie at only a slight premium to the U.S. Treasury, with the prices of their obligations inflating in the face of these institutions’ ongoing financial implosions. Today’s price distortions go right to the heart of system “money.………….….The massive expansion of GSE obligations, coupled with a speculative marketplace’s anticipation of yet another major government-induced reflation, severely distorted the marketplace and provided the bedrock for a historic mortgage finance Bubble. Today, the government’s intrusion into the marketplace is greater than ever. The markets readily accommodate a couple Trillion of annual issuance – as if the U.S. economy and Credit system were on solid footing. And I would argue that today’s mispricing of government finance reinforces the market’s perception that U.S. policymakers will successfully reflate the economy. This Bubble distortion, then, fosters a problematic explosion of government debt issuance – and a most dangerous case Minskian “Ponzi finance.……………………There are a number of reasons why the government finance Bubble is even more dangerous than the Wall Street/mortgage finance Bubble. First of all, the $2 TN or so of “government” issuance over the past year is greater than the $1.4 TN peak total mortgage Credit growth during 2005 and 2006. I would expect another $2 TN next year and the year after. Government debt enjoys the attribute of “moneyness” in the marketplace to a much greater capacity than mortgage securities did during the boom. The risks associated with debasing this “moneyness” are momentous. And there is, as well, the dynamic where the greater the government finance Bubble inflates the more convinced the marketplace becomes that the Federal Reserve will do everything within its power to accommodate the debt markets (ultra-loose monetary conditions for the duration). And destabilizing speculation can return to all markets………………………….Central to the analysis of unfolding precarious Bubble Dynamics is my view that few, if any, policymakers anywhere around world will be willing to act decisively to tighten Credit conditions and address increasingly speculative financial markets.”

Waiting for Markets to be Silly Again!!

2009-08-06T10:50:00.002+05:30

Jeremy Grantham’s investment insight, wisdom and prescient is well known. Grantham’s 2Q 2009 letter (click here) includes the topics “Boring Fair Price” (or, “Waiting for Markets to be Silly Again”) and “Running Out of Resources”, which looks at slower economic growth in light of the recent financial crisis and dwindling resources.

Grantham’s newsletter first paragraph talks about how markets have run up ‘too fast, too furious’:
“A year is certainly a long time in markets, and so is a quarter. A year ago, equities globally - and everything else for that matter - were very overpriced, particularly if they were risky. A quarter ago, in mid-March, prices everywhere were cheap. Now they have all - or almost all - converged for a few unusual moments at fair value. A year ago, it was very easy to know what to be: a risk avoider. It was not so easy reinvesting when terrified, but most of us knew that we should have been doing more. But today? It’s difficult to be inspired at fair value.”

In the middle paragraph Grantham talks about what do if market overruns:
“In March and April, I wrote about Plan A: you must force yourself to invest in a cheap market even when you are terrifi ed by rapidly falling prices, as I admit I was to some extent. I also suggested Plan B: if you missed the earlier lows, you must grit your teeth and phase slowly into a cheap market. You can’t gamble that it will oblige you by another low, and historical analogies with earlier, much lower market lows are fraught with genuine differences. Now it is time for Plan C.

Plan C: What to do if the Market Overruns: Given our view that we are in for seven lean years in which the market will be looking for an excuse to be cheap, we recommend taking some risk units off the table, including becoming underweight in equities – between 1000 and 1100 on the S&P, if it gets there this year. Around 880 you should continue to move slowly to fair value, twiddle your thumbs, and wait to see what happens. Boring! Otherwise, it is time to focus on the lesser issues: which types of equities are cheaper or more expensive than the market. This leads us back once again to the bet on quality stocks.”

And in the concluding paragraph warns us not to be overoptimistic and overconfident (behavioural biases):
“…When markets sell at normal prices, life for us becomes much harder, perhaps 10 times harder. Predicting movements away from rational prices in an irrational world should not be easy, and indeed it is not. Our one and only effort at predicting a bubble – in emerging markets – is likely to stay just that. Only U.S. quality feels (and measures) to us like a real outlier. If you feel yourself becoming overconfident about anything, take a cold shower and start again. Just be patient. In our strange markets, you usually don’t have to wait too long for something really bizarre to show up.”

Successful investing over complete market cycles

2009-08-05T10:49:00.002+05:30

The common themes that most successful investors propagate (through books, interview, et al) are (a) focus on the investment process rather than outcome. If the process is good the probability of outcome being good is very high, (b) Pursue an investment approach (with contained risk) that provides outperformance over complete market cycles. (c) Think in terms of probability rather than certainty for improved thought process.

Dr. John Hussman latest piece reiterates the aforementioned themes, “Momentum-based, trend-following, simplistic thinkers with a speculative bent generally do very well during bubble periods (though not over the full cycle). Such analysts appear to have no reservation about jumping in here, because they assume that there will be no consequences to the overhang of deteriorating mortgage and commercial debt, even when coupled with “trigger events” such as rising unemployment (not to mention a median duration of unemployment that is far in excess of that of previous recessions)………………………… If I knew we could speculate on these themes and still get our shareholders out unharmed, I would do it. But I don't know how. It's frustrating to have missed what has turned out in hindsight to be a significant rally. We simply have not had the evidence to say “Yes, the conditions we observe now have historically been associated with a satisfactory expected return, on average, given the risks involved.” Still, I have no doubt we'll eventually see such conditions emerge as we work through this deleveraging process. Meanwhile, we will continue to pursue our investment approach, which has served us extremely well at contained risk, particularly over complete market cycles.”

Other good articles that I have read over the last few days are (click for link below):
1. Mkt outlook: JP Morgan, ChrysCap, Franklin Templeton debate
2. It’s getting dangerously bubbly in Asia
3. Coming soon: China slide from trade surplus to deficit
4. Overconfidence and greed
5. How much oil do Opec countries really have?
6. Akash Prakash: Why India will do a China
7. Rewarding Bad Actors
8. The Joy of Sachs

Happy Reading!!

Biting A Bullet

2009-07-29T12:29:00.001+05:30

Dr. John Hussman remains defensive in an ebullient environment. You can read his latest article here.

Some important points worth pondering over are:

“There is little information content in mean reversion following extreme moves………to a much greater extent than has typically been the case at the end of recessions…….. Put another way, the case for an economic recovery is based largely on mean reversion from the early 2009 extremes (not on improvements in jobless claims or other measures to a level that is on par with prior recoveries).”
“That said, I can only describe our investment stance here as “uncomfortably defensive.” ………………….. “It's a lot like watching people scale across a tenuously secured rope bridge and get a nice meal at the center. You'd like to climb across and join them, but you know that too many things aren't right with the bridge, and it's not clear that the people who are eating will ultimately survive.”
Moreover, from a fundamental standpoint, the ebullience about an economic recovery is based on what I've frequently called the “ebb and flow” of short-term economic information that very well can turn hostile again – particularly given that there is no reason to assume that deleveraging pressures have seriously abated.
"Still, knowing why we are defensive doesn't make holding a defensive stance in an advancing market any less uncomfortable. We can certainly look back on the past several years and observe many instances where we felt the same sort of short-term discomfort, and where our caution was clearly validated later. It would be nice to be able to take risk in a dangerous environment and get away with it. The fact is that you can get away with it, in hindsight, a good portion of the time. But on average, you'd get destroyed. Suffice it to say we're biting a bullet."
"The extent of the recent rally is still smaller than the rally that stocks enjoyed following the 1929 crash (and was later followed by spectacular losses). That doesn't mean the same outcome will follow in this event, but I continue to believe that the path to recovery will be far harder, with much greater headwinds, than investors seem to assume at present. Taking the rally in stocks as an indicator of economic recovery (which the LEI largely does), and then taking the presumption of an economic recovery as a reason to buy stocks, all strikes me as circular reasoning."

Stock Picker

2009-07-28T15:34:00.001+05:30

A very interesting interview of Akash Prakash, FM, Amansa Capital, can be read from here. Key learning from his interview: (a) understanding price-implied expectation is the key to successful investing and (b) Be a stock picker (try to be more stock specific…. companies which can grow without diluting, companies which can generate strong free cash, companies with high RoE, can grow at 15-20%) rather than focus on sector rotation for a successful investment process.

Some interesting highlights from the interview are given below:

Buying on dips? Yes, which is why I think you don’t have huge downside; its not going to see 666, it does not look that it is going to happen now because I think the investors are caught in the sense that a large part of the real money or the long-term money has been under invested in equities, they need to rebalance allocations so that is one aspect. The other aspect is that everyone shows this famous wall of mountain chart, the amount of money lying in the mutual funds as a percentage of the market cap which is the highest ever. So there seems to be a lot of money waiting on the sidelines both in terms of asset allocation as well as in terms of sitting in cash or quasi cash kind of instruments. So I do see any significant drop will be bought into.
On Indian Market? I think in the next three months India will also catch a breath, in the sense that I think we had a huge move and I think we are going to be in trading zone for some time because of the quantum of the move or so, people need to digest some of these gains. So, for the next three months we are in a trading zone and but I think from a three-five years perspective I think India is one of the most exciting markets. So three-five years basis it’s a very interesting time to be India, next three months I think we are going to be probably stuck in a range……………….. I think 3,900-4,000 for the Nifty on the downside and maybe 4,600-4,700 on the upside, somewhere in that range, 15% here or there.
On companies raising money in India? I think that you will become more discerning, we have already seen that to some extent where some companies have been unable to raise money and some have. So, I do believe that it will get more discerning but I do believe that most of the good Indian companies will be able to raise money maybe at slightly less valuation than they expect but money is available for both the private as well as public markets but the investors will be more discerning.
Downside risk on Sensex? I think that numbers are difficult to be precise but I definitely don’t think that we are going back to 8,000. I think that the general awareness among the investors is that this is a different kettle of fish in terms of this government. I think they are talking a lot of positive things and hopefully you will see some action soon. So, I do think we are in a new range for India because of the new government and largely because investors feel that this new government is a lot more serious about taking action on a whole bunch of policy fronts. So, I don’t think that the ranges which we saw in early March are relevant anymore unless you expect a total meltdown in US which I don’t expect, so I think it was a different global environment and the risk aversion or panic was greater than you likely to seeing going forward and I think there is a general awareness and understanding that the India story is stronger today than it was three-four months ago.
Budget overreaction? I think so, because I think the budget was a case of poor packaging in the sense that what Pranab Mukherjee tried to do was nothing dramatically negative. I think the people were disappointed because there was sense that he was almost shy of talking about certain things, he was shy of talking about disinvestment, he was shy of talking about FDI and whole bunch of other economic reforms which the people were expecting to see, a hard target on the fiscal deficit. So, people were a little confused that why he was so averse to talking to public and so I think it was a case of poor packaging and I think they have come out subsequently in a whole bunch of interviews and kind of clarified most of those issues and said that most of the issues are on table and we are going to implement those things, just give us some more time. I think the need to ensure 8-9% GDP (gross domestic product) growth will ensure that these measures get taken, because you can’t get back to 8-9% growth without these measures being taken. If you don’t get back to that growth target then you are not going to get those funds you need that the government wants to transfer into rural India.
Stock picker? We are more of stock pickers in the sense that we try to be more stock specific. We don’t look at sector rotation, we are more of stock specific stories, so we are consistently looking at the same type of stories; companies which can grow without diluting, companies which can generate strong free cash, companies with high RoE, can grow at 15-20% and there are enough of them, so we don’t look from sector to sector, so we are not really good at making that type of a call.
IT? We have been overweight IT for some time and the reason for that is that they had become really cheap and if you look at the top tier IT companies they had come down to eight-nine times, not Infosys but others. Some of the midcap companies had come to four-five multiples which did not make sense to us because one we don’t think that the industry is an ex-growth industry, I think in the next 12 months they will get back to 15% earnings growth at least. So, we have been overweight IT, the run has been good and I think the short term run seems to be done because the tier one players are 15-18 times, if not more. Some of the midcap stocks there is till some juice left because some of them are still six-seven times mean they could get to 10-11 times but the easy money in IT I think is, a lot of it is over, done.
Financials? I think that financials are a very good long term story, you need to make sure that you bet on the right business model, in terms of people which have a good capital adequacy and good return on assets. So a bank with fundamentally good RoA is a bank that can deliver strong earnings growth and strong RoE in the long term.
Cyclical? We are not good in buying commodities, so we don’t play in that space much and we really don’t have that edge to predict the commodity cycle. But if you are talking of cyclical for e.g. companies like auto ancillaries, there are some interesting plays there where if you look at a normalised earning basis they are not that expensive, I mean they look expensive now as the earnings have been shot to pieces. But if you look at the normalised level of capacity utilisation, what is the earnings power of that business then they are quite cheap. So, there are some plays there which we find interesting in the auto, capital equipment kind of space.
Cement? Cement is also good, we are looking at one play in cement which we looked at closely and we like that and cement has been a bit of a surprise because they have delivered a much strong growth than I would have expected and it has been consistent. If they are able to grow at 8-10% or 10% is what there are growing at right now then the capacity demand supply mismatch will be less than what people think.
Power? I think the call there is what you believe is the long term power tariff, because they are all discounted cash flow valuation (DCF) model first of all because the capacity will come on stream two-three years down the road. So, the real critical variable is what do you believe is the long-term power price you are willing to sell, you can get. We think Rs 3.50-4 a unit is realistic. I don’t think that in ten years Rs 6-7 a unit for large capacities you can get. So you do the math because the plant load factors are pretty real, you know what the cost of the coal is, the real delta is the power price, if you assume Rs 4 for the next five-ten years and if you can find a decent valuation assuming those kind of valuation multiples then we look at it and if you look at more than that of power prices then we are not interested but then that is a view, there are some people who believe that we can Rs 6-7 a unit for the next five years, I mean maybe they are right but I don’t know. My view it is a political subject and it is going to be difficult to have huge chunks of capacity, consistently get that kind of power pricing for a very long time. One or two plants may get it because of location but to assume it for all in my view is strange.

Don't judge each day by the harvest you reap, but by the seeds you plant.

2009-07-20T11:34:00.002+05:30

Dr. John P Hussman of Hussman Funds has written a brilliant article, “Tending Seeds - Reacting, Responding, Planting, and Watering”, which urge investors to focus on the process rather than outcome. You can be read the full article from here (an earlier article on the same issue can be read from here).

Dr. Hussman writes, “As Jean Paul Sartre wrote, “Je ne suis rien autre que mes actes” – I am nothing other than my actions….....If an investor consistently takes positions based on forecasts, and changes those positions only when the market proves those forecasts wrong, that investor's life will predictably be dominated by hope, uncertainty, disappointment, reaction and frustration. If an investor constantly takes positions by responding to opportunities and conditions as they develop, with equanimity to what will happen next, making a habit of purchasing favorable value or early strength, and a similar habit of selling overvalue and early weakness, that investor's life will most probably be dominated by a sense of peace and control. Though it is not obvious which investor will have better results, my own opinion on that should be fairly clear…………."This doesn't mean that an investor who responds – rather than reacts – will know what will happen next. Rather, it means that this investor will be able to accept what happens next, knowing how to respond whatever the outcome. The point is to live in reality, and to take the next action from where one stands, without ignoring inconvenient aspects of reality in the hope of justifying one's position, and without wishing for the starting point to be somewhere else. The greatest source of human frustration is the desire for reality to be something other than it is.” ………In short, as Robert Louis Stevenson wrote, “Don't judge each day by the harvest you reap, but by the seeds you plant.”

Other important points from the article are:

The distinction between reacting and responding is one that I've emphasized often over the years. To react is essentially to change one's plans abruptly based on what the market has just done – usually involving a certain amount of panic or worry that essentially forces one's hand. In contrast, to respond is to take the most recent market move as a piece of information, and to change the investment position accordingly, following a very specific discipline (ideally which allowed for the move in the first place).
My impression is that the single best mark of a reactive investor is the tendency to measure investment success by the amount gained or lost on any particular day. In contrast, the investor who responds puts much more emphasis on daily actions than on daily outcomes. That doesn't mean ignoring outcomes, but it means following a specific, well-studied discipline with the expectation that the results will emerge through repeated application. As usual, those results are best measured in terms of long-term return and risk over the complete market cycle.
The basic idea is that, confronted with a whole host of seeds in our daily lives, the ones that we water will generally (though not always) be the ones that grow. So if we tend and water the negative seeds; worry, anger, disappointment, fear, and so on, the energy we put toward those seeds will tend to make them grow and become very big in our daily lives. If instead we tend and water the positive seeds; friendship, gratitude, discipline, peace, and happiness, then those are the seeds that will grow. That doesn't mean walking around like a Polyanna (which is unlikely for a crusty skeptic like me), but it does mean that there is some tendency, however imperfect, to reap what we sow, even just by what we choose to habitually think about. As the Buddha said, “with our thoughts, we create our world.”
But there are all sorts of other seeds to water. An investor who waters the seed of curiosity will not be content with investment platitudes and will stare at lots of data to figure out what actually works in the markets, and what the pitfalls are. An investor who waters the seed of discipline will emphasize consistency and persistence over one-off decisions and attempts to “make a killing” on a particular trade. Tending the seed of patience, on the other hand, can be either a help or a hindrance, depending on whether it is coupled with sober analysis or instead with blind hope. Patience, coupled with discipline and analytical curiosity, is not a bad combination of seeds from my perspective.
All of this may seem silly or simplistic on its face, but the reason for spending some time with this idea is that it can also be very powerful in re-orienting your actions and perspectives. It's worth the time to ask which seeds you habitually plant, tend and water, and what you expect them to grow to become as a result. This is true for investing, and isn't completely removed from relationships or parenting either.
Seeds not planted or tended by choice tend to be weeds, so at least for me, it's very helpful to consciously and periodically choose which seeds I want to water, and to think through what I expect to happen from that watering. Investors can spend a lot of time and energy reacting to the latest bits of news and trying to predict the next surprise, rather than choosing a consistent set of daily actions that they can carry out as things develop, regardless of how they develop.

Happy Reading!!

China, the dollar, and the 'nuclear bomb'

2009-07-16T18:18:00.001+05:30

65% of world foreign exchange reserves by currency are in Dollar (total: US$ 6.5 trillion) and China holds ~1/3rd of the global stash. Therefore it is not surprising to see the clamor pertaining to dumping of Dollar and the rising demand for a new reserve currency. Read The Economist article here.

An interesting take on the aforesaid issue was articulated (in a newspaper interview; a long interview but worth a read and re-read) by Michael Pettis, a professor at Peking University's Guanghua School of Management, and a specialist in Chinese financial markets. You can read the full document here.

Prof Pettis says, "These ideas of 'nuclear options' are the sort of things that politicians and ordinary people get very nervous about. But the problem that I cannot figure out is exactly how you go about doing this in a way that benefits China and disrupts the US………………………..it should be the US that should be the prime proponent of eliminating the dollar as the primary reserve currency" and creating an alternative. This would eliminate the ability of the US to run large trade deficits and the ability of foreigners to create growth by systematically running large trade surpluses against the US…………………………….I would say that we all need to understand that the "decision" about which currency is the reserve currency is not a "decision", and has little to do with the political interests or perceptions of interested parties. The world chooses a major currency in which to denominate international trade and reserve accumulation for a variety of very functional reasons - such things as the flexibility and political independence of the domestic financial system, a sense of political non-interference in issues of trade and capital, the ability and willingness of countries to run current account deficits, which in part reflects domestic economic rigidities, a sometimes bewildering variety of geopolitical rivalries, demographic changes (which in China are terrible) and last but certainly not least, sheer inertia. Policymakers cannot somehow just "choose" to shift from one dominant currency to an alternative.”

Happy reading!!

The inflation vs. deflation debate

2009-07-11T12:50:00.002+05:30

Niels C. Jensen of Absolute Return Partners in its latest market commentary tackles in detail the question of whether inflationary or deflationary forces are more likely to prevail. The inflation vs. deflation debate is "the single biggest investment story right now, and being on the right side of that trade will effectively secure your investment returns for years to come.". You can read the full document from here.

The implication of US Stimulus II ( if implemented) on Asian Stock markets!!

2009-07-10T16:02:00.001+05:30

William Hester of Hussman Funds has written a thought provoking article, “Secular Bear Markets and the Volatility of Inflation”, which can be read from here. Hester notes that high multiples almost always coincide with low economic volatility, and bubble valuations coincide with very low volatility. Currently, the level of the volatility of inflation is still low compared with the historical range (see the article for detailed chart). However, the next few years could include both the effects and the reversal of the recent emergency fiscal and monetary stimulus (the Great Unwinding) and inflation volatility could move above average, leading to more moderate valuations. It is important to note that it is not only the level of volatility and uncertainty in the economy that matters to investors, but also the trend and the persistence in this uncertainty. Shrinking amounts of volatility in the economy creates an environment where investors are willing to pay higher and higher multiples for stocks, while growing uncertainty brings lower and lower multiples. Finally, the level of inflation volatility is still low, relative to the peaks reached during prior secular bear markets. If the level of inflation volatility continues to increase, it will become more difficult to argue that the secular bear market has come to an end. Any increase in economic volatility during Great Unwinding of the next few years will be crucial in determining the outcome for stocks.

An important debate that has emerged recently is calls for second round of stimulus in the US and the most notable proponent of it being Dr. Krugman. With the recent jobless data reporting much higher than expected numbers, Dr. Krugman worries about Japanese-style deflation if US does not take action (US Stimulus II). You can read Dr. Krugman articles here and here. It is interesting to note that amongst the call for Stimulus II, yields on 10-year notes continue to tick steadily lower, as they have since mid-June. FT ( Lex) notes, “Bond investors, therefore, either believe there is no chance of a second bill getting through Congress or, if one does, that a bulging fiscal deficit is now secondary to the likelihood that the economy will stay soggy for years and deflation might set in. ……….…. Is more stimulus needed? There is no clear answer. For one, there is little consensus among economists whether deficit spending even works. A related headache is proving the counterfactual: for example, nobody knows what last quarter's growth would have been without the $200bn-odd of the $787bn stimulus so far committed. And if you do want to spend more, how much is enough? The first bill is equivalent to 6 per cent of 2008 output, according to the International Monetary Fund, far higher than the G20 average of 1.4 per cent. The next biggest package is China's at 4.8 per cent of last year's output. Some economists reckon the US should at least double its efforts. Perhaps the biggest sticking point for now, however, is that few agree whether the US economy is recovering or not. Certainly the latest data are worrying. Less clear is what Washington can do about it.”

The base money in the US, as of May, 09, was expanding by 114% YoY, compared with 1% YoY a year ago. Dollars in circulation in the US have gone from US$827 bn in May 2008 to US$1770 bn in May, 2009. Here it is important to note that the short-term impact on Asian stock markets will be significantly positive ( tap of liquidity will be turned on full throttle) if US Stimulus II is implemented given the leakages witnessed out of the US during Stimulus I. However, in the medium-term, this will be negative for stocks as the level of inflation volatility increases (as a result US Stimulus I&II) significantly + trend and the persistence in the uncertainty also increases, which will ultimately result in lower and lower multiples.

Happy Reading!!

(NB: Monetization of fiscal deficits is not inflationary in the short run, whereas slack product and labor markets imply massive deflationary forces. But if central banks don’t find a clear exit strategy from policies that double or triple the monetary base, eventually either goods-price inflation or another dangerous asset and credit bubble (or both) will ensue. Some recent rises in the prices of equities, commodities, and other risky assets is clearly liquidity-driven)

Indian budget

2009-07-10T11:14:00.002+05:30

Click here for diverse thoughts on the Indian budget.

Great expectations!!

2009-07-09T15:08:00.002+05:30

The Indian Budget failed to meet the markets heightened expectation. Let us analyse what was embedded in the market’s pre-budget expectation: (1) some announcement pertaining to Infrastructure sector, which comes as a panacea for the sector and the country, (2) formal announcement of disinvestment targets, (3) hike in FDI limits for Insurance, et al, (4) a firm target to reduce subsidy burden especially pertaining to Oil sector, (5) a road-map to reduce the high fiscal deficit, which is clearly unsustainable, (6) Many more…..

The price-implied expectation (pre-budget) in some sectors had factored the best of the aforementioned expectation and much more (valuations were grossly stretched). The right thing would have been to objectively analyse the upside potential (if all good announcement happens) + the probability of the same, and vice-versa (remember Robert Rubin) and position our portfolio/investments accordingly. The heightened expectation was highlighted in a previous note which can be read from here.

Post Budget, stocks have come-off a bit but cannot be considered cheap. Things that we should keep in mind while building near-term optimistic assumptions are, (1) Indian fiscal deficit at ~12% of GDP will be highest since 1993, which could prove to be a serious drag on economic growth (2) Government borrowing programme + increase in bond yields will eventually crowd out private investment, (3) global macro factors continues to be on shaky ground and the ‘LUV’ could eventually look more like ‘W”.

Mr. Grantham rightly said that there are no near certainties in investing because life is not meant to be that easy. In the short-term, strong gush of liquidity could take the markets much higher than justified by fundamentals. However, we should be mindful of the aforementioned problems, think in terms of probability, focus on the process rather than outcome, not get flummoxed by behavioural stumbling blocks, et al, and this will eventually lead to good investment decisions.

Happy reading!!

Some good articles that I have read recently:
http://blogs.telegraph.co.uk/finance/ambroseevans-pritchard/100000188/shipping-flashes-early-warning-signals-again/

http://online.wsj.com/article/SB124701217125708963.html (Oil Prices Need Government Supervision- By GORDON BROWN and NICOLAS SARKOZY)

http://ftalphaville.ft.com/blog/2009/07/08/60921/guest-post-mohamed-el-erian-the-global-crisis-is-morphing-again/ ( PIMCO)

http://www.guardian.co.uk/commentisfree/cifamerica/2009/jul/08/g8-china-us-dollar-yuan (China’s Dollar delusion)

http://www.dnaindia.com/money/report_why-pranabda-can-run-a-ponzi-scheme_1272376 (Why Pranabda can run a Ponzi scheme)

http://www.moneycontrol.com/india/news/budget/sensex-unlikely-to-go-back-to-21k-levels-this-yr-enam-sec/14/29/404192 ( Manish Chokhani)

http://www.business-standard.com/india/storypage.php?autono=363082 ( Akash Prakash- Amansa Capital)

RIP fundamental research; follow the liquidity and the crowd

2009-06-30T14:22:00.000+05:30

"In speculation, as in most other things, one individual derives confidence from another. Such a one purchases or sells, not because he has had any really accurate information as to the state of demand and supply, but because someone else has done so before him" (J. R. McCulloch, Principles of Political Economy, 2nd ed., London, 1830).

“ As a general rule, it is foolish to do just what other people are doing, because there are almost sure to be too many people doing the same thing” William Stanley Jevons ( 1835-1882).

Of late, a healthy debate has emerged amongst my peer group over the value of fundamental research. The usual arguments against fundamental research (FR) have more or less prevailed—fundamental analysts (FAs) can neither estimate EPS nor P/E (liquidity), so what’s their utility. The last few heady years of Bull market (well who remembers the short bear period!!) have firmed the view of FR detractors--- take a macro call on a sector with high growth and put your money in the same (and make money). Who cares about RoE, FCF, Working Capital, valuations, quality of companies, et al?

Behavioural stumbling blocks like overconfidence, overoptimism, availability heuristics, etc has been in play here. We are overconfident that value of stock, commodities, etc will continue to increase based on "excessive liquidity" and "money printing" and thus are overoptimistic about the future of companies and economy ( both local and global). Also, we have started making judgment based on what we can recently remember (availability heuristics)…the ‘green shoots’.

History book are replete with stories of how liquidity based bubbles have not sustained. Dr. Marc Faber points to four manias from recent history, (1) the parabolic increase, between 1970 and 1980, in the prices of precious metals, oil, mining and energy-related equities. (2) The "big" investment mania in Japanese equities and real estate in the late 1980s. It culminated in Japanese stocks commanding a larger market value than the combined values of the US, British, and German stock markets. (3) Then, in the 1990s, the several rolling investment manias in the emerging markets, which ended with the devastating Asian crisis of 1997, and the Russian crisis and LTCM in 1998. (4) In the fourth mania, the object of speculation was the telecommunications, media and technology (TMT) sector on a worldwide scale, and we all know very well how that ended.

Well now we can add the fifth bubble of “The global financial crisis of 2008-09”, caused by global-imbalance, which culminated into the downfall of several financial houses in developed markets and the world receding to deep-recession. A common theme at the end of each investment mania was that investors believed in some sort of "excess liquidity" that would drive the object of the speculation forever higher ( we saw the same in 2007-08 period). Albert Edwards explained it neatly in his strategy report of 2007, “when markets are rallying but seem expensive, when new issues fly out of the door and when fundamental analysis often appears to fail to explain events, the safe haven for the market commentator is often to rely on the explanation that there is lots of liquidity." Every epic investment boom lifted prices far higher than anyone could have. But once the boom comes to an end, most, if not all, of the price gains that occurred during the mania are given back. In 1992, silver prices were lower than they had been in 1974. In 2003, the Nikkei was lower than at its high in 1981. In 2002, in dollar terms, most Latin American markets were no higher than in 1990 and most Asian markets had declined to their mid- or late 1980s level. And in those manias where prices didn't retreat in nominal terms to the level — or, as frequently happened, to below the level — from where the investment boom had begun, prices retreated in inflation adjusted terms to those levels. Adjusted for inflation, in 2001 the CRB Index was far lower than it had been in 1971, while precious metals, oil, and grains were all either no higher, or lower, than they had been in the early 1970s.

The most outrageous idea that I have recently heard was that one has to just take a call on liquidity and RIP fundamental research. If investing was so easy then we would all be billionaires. One cannot deny the role of liquidity in markets but history once again proves that if liquidity based returns is greater than fundamental based returns then eventual downfall is assured.

Thankfully, at present, Indian markets, though expensive, is nowhere near the bubble zone (though speculative return is higher than fundamental return in some sectors as liquidity + growth story is a play there; we all know which sectors). However we should be mindful of the fact the basing our investing process by taking a call on liquidity implies that we subscribe to “the greater fool theory” and in such a scenario we should go back and re-read our financial history books once again.

Reading

2009-06-23T19:35:00.000+05:30

Working on an initiating coverage, so will leave you with some of the good articles that I have read over the past few days. Happy Reading!!

Nouriel Roubini, “As a result, one cannot rule out that by late next year or 2011, a perfect storm of oil above US$100 a barrel, rising government-bond yields and tax increases (as governments seek to avoid debt-refinancing risks) may lead to a renewed growth slowdown, if not an outright double-dip recession.”

John P. Hussman, “What we're seeing focuses not on short-term “green shoots” stuff, but on longer-term concerns that investors appear to be grappling with – concerns that have to do with the longer-term potential for economic growth, and nagging concerns about the sustainability and effects of the massive fiscal deficits we are running to defend bank bondholders (we are emphatically not defending bank customers here – there is an enormous cushion of bondholder capital in the financial system. Even the failure of the largest banks in the country would not pose a single dollar of loss to depositors). ….A very simple way to observe the long-term concerns of investors is to couple what we observe in the precious metals market with what we observe in the Treasury bond market. Specifically, despite very weak inflation figures, gold prices have remained relatively strong, while Treasury bond prices have been spectacularly weak. This suggests that despite any short-term optimism, investors are harboring a persistent sort of risk aversion about the long-term. This may seem like a small point, but it is actually a fairly powerful consideration here. Historically, when both gold prices and the 10-year Treasury yield have been above where they were 6 months earlier (representing just under a quarter of the historical record), the S&P 500 has averaged a total return of just 3.5% annualized until that condition was reversed. Excluding such periods, the S&P 500 has averaged a total return of 14.3% annualized. The depressing effect has been largely independent of prevailing valuations and even market action.”

FT lex, Dr. Copper,“It has been called the only metal with a PhD in economics, and for good reason. Copper’s record as a leading indicator of economic slowdown or recovery is impressive. Used mainly for wiring, plumbing or electronics, an uptick in demand often precedes a recovery in building and manufacturing. A recent rise in prices to nearly $5,000 a tonne in London trading, up almost 75 per cent from the December low, seems to underpin the “green shoots” thesis and the recovery in animal spirits. But Dr Copper’s diagnosis may be misleading this time….While it is far simpler to take copper’s price rather than physical shipments as a proxy for global growth, this holds pitfalls. The most obvious is that commodity prices are set by supply as well as demand, so a miners’ strike in South America will send prices soaring in the same way as a sabotaged pipeline in Nigeria will for oil. Neither says anything about growth. With capacity utilisation tightening in recent years, copper price volatility has increased the odds of false signals. Other problems are speculation or stockpiling. Chinese stockpiling may be playing a role lately. Imports hit a record last month, seemingly decoupled from underlying demand. One interpretation is bargain hunting. But recent prices only appear cheap relative to last July’s $9,000 record high. Another is flagging faith in the greenback, encouraging China to buy hard assets with its reserves. Copper is more useful than gold and easier to store than crude oil or perishable “soft commodities” such as soyabeans. A bounce was natural after last year’s panic, but such a big one may presage a dollar crisis rather than a global recovery. Investors should always seek a second opinion.”

Frederic s. Mishkin, “One cause of the rise in long-term rates is the more positive economic news of the past couple of months, particularly in financial markets. The bad news is that long-term interest rates are higher because of concerns about the deteriorating fiscal situation, with massive budget deficits expected for the indefinite future. To fund these budget deficits, the Treasury has to sell large quantities of bonds both now and in the future, causing bond prices to fall and interest rates to rise. The increased supply of Treasury debt puts pressure on the Fed to buy it up. Although an expansion of Treasury bond purchases by the Fed would have the benefit of lowering long-term interest rates temporarily to stimulate the economy, in the current environment it could be dangerous for two reasons. First, it might suggest that the Fed is willing to monetize Treasury debt. The Fed does not, and should not, want to make it easy for the Treasury to sell its debt and thereby be an enabler of fiscal irresponsibility. Second, if the Fed loses its credibility to resist pressures to monetize the debt it could cause inflation expectations to shift upward, thereby leading to a serious problem down the road.”

Ambrose Evans-Pritchard, “Flush from last year's 234pc rise in their Black Swan Fund, they are betting that quantitative easing and war-time deficits have sown the seeds of inflation reaching "10pc, 15pc, 20pc, or more". They capture the mood of the times, but are they right?”

Rich Miller and Michael McKee, “Chairman Ben S. Bernanke has to convince investors the Federal Reserve can take back more than $1 trillion it pumped into the U.S. banking system to pull the economy out of the longest decline in more than six decades. Bernanke and his colleagues, who meet June 23 and 24 to map monetary strategy, have said they need to continue buying assets and keep interest rates low for a long time to help revive growth. Rising Treasury bond yields show Wall Street is concerned their policy may lead to an inflationary bubble: Ten- year notes reached an eight-month high of 3.95 percent June 10.”

FT Lex, “Former Fed chairman Alan Greenspan introduced the idea of a bond “conundrum” four years ago when he noted that short-term interest rates were rising while, unusually, long bond yields were falling. Today, the opposite is true. Short-term rates are low – and in some countries still falling – yet long-term bond yields are rising. Some say this reflects fears of Zimbabwe-style inflation. The evidence suggests something else.”

The Economist, “LOW interest rates are intended to ease the burden on debtors, discourage saving, encourage spending and thereby revive the economy. But they also have a distorting effect on asset markets. By reducing the cost of speculation, they encourage bubbles.
So although it is good news that some indicators (such as the cost of bank borrowing) have improved, risk appetites also need monitoring closely. The “search for yield” which marked the boom of 2005, 2006 and early 2007 seems to have started again. ………..All this is encouraging the feeling that the worst of the crisis is over. Equity markets enjoyed an almost uninterrupted rebound between March and mid-June; according to Société Générale, the MSCI World index rose in 13 out of the 14 weeks to June 12th, the best sequence since December 1999. This, in turn, was linked to the feeling that the worst of the recession was seen in the first quarter, and that the global economy could be rebounding by the second half of this year.
There is a kind of positive feedback loop here, in which confidence about the economy boosts the stockmarket and a rising market helps restore economic sentiment (indeed, share prices are included in leading indicators)……….. This bubble may start to deflate. Investors are already rediscovering their appetite for government bonds: the yield on ten-year Treasuries had drifted back from a peak of 3.93% on June 10th to 3.67% a week later. Investors may be starting to realise that, even if the biggest falls in output have passed, the outlook for 2010 is still likely to be sluggish.
After all, the problems that existed at the start of this crisis have not gone away. Delinquencies on American mortgage loans are still rising: the seasonally adjusted rate in the first quarter was higher across all categories. European banks may still need to write down another $283 billion of assets this year and next, according to the European Central Bank. Worst of all, Capital Economics says American consumer debt is more than 130% of disposable income, double its level in the 1980s. Reducing this ratio will require widespread defaults, rapid inflation or a prolonged period of higher savings rates. None of those would be particularly good news for the markets. The crisis took a long time to build up. It will not disappear as a result of one good quarter.

Christina Romer, “The 1937 episode provides a cautionary tale. The urge to declare victory and get back to normal policy after an economic crisis is strong. That urge needs to be resisted until the economy is again approaching full employment. Financial crises, in particular, tend to leave scars that make financial institutions, households and firms behave differently. If the government withdraws support too early, a return to economic decline or even panic could follow. In this regard, not only should we not prematurely stop Recovery Act spending, we need to plan carefully for its expiration. According to the Congressional Budget Office, the Recovery Act will provide nearly $400 billion of stimulus in the 2010 fiscal year, but just over $130 billion in 2011. This implies a fiscal contraction of about 2% of GDP. If all goes well, private demand will have increased enough by then to fill the gap. If that is not the case, broad policy support may need to be sustained somewhat longer. …Perhaps a more fundamental lesson is that policymakers should find constructive ways to respond to the natural pressure to cut back on stimulus.

Devil's advocate

2009-06-17T11:05:00.002+05:30

Being a devil’s advocate in a rising market is not a great experience. Last Saturday, a friend accused yours truly of completely missing the up-cycle. Agreed! Once a person questioned Keynes on the frequency with which his opinions changed, to which he replied, “When the facts change, I change my mind – what do you do, sir?”

My question to my friend is that “has the fact (fundamentals) changed enough for us to become overtly bullish from being plan bearish?” To some extent the answer is yes, especially in the Indian context. However, the major up-move has been due to strong gush of liquidity flowing into the system, which has helped most sectors, either overtly or covertly. Hence, we should not be lulled into thinking that India will not be impacted by global factors (we increasingly hear the de-coupling theory once again).

Some companies has run-up beyond any fundamentals (we all have started looking at FY11 fundamental growth, returns, et al, as FY10 is a passé). The price-implied expectation suggests strong growth, margin expansion, little competition, etc, etc. However, the major upside has been because of the P/E re-rating (because of liquidity), which has gone to pre-Lehman levels (never mind that growth has gone down and competitive intensity has increased). CAUTION should remain the buzzword of the day.

Below are some interesting artciles that I have read over the last few days. Happy Reading!

Akash Prakash, “The green shoots may themselves sow the seeds of the economy’s relapse. As more people buy into a recovery scenario, we are seeing yields, oil prices etc all normalise and increase. This process of normalisation is itself making the risks of a relapse greater.”

V. Anantha Nageswaran, “In this milieu, if one writes something regularly highlighting how the stock markets are losing touch with reality and decrying the tendency on the part of stock market investors to selectively absorb news, then one receives pushback: “Hey, you are shrill. It is sour grapes for you. You missed part of the rally. So, now you are defending yourself. In fact, you are now boxing yourself in. What will you do if the index breaches a particular level?”
Up to a point, it is a plausible reaction. After all, when one takes issue with market pricing, is it ex-post-rationalization or does one genuinely wish to warn investors not to get ensnared at certain price levels?....... ……………………….In other words, being positive and wrong is tolerated more easily and for longer than being negative and “wrong” (for anything more than a week)………………… If only they’d pause for a moment, they’d know that merely having money to invest comes second. The first question to ask when investing is the prospect of returns. At higher prices, the prospects of returns recede. So, the correct behavioural response would be to hold back from investing. Instead, money chases other money and that seems both the necessary and sufficient condition for stocks to go higher. Professor of behavioural economics Dan Ariely hopes we will understand our cognitive limitations the same way we understand our physical limitations. I am sceptical.”

Mohamed El-Erian, PIMCO, “Most investment professionals I meet are no longer hesitant to talk about experiences they had last year. The phenomenon is reminiscent of a group that, having survived a near-death experience, now feels the need (and has the confidence) to talk about it. This is understandable. The recurrent shocks and related disorientation that were so common last year have given way to a greater sense of stability and predictability in financial markets. Yet it would be wrong to conclude that we are returning to “business as usual.” The next few quarters will be dominated by the aftershocks, driven not by a financial system in disarray but by the slower process of structural adaptation of the real economy, the political system and the financial services industry itself. We are facing a world of lower growth and accelerated country realignments. Policy experimentation will remain the norm for much longer than most expect. Governments will act as marginal price setters in many markets. The endogenous credit lubrication process will be curtailed for years to come. And yet, inflationary expectations could eventually deteriorate as the potential growth rate for the U.S. comes down. All of this constitutes an inherent part of the world’s bumpy journey to a new normal. It is a reality that also impacts key elements of successful investment management – in particular, asset allocation, manager selection and risk management. It calls for some critical re-tooling of mindsets, institutions and approaches. It challenges traditional comfort zones. Inevitably, some will resist such a re-tooling. After all, it is difficult and risky, and it involves a non-negligible degree of uncertainty. Others will embrace the re-tooling challenge, and in doing so thoughtfully and responsively, they are likely to gain an important first-mover advantage.”

Timothy Geithner and Lawrence Summers, “we live in a globalized world, and the actions we take here at home -- no matter how smart and sound -- will have little effect if we fail to raise international standards along with our own. We will lead the effort to improve regulation and supervision around the world.
The discussion here presents only a brief preview of the administration's forthcoming proposals. Some people will say that this is not the time to debate the future of financial regulation, that this debate should wait until the crisis is fully behind us. Such critics misunderstand the nature of the challenges we face. Like all financial crises, the current crisis is a crisis of confidence and trust. Reassuring the American people that our financial system will be better controlled is critical to our economic recovery. By restoring the public's trust in our financial system, the administration's reforms will allow the financial system to play its most important function: transforming the earnings and savings of workers into the loans that help families buy homes and cars, help parents send kids to college, and help entrepreneurs build their businesses. Now is the time to act.”

Andy Xie, “A combination of growth optimism and inflation fear has catapulted asset markets in the past few weeks. These two concerns should drive markets in different directions: Inflation fear, for example, should limit room for stimulus and prompt stock markets to retreat. But the investment camps expressing these opposite concerns go separate ways, each pumping up what seems believable. As a result, stock and commodity markets are mirroring the behavior seen during the giddy days of 2007. Regardless of what investors or speculators say to justify their punting, the real driving force is the return of animal spirit. After living in fear for more than a year, they just couldn't sit around any longer. So they decided to inch back. The resulting market appreciation emboldened more people. All sorts of theories began to surface to justify the market trend. Now that the rising trend has been around for three months globally and seven months in China, even the most timid have been unable to resist. They're jumping in, in droves………….The world is setting up for a big crash, again. Since the last bubble burst, governments around the world have not been focusing on reforms. They are trying to pump a new bubble to solve existing problems. Before inflation appears, this strategy works. As inflation expectation rises, its effectiveness is threatened. When inflation appears in 2010, another crash will come. If you are a speculator and confident you can get out before it crashes, this is your market. If you think this market is for real, you are making a mistake and should get out as soon as possible. If you lost money during your last three market entries, stay away from this one – as far as you can.”

Simon Johnson, “Emerging markets are increasingly viewed as having “decoupled” from the US/European malaise. This idea was wrong in early 2008, when it gained consensus status; this time around, it is probably setting us up for a new bubble – based on a “carry trade” that now runs out of the US. The”appetite for risk” among investors is up sharply. The G7/G8/G20 is back to being irrelevant or merely cheerleaders for the financial sector.”

V. Anantha Nageswaran, “More than in stock markets, there is a bubble in the orchestrated positive spin on economic data. There is a dangerous agenda behind it………… Unfortunately, investors are not asking hard questions. They prefer short-run bubbles. Governments and the elite are ready to generate one. This is dangerous behaviour by all concerned.”

Why global liquidity should remain easy........Or Why, at current juncture, Fed's monetary tightening is highly unlikely

2009-06-15T10:55:00.001+05:30

Dr. Krugman's, in his latest NYT article, has the following arguments against those who want fiscal and monetary tightening to start now:

1) Money supply growth is NOT inflationary if the economy is in a liquidity trap (eg: Japan in late nineties, early oughts; US in the thirties)
2) Recent rise in long term yields reflects investor confidence rather than govt. borrowing (this is the point that many debate). And rates are still below normal range. Govt. borrowing is simply compensating for pvt borrowing--overall borrowing in the US has fallen.

Our economist has the view on Dr. Krugman's article, "If developed country central bankers listen to Krugman--with whom I happen to agree--they will hold off on rate hikes until mid-2010 at least. This is a big if, of course. Note that, in our view, besides a bad monsoon this year, a 'too-soon' G3 rate hike is the key risk to India's macro over the next 18 months as they interest rate outlook would darken just as capex plans were being revived."

The first line of the summary of latest Fed Beige book says it all on the current economic condition in US, “Reports from the twelve Federal Reserve District Banks indicate that economic conditions remained weak or deteriorated further during the period from mid-April through May.”
Given the aforesaid, it is highly unlikely that Fed will increase the rates in near future. This should help the liquidity tap to be on full-throttle for next couple of quarters. A recent meeting with a FM suggested that they now bother more about P/E (where delta is more) then EPS!!! More on that later.

The thing to watch out for is Latvia’s currency crisis, which could, once again, increase the risk-aversion as currency contagion spreads very fast.

Happy Reading!!

NB: The Fed Beige book is a qualitative survey on economic conditions and is presented two weeks before the Federal Reserve Open Market Committee meets to decide on monetary policy.

What could expose the markets?

2009-06-08T10:37:00.000+05:30

There is a consensus that, at current levels, Indian market valuations are relatively fair to being on the slightly expensive side. The questions that most of us ask ourselves are that given the strong bullish undercurrent, what could expose the markets at current levels. Three possible global issues ( apart from local issues like Budget, fiscal deficit, et al) needs to be carefully watched:

a) Sharp rise in US treasury yields (over 5% nominal), which would fracture the current source of global liquidity (government financing).

b) Sharp rise in commodity prices, which will strangle the recovery in its birth. See the Economist article here.

c) The eventual realization that the world will see a W-shaped recovery rather than V-shaped ( as currently priced) and by the end of this year or early next year we will see a relapse just because the structural problems have not been cleared. See Dr. Roubini’s article here.

The one thing that we can’t price-in is a black swan event that, off-late, has become a norm rather than exception.

Rise in long term bond yields-What does it imply?

2009-06-02T08:27:00.001+05:30

The recent significant rise in US government long term bond yields is seen by many as signs of (a) concerns that the monetization of fiscal deficits will eventually lead to inflationary pressures and (Federal Reserve is printing lots of money, which must be inflationary), and (b) deficits will eventually force the U.S. government to inflate its debt way out of debt (US debt-to-GDP eventually rises over 100% and this shall force them to drive up prices so that the real value of the debt is reduced).

Prof. Krugman in his latest NYT article thinks that aforementioned point (a) is just wrong and point (b) could be right, but isn’t. He writes, “Now, it’s true that the Fed has taken unprecedented actions lately……. And in ordinary times, this would be highly inflationary: banks, flush with reserves, would increase loans, which would drive up demand, which would push up prices. But these aren’t ordinary times. Banks aren’t lending out their extra reserves. They’re just sitting on them — in effect, they’re sending the money right back to the Fed. So the Fed isn’t really printing money after all. Still, don’t such actions have to be inflationary sooner or later? No. The Bank of Japan, faced with economic difficulties not too different from those we face today, purchased debt on a huge scale between 1997 and 2003. What happened to consumer prices? They fell…………………………….Is there a risk that we’ll have inflation after the economy recovers? That’s the claim of those who look at projections that federal debt may rise to more than 100 percent of G.D.P say that America will eventually have to inflate away that debt ………..Such things have happened in the past. For example, France ultimately inflated away much of the debt it incurred while fighting World War I. But more modern examples are lacking. Over the past two decades, Belgium, Canada and, of course, Japan have all gone through episodes when debt exceeded 100 percent of G.D.P. And the United States itself emerged from World War II with debt exceeding 120 percent of G.D.P. In none of these cases did governments resort to inflation to resolve their problems.”

Niall Ferguson contradicts Dr. Krugman’s hypothesis in FT. You can read the detailed article here. He says, “It is a brave or foolhardy man who picks a fight with Mr. Krugman, the most recent recipient of the Nobel Prize for Economics. Yet a cat may look at a king, and sometimes a historian can challenge an economist………….. A month ago Mr. Krugman and I sat on a panel convened in New York to discuss the financial crisis. I made the point that “the running of massive fiscal deficits in excess of 12 percent of gross domestic product this year, and the issuance therefore of vast quantities of freshly-minted bonds” was likely to push long-term interest rates up, at a time when the Federal Reserve aims at keeping them down. I predicted a “painful tug-of-war between our monetary policy and our fiscal policy, as the markets realize just what a vast quantity of bonds are going to have to be absorbed by the financial system this year”…………… Now, I do not need lessons about the General Theory. But I think perhaps Mr. Krugman would benefit from a refresher course about that work’s historical context. Having reissued his book The Return of Depression Economics, he clearly has an interest in representing the current crisis as a repeat of the 1930s. But it is not. U.S. real GDP is forecast by the International Monetary Fund to fall by 2.8 percent this year and to stagnate next year. This is a far cry from the early 1930s, when real output collapsed by 30 percent. So far this is a big recession, comparable in scale with 1973-1975. Nor has globalization collapsed the way it did in the 1930s. ………………………..But the stimulus package only accounts for a part of the massive deficit the U.S. federal government is projected to run this year. Borrowing is forecast to be $1,8400bn -- equivalent to around half of all federal outlays and 13 percent of GDP. A deficit this size has not been seen in the U.S. since the Second World War. A further $10,000bn will need to be borrowed in the decade ahead, according to the Congressional Budget Office. Even if the White House’s over-optimistic growth forecasts are correct, that will still take the gross federal debt above 100 percent of GDP by 2017. …………………………It is hardly surprising, then, that the bond market is quailing. For only on Planet Econ-101 (the standard macroeconomics course drummed into every U.S. undergraduate) could such a tidal wave of debt issuance exert “no upward pressure on interest rates”. ….Of course, Mr. Krugman knew what I meant. “The only thing that might drive up interest rates,” he acknowledged during our debate, “is that people may grow dubious about the financial solvency of governments.” Might? May? ………………………..No doubt there are powerful deflationary headwinds blowing in the other direction today. There is surplus capacity in world manufacturing. But the price of key commodities has surged since February. Monetary expansion in the U.S., where M2 is growing at an annual rate of 9 percent, well above its post-1960 average, seems likely to lead to inflation if not this year, then next. In the words of the Chinese central bank’s latest quarterly report: “A policy mistake ... may bring inflation risks to the whole world.” …………..The policy mistake has already been made -- to adopt the fiscal policy of a world war to fight a recession. In the absence of credible commitments to end the chronic U.S. structural deficit, there will be further upward pressure on interest rates, despite the glut of global savings….”.

James Surowiecki blog had a very interesting take on the issue, “ I’m back from a couple of weeks on the road, and was greeted on my return by the precipitous rise in the interest rate on long-term U.S. bonds—in less than a week, the yield on the ten-year note jumped more than fifty basis points (in layman’s terms, it rose more than half a percentage point), which is a huge move for an asset as theoretically stable as a U.S. government bond. This now has pundits and bloggers fretting about inflation, and about the prospect that higher interest rates will squelch the nascent recovery before it can even get started. (Although, to be honest, most of the people predicting disaster as a result of higher interest rates don’t think there was ever a hope of recovery to begin with.) The size of the move was undoubtedly eye-catching, but the notion that investors are starting to panic about inflation seems improbable at best, given the fact that even at its peak this week the ten-year note was yielding only around 3.7 per cent, which is still cheap by historical standards. (If you really thought there was a meaningful prospect of skyrocketing inflation, would you lend money to the government for ten years at only 3.7 per cent?) And while there is reason for concern about the recent rise in oil prices, given their psychological (and material) impact on consumer spending, the evidence of inflation in the real economy is just about nonexistent. At the same time, the argument that a 3.7-per-cent—or four-per-cent—long-term interest rate is going to demolish the would-be recovery is mystifying. Generally speaking, steeper yield curves—that is, when long-term debt has a significantly higher interest rate than short-term debt—are what you’d expect when an economy is getting stronger (or at least getting less weak). And surely part of the weakening demand for long-term government debt reflects the greater (if still fragile) willingness of investors to take on some risk. The minuscule yields we saw on the ten-year note (which earlier this year fell as low as 2.5 per cent) were the result of, more than anything else, the enormous fear and risk aversion that gripped investors. The waning of that is, on balance, a good sign. While it’s true that meaningfully high interest rates would put a significant crimp in corporate and individual borrowing and the like, 3.7 per cent doesn’t count as meaningfully high (and, in fact, the ten-year yield has dropped quite a bit in the past two days alone). And while a 5.4-per-cent mortgage rate will slow down refinancing and, to a lesser extent, new-home buying, that was never going to be the engine of recovery for the U.S. this time around. There are plenty of things to worry about at the moment, but inflation and interest rates probably shouldn’t be high on that list.”

Dr. Roubini’s too has a different take on the aforementioned issues, “….. the rapid and massive monetization of fiscal deficits – that has been pursued by central banks this year - is not yet inflationary in the short run as there are massive deflationary forces in the world given the slack in goods markets and labor markets; also the collapse in the velocity of money implies that the excess liquidity has been so far hoarded by banks in the form of excess reserves. But if central banks don’t find a clear exit strategy from very easy monetary policies - that have led to the doubling or tripling of monetary base in the US alone - eventually either goods prices inflation and/or another dangerous asset and credit bubble will ensue when the global economy gets out of this severe recession. And some of the recent rise in equity prices, commodity prices and other risky assets prices is already clearly liquidity driven rather than being fully justified by the improving economic fundamentals. Inflation may indeed become the path of least resistance for policy makers as it is easier to run the printing presses and cause inflation rather than pass politically difficult tax increases or spending cuts in Congress or other legislative bodies. But inflation is not a cheap solution to high public debts and the debt deflation problems of the private sector. If central banks were to allow the inflation genie out of the bottle allowing expected inflation and actual inflation to rise from low single digits to high single digits to double digits at some point a painful Volcker-style recessionary disinflation policy (like the one in 1980-82) would have to be implemented to break the back of inflation expectations and bring back the inflation genie expectation into the bottle. Thus, central banks destroying a quarter of century of achievement of price expectation stability and low inflation credibility to reduce the real value of public and private debts would be a costly solution to these debt problems. And high and variable inflation close to double digits would then lead to much higher real interest rates for government bonds, mortgages and other long term fixed interest rate debts of the public and private sector as investors will have to be rewarded with a high risk premium for high and volatile inflation. So the result would be another dismal low growth decade like the 1970s of high inflation and high and volatile real interest rates…”

Given the possibility of US government inflating its way out of debt, The Economist recently questioned ‘The long-term appeal of American Treasury Bonds’. Also, The Economist, in its recent edition, carried this article, “The world economy: Drowning, not waving? -- Don't get too excited about some recent brighter economic news” The W-shaped painful recovery process could be a reality given the structural problems worldwide. Important to remember Ruchir Sharma’s words---- The overall regime has changed and the future will be very different from the 2003-2007 phase (no matter how hard the governments try, the 2003-07 period will not come back). Markets will relapse just because the structural problems have not been cleared and “If you board the wrong train, there is no point running down the corridor in the opposite direction.”

Happy Reading!!

The risks of a double-dip W-shaped contraction

2009-06-01T09:07:00.000+05:30

Dr. Nouriel Roubini’s latest analysis on global macroeconomics talks in-depth the problems that world continues to face (Bulls please read!!). You can read the full analysis here.

Some important points from his analysis are given below:

Thus, even those who believe in an excessive debt & spending view agree that aggressive monetary and fiscal easing is necessary to prevent a severe and unavoidable recession triggered by such excesses from turning into a near depression. I.e. animal spirits, self-fulfilling expectations, coordination failure that lead agent to focalize on bad equilibria, and crises of confidence and trust can lead an unavoidable serious recession into a real depression.
Worse, the socialization of private losses – while private debts and leverage are barely reduced – implies that the process of re-leveraging continues with the public sector levering up to pick up the losses of the private sector. So, this policy solution creates – down the line – another dangerous debt and solvency problem, this time for the sovereign, with risks of a more severe financial crisis down the line once a refinancing crisis occurs and/or the ability by the sovereign to borrow more is curtailed.
Instead of this efficient debt conversion we are socializing the private losses and putting them on the balance sheet of governments and increasing public debts, thus increasing the overall leverage of the economy rather than reduce it and risking to create a sovereign debt problem while not reducing private leverage.
The burden of trillions of dollars of additional public debt in the US and other advanced economies will be a medium term drag on growth. High debt levels may be financed only with default (an option that advanced economies have not followed in recent decades), a capital levy on wealth, the use of the inflation tax to wipe out the real value of public debt or a painful increase in regular taxes or reduction in government spending.
And over time rising debt ratios of government will eventually lead to increases of real interest rates that may crowd out private spending and may even lead to sovereign refinancing/default risk. Indeed, sovereign risk that was until recently limited to emerging market economies is now on the rise in advanced economies, especially those in the Eurozone: rise of sovereign spreads relative to safer German Bunds or US Treasuries, downgrades by rating agencies, risks of failed government auction, risk of a refinancing crisis, less ability/willingness to monetize fiscal deficits (especially in a Eurozone where the ECB is hawkish on inflation) are becoming pervasive in many advanced economies; and eventually even the US may face a downgrade of its AAA rating.
If central banks don’t find a clear exit strategy from very easy monetary policies - that have led to the doubling or tripling of monetary base in the US alone - eventually either goods prices inflation and/or another dangerous asset and credit bubble will ensue when the global economy gets out of this severe recession.
And high and variable inflation close to double digits would then lead to much higher real interest rates for government bonds, mortgages and other long term fixed interest rate debts of the public and private sector as investors will have to be rewarded with a high risk premium for high and volatile inflation. So the result would be another dismal low growth decade like the 1970s of high inflation and high and volatile real interest rates
The risks of a double-dip W-shaped contraction----Finally, we have so far discussed why yellow weeds – rather than green shoot – will cause the global economy to bottom out and get out of its recession later than the optimistic consensus; and why structural weaknesses may led to lower actual and potential growth over the medium term once we are out of this severe economic downturn. But there is a third risk that has to be kept in mind. Once the global economy bottoms out there may be a couple of quarters of faster GDP growth as production is increased to rebuild inventories and as the effects of the policy stimulus reach their peak. But that recovery will be constrained by two factors: first, the medium term vulnerabilities and constraints to robust growth discussed before. Second, the risk of a double dip W-shaped recession as the wings of a tentative recovery of growth in 2010 could be clipped towards the end of that year or in 2011 by a perfect storm of rising oil prices, rising taxes and rising nominal and real interest rates on the public debt of many advanced economies. First, oil and energy and commodity prices could spike as soon as there are tentative signs of a global recovery if the elasticity of supply of such commodities is inelastic to the price because of limited excess capacity of commodities after years of underinvestment in commodities and especially oil and energy. The resulting spike in commodity prices would be first inflationary but, more importantly, a sharp negative terms of trade effect on commodity importers that will reduce their real income and lead to further demand slowdown. Second, by the end of 2010 many US tax cuts (on incomes, capital gains, dividends, estates) will expire and will be partially reversed; and the likely introduction of cap & trade will represent an additional tax increase (however necessary to control greenhouse emissions). This incipient tax increase may lead to a slowdown of consumption and investment spending. Third, concerns about medium term fiscal sustainability and about the risk that monetization of fiscal deficits will eventually lead to inflationary pressures after two years of deflationary pressures could lead to increases in nominal and real interest rate on government bonds thus crowding out consumption, capex spending and a tentative recovery of housing.

Figure out what is the overall regime!!

2009-05-31T12:57:00.005+05:30

Every time one read articles, interview, et al, of Mr. Ruchir Sharma, , he feels enlightened. Undoubtedly he is one of the best minds in the Investment Management industry today. His latest interview in CNBC is a must read for all. You can read the full interview here.

Mr. Sharma feels we are in a cyclical bull market in a structural bear market. For Indian markets, valuations are relatively fair to being on the slightly expensive side and the flurry of QIB will definitely will put a cap on the market, which has a maximum of 10-15% upside from hereon. The technical rally will fizzle out and fundamentals will finally prevail. The bull market rules will come back to play only in the 2H-2010 and surge to new high by 2011-2012.

Highlights from his interview are given below:

Have things changed really? I think the very important thing is to figure out what the overall regime is because once you know what's the overall regime then it is easier to know what the rules of the game are and in that regard there were three possibilities that we had sort of outlined at the start of the year, which is that we could either have a bear market rally or this could be a cyclical bull market within a structural downtrend or that this is the start of a new bull market. Our bias has been that we are in a cyclical bull market within what is still a structurally difficult environment.
What is a bear market rally? A bear market rally is basically just a rally that takes place on the back of technicals, which when the markets get oversold, they have a sharp bounce to clear out the oversold but there is no change in fundamentals.
What’s the quantum of bounce in a bear market? That bounce is varied over history. If you go back to the 1930s, there were bounces of as much as 30-40% even from the lows but here I am talking about the US markets. For the Indian market it is probably going to be more because you have got to adjust it for volatility and the Indian markets are more volatile, so the bounce could be bigger. So a bear market rally is just that. Now what does a new bull market mean? A new bull market basically means that you’re starting a new era where the highs of the old bull market are going to be taken out. Instead there is a middle path, which is what we call a cyclical bull market within a structural downtrend. Now the implication of this is that there is some turn in fundamentals. The turn fundamentals is not meaningful enough to start a bull market but it is enough to have markets rallying by anywhere from 50-100% over the space of a year and this is something which we saw in Japan quite often in the 1990s.
Duration of bear market rally in a structural bull market? The average duration of this if you look at what happened in Japan in the 1990s was about 6-12 months. So it varied a bit. So about 6-12 months was the average duration and there are some signs of what's going on now with the first big cyclical market that took place in Japan in 1992-93 which lasted for about 10-months and the Nikkei went up by about 50% in that space. So I think that’s the paddle that we are using for the US market at least and what exactly is this cyclical bull market? It means that a lot of the structural problems have not been written down or not purged from the system but enough has been done to cause some sort of an economic upturn and that is exactly what we are seeing now that the amount of government spending that has taken place over the past few months has been enormous. ………………………….. So this is a massive global effort going on here on the back of governments to reflate the economies and our view is that it will succeed at least for a while. But come next year or the end of this year we will see a relapse just because the structural problems have not been cleared, and the duration of this bear market still hasn’t been long enough to set the scene for a new bull market to begin.
With the end of cyclical bull markets in a structural bear market, does the market retest old lows? I think the evidence is mixed. As far as Japan is concerned, in the 1990s it basically remained in a trading range, it went back to its old lows but it never really made new lows until you got a new deflation shock later in the decade. So, I think that my best guess basically is that the S&P 500, the benchmark in the US, is in a trading range in a long-term construct where the lows that were made in March will hold. On the upside, the levels that existed before the Lehman crisis will never come back for a while to come or at least for the next three-four years I don’t see those levels being breached. So, that was about 1200 or so on the S&P.……………… The S&P is going to remain in that range and torture us because every time it goes on the lower end of that range, you think that this is breaking down and the world is coming to an end and every time it gravitates to the higher end of the range, we think this is a new dawn. But in fact the truth lies in the middle, which is this is a lot of slush and we are just working our way through this slush.
Is India is also in a cyclical bull market? Is it the assumption that India will do pretty much what the world is doing or something else? That is the basic assumption. That said, I think India can exit this bear market regime a lot quicker. I just don’t think that what we have seen since late October of last year when we made the lows and retested them almost this March, I just don’t think that those lows will crack. But neither do I feel that the conditions are in place for a new dawn to begin. If you look at the big bear markets in history, they typically tend to last about three years. The Great Depression lasted from 1929 to 1932; Japan’s market lasted from 1989 to 1992. Similarly, the last tech boom-bust cycle, of which India also was a part, lasted from about 2000 to 2002. But the Indian market even back then made its lows in 2001 and then it sort of spent some time in a trading range over the next 12-18 months after making its initial lows in September-October of 2001. So, I think that India and other emerging markets can definitely exit this bear market regime a lot quicker than the developed world. But after the run that we have had of late, I think that it is going to trade water for a while, maybe make some upside. But I still feel that even markets are going to take a while to break above the levels that existed before the Lehman crisis broke out. So, in many ways the Lehman episode basically was a defining moment, and in history it will go down as a period where Before Lehman will be referred to as BC and After Lehman will be referred to as AD because the dividing line. The credit bubble, which was inflating economies and asset markets burst decisively with the Lehman episode. No matter how hard the government’s tried they could not get us back to that era from ’03 to ’07. But they can prevent the world from falling apart, which is how it seemed in October-November last year.
21,000 Sensex ? Yes, I’d be shocked if it does. So, I’d say that even in dollar terms currently if you look at it, the Indian market today is about 15-20% lower than where it was just before the Lehman crisis broke out because in nominal terms the Sensex is at the same levels, but the rupee is about 15% odd weaker since then, or maybe a bit less now. So, my own feeling is that another 10-15% in dollar terms for this market and after that it will sort of struggle to break above that.
Valuation stretched? I think that valuations have already now from being cheap in March or in late October of last year to being sort of relatively fair to being on the slightly expensive side. So, I think it just takes time for these problems to work their way through. See how the mechanism is working just now even in India. As the market has moved higher there is a flurry of new issuance that is going out in the market. Over the past month or so, Indian corporates have raised about USD 3 billion or something in new equity or other deals that they have done - QIPs etcetera and another USD 3 billion is out there, maybe more depending on how the market does. I think that our own team sort of estimates about USD 12-15 billion needs to be raised to just clean up the legacy mess from the previous bull market going sour. So, I think that is going to put some sort of a cap on this market as we go ahead.
Will QIB squeeze out the money from the secondary market? Maybe not squeeze out, but it will definitely put a cap. That is how it functions because you will have to again think about some serious disinvestment because the government’s finances are in a mess. So, I do feel that supply is going to be a bit of an issue and that valuations for the market have already become fair. They are no longer cheap like they used to be and they can get more expensive. But I also feel that after the pain that investors suffered from the boom bust cycle, will be very wary of assigning an expensive valuation to any stocks and sectors after being burnt so badly in the boom bust cycle in the past five years.
You don’t belong to the camp that believes that there is such a big left out feeling that at every dip money will come in and chase the market and downsides could be very limited and in the near-term maybe we can trade at fair valuation plus? That can happen. But I just don’t feel that beyond that 10-15% there is not much upside. So, that can happen. But the way that can happen basically is that the corrections for the time being can be shallow. But my point is that eventually it is about fundamentals. Technicals can drive the market beyond a point. What has happened is something that is not unexpected. We were looking for some sort of a cyclical recovery to take place, because we knew that the government’s spending efforts across the world were incredible and enormous…………………But I think that at some point in time a cap is going to come because the government’s finances across the world are in a mess whereas the private sector wouldn’t have de-leveraged enough and that is going to cause some sort of a relapse next year, not a full blown crisis, but a widespread recognition that the 2003-2007 era is not coming back. That is a dream, no matter how hard the government’s try.
New Indian government expectation? I am sure if it over expecting because even last week by the time the week ended the relative out performance of this market have been whittled down to about 10% versus other emerging markets which is a fair out performance to take place and typically if you look back at history since 1980, whenever a stable government had been elected in the first year the market has done reasonably well but those expectations have faded as time goes by. So I am not sure if it’s over expecting because typically in the first year of a stable government the reform momentum tends to be strongest on a relative basis and we could see some signs of that but the big picture which will come back to haunt India later on in the year, is going to be that we now have the highest debt to GDP ratio at 80%, of any emerging market in the world and the reason we are able to sustain this is because lot of the debt is held internally, it is not held by any foreign investors. Second reason is that our financial and our consumer sectors are quite under leveraged, so they will be able to compensate for the over leveraged position of the government but it is only that much that the government can do because beyond a point what will happen is that, if the economic recovery begins here then you will have a massive surge in bond yields just because the pressure on borrowing from the government is going to remain enormous through this period. You don’t think there will be an aggressive capital recedes programme- divestment, 3G etc which might partly compensate for it?Ofcourse it will partly compensate for it but this is another reason why the market will have sort of trouble going high beyond another 10-15% because there is going to be sort of constant demand for capital whether its from the government or whether it is from the private sector which is going to put a lid on any meaningful advance that takes place. Ofcourse the wild card here is that if global equity markets truly fire and that opens up the international tap a lot because over the past couple of months, I have been speaking to some Indian corporates and their borrowing has been done largely from Indian banks, as the foreign banks have sort of withdrawn from the market or have cut back a lot on their lending to Indian corporates but if that were to open up then the game might change. My own feeling is that now a lot of this is getting into the price across the world and so we can see this year get by but sooner rather than later, we will get a relapse because we just haven’t spent enough time working out the structural excesses in the global economy.
Rupee to 40/41 to the dollar in 12-18 months? I don’t think so. Because the legacy problems are still there in terms of funding of the corporates, how much they need to raise, how much they need to repay, there will still be some mismatches. I think the rupee is basically still highly correlated with the stock market. So the stock market might have another 10-15% upside, I doubt very much that the rupee is going to get beyond 45 to dollar or so, because there has to be some adjustment of some reality and so I don’t believe the forecast of the rupee going to below 40 to a dollar anytime soon or close to 40 in the next 12-18 months, I don’t buy that.
What’s the bottom end of the market for the next 12 months? I would say the worse case scenario is about 8,000 because I think that will hold, I don’t see us going back, I would say to about 10,000 but its possible that we would get to 8,000-10,000 in the relapse situation sometime next year. So I would say 8,000-10,000 somewhere in that zone we could get back to that. So when we look back at this period in history, it will seem like a big trading range but when you are living through it, there are periods of lots of excitement in terms of both greed and fear as alternating emotions. So it seems that way, but when we look back in history this will seem like one big trading range. Having said that, I still feel that, emerging markets such as India, will exit this trading range and this overall structure bear market regime a lot quicker than the developed markets. My rough path at this point and these are all best guesses, that we do find for a while here, we start to get signs that economic activity across the world including in China is beginning to fade towards the end of this year, we get some sort of a relapse early next year and then we make a true double or triple bottom for the Indian market and other markets in the emerging market space by second half of 2010 and then that sets the stage for the new bull market to begin…………By then you would have cleaned out a lot of the excesses, in the system, a lot of corporates would have paid down their excessive debt that they took, they would have readjusted their P & L’s, other operating metrics for the new environment which this 9% economic growth was caused by excessive liquidity that is not coming back. Indian GDP is more likely to be at 6-7% unless you get a new burst of productivity enhancing reforms. People would have made those adjustments and then the stage would be set for a true new bull market to begin.
What is going on with the midcap universe? I think the midcaps tend to do well once there is some sort of bull market gains traction and this is a cyclical bull market but till about a month ago people just thought this was a bear market rally. There was a lot of sneering about what was going on that this won’t even last that long that is where people got it wrong. This is a cyclical bull market and not just another bear market bounce and this catch up taking place. Historically what we have seen is that when the domestic economy does okay that is when the midcaps and the smallcaps tend to do well. So we are seeing some signs of a cyclical recovery. Even in India the economic activity has shown some signs of turning around in terms of car sales and cement numbers etc, so we have seen some signs of that. So it is not that surprising in terms of what is happening this catch up which is going on.
Lots of trading opportunities? Yes with lots of trading opportunities and we will still see that in the months ahead and I think as an investor there will always be an opportunities and the sectors will always matter. There will always be relative trades to do. But to me the most important thing about the markets basically is that you need to figure out what is the overall regime. In that regard, I think there is an overall quote which I live by which is, “If you board the wrong train, there is no point running down the corridor in the opposite direction.” So it is very important to figure out what the overall regime is to understand that markets go through phases and cycles and the rules are different. The rules in 2003, and 2007 were different, the rules after the Lehman crisis had been different and now we are seeing a cyclical bull market with the rules change a bit but broadly the bull market rules will come back to play only in the second half of 2010, when you will see a much broader thrust and a surge to new high by 2011-2012 something around that.

Deep dilemma!!

2009-05-28T09:10:00.003+05:30

Liquidity conditions have improved worldwide as is visible from TED spread, which was .88 in April, 09 from October, 08 peak of 4.57. India has been a big beneficiary of the improved liquidity. Indian corporate who were facing immense credit crunch a few months back have been able to raise money because of the improved conditions. Samir Arora, FM, Helios, commented in CNBC on improved liquidity conditions, “……….I am only drawing this conclusion from how I saw DLF happen. It happened in four hours to USD 750 million and get oversubscribed and all that, it means that there is real willingness and this event had to be negotiated and it has not only been negotiated it is way beyond that. Therefore it will be strong. Even flows will be strong…”. Indian markets have gone up taking cues both from liquidity and better outlook of corporate and is up significantly from Feb,09 lows. However, the recent flurry of QIPs announced has raised concerns on quality, which can be read from here.

The dilemma now is, where is the market headed from here and how long will FIIs flows continue? Are investors chasing price rather than focusing on valuations? Akash Prakash (Amansa Capital), an erudite FM based in Singapore, recent article tersely captures dilemma of most investors, “……Having gone through a very tough 12 months, investors are naturally worried about not taking further losses, and are thus loath to chase this rally. Investors are damned if they do and damned if they don’t. If they buy now and the markets fall, they are bound to get asked questions on chasing the market, and if they do not participate they will be asked on underperformance. Invariably it is now when fund inflows will also start. It is rare to have so many investors, all hoping for a market pullback, and unhappy as the market keeps rising. There is a very strong left-out feeling globally and across investors.”

The current price-implied expectation factors very strong earnings upgrade + continued strong inflow of FII money. Any of the following reasons could be a precursor for FII flows going in to the reverse, (a) Budget announcement lower than expectation (b) an agreement that valuations are stretched across the board and other markets look attractive ( atleast in the short-term), (c) macro announcement worse than expectation leading to increase in risk aversion.

Simply put, given the consensus that market is fully-valued there is a high-probability of strong push-backs at any up-moves.

There is a heightened Budget expectation and probability of actual announcement exceeding expectation is very low. Pranab Mukherjee, our FM, said in CNBC yesterday, “I. ……………………. .So I remain quite hopeful that this will not be a damp squib of a Budget because the stakes have been raised too high. I think if this is a disappointing Budget, you won’t see a 2% cut on the market, it will be more like 8-10%.

Guess our FM understands expectation investing better than most of us!!

Bernanke's commencement address at Boston College

2009-05-26T11:05:00.001+05:30

Summary of Bernanke's commencement address at Boston College School of Law, Newton, Massachusetts, "So, my advice to you is to stay optimistic. Things usually have a way of working out. My second piece of advice is to be flexible, even adventurous as you begin your careers. As I have tried to illustrate today, you are much less able than you think to foresee how your life, both professional and personal, will play out. The world changes too fast, and too many accidents and unpredictable events occur. It will pay, therefore, to be creative and open-minded as you search for and consider professional opportunities. Look most carefully at those options that will give you a chance to learn new things, explore new areas, and grow as a person. Think of every job as a potential investment in yourself. Will it prepare your mind for the opportunities that chance will provide?"

The dollar debasement trade

2009-05-26T10:30:00.000+05:30

"The US dollar is not strong because people want to hold the dollar, but it's strong because people have debt in dollars." --George Soros

Recently, the dollar debasement trade debate has gained significant momentum. It is explained is a very simplistic manner in today’s article in DNA by Vivek Kaul. You can read the full article here.

In today’s note to clients, Christopher Wood from CLSA says that dollar debasement is coming ‘sooner rather than later’. Nevertheless, he thinks that the current selloff of US dollar, US stocks and US Treasury bonds makes no sense and he asks macro investors to start buying long-term government bonds. Mr. Wood surmises that the US currency will be the beneficiary again of a renewed realisation that deflation remains the predominant present danger, not “inflation”. After all, most of the world’s debt is still denominated in greenback.
Most experts ( Soros, Roubini, Wood and Napier, et al) agree that the debasement trade will start a few years from no. Till then, enjoy the liquidity tap that has been turned on again.

Anyways, do we really care about economics anymore. The doom predicters still debates on whether world faces V or L or W shaped recovery. In the meanwhile, equity markets are up very strongly over the last two months, precicting a V shaped recovery. What shape of recovery we are in will be clearer by end of this FY; however markerts price-implied expectation points to very strong recovery and probaility of dissapointment is very high.

Some interesting links on Inflation vs. Deflation debate that is currently raging worldwide are given below:-

http://www.nytimes.com/2009/05/04/opinion/04meltzer.html?_r=1&pagewanted=all
http://krugman.blogs.nytimes.com/2009/05/04/a-history-lesson-for-alan-meltzer/
http://www.federalreserve.gov/newsevents/testimony/bernanke20090505a.htm
http://www.economist.com/opinion/displaystory.cfm?story_id=13610845
http://www.economist.com/blogs/freeexchange/2009/05/fear_not_inflation.cfm
http://blogsandwikis.bentley.edu/themoneyillusion/?p=1164
http://gregmankiw.blogspot.com/2009/05/inflation-or-deflation.html

Happy reading!!

When will we learn to ask more questions?

2009-05-21T12:25:00.004+05:30

The Positive Feedback Loop seems to be working too soon and too fast for Indian equity markets. As we had written earlier that, ‘Higher corporate earnings (EPS) + better liquidity (higher P/E) could result in Higher Target Price.’ Higher corporate earnings (EPS) will still take time to emerge, though results of better liquidity (higher P/E) can be easily seen in current target prices given by analysts. Too my surprise, in one of the companies, which I track (results announced yesterday), people have started giving P/Es of 18x on FY10E EPS (2 months back even P/Es of 9x looked expensive for this company given some corporate governance concerns). Reasons of higher P/Es that I have gathered so far from my peers are, “(a) the sharp discount to peers, (b) relatively attractive valuations.” The aforesaid for me means that, “I understand that A stock is expensive BUT companies in the same sector are much more expensive than A, hence A is a BUY. Cool!”. Is this what we are paid for?

Fundamentally, for lower visibility (even for current fiscal) + corporate governance issues, stock should command lower P/E. But who cares about all the aforesaid when liquidity tap has been turned on. V Anantha Nageswaran depicts a conversation between an inquiring mind (IM) and an ebullient Indian investor (EI), which somewhat relates to our aforesaid dilemma. You can read the detailed conversation here.

EI:
The problem with you is that you can only ask questions but not make money. We make money on hope. You want to make money on reason and rationality. That is why you got it all wrong. Since when stock markets have been about reason and logic? It is about easy money, hope, hype and greed.

IM:
Look, I realise that those things drive the market. Up to a point, I buy the argument that these factors drive the market in the short-term. Of course, short-term and long-term are never precisely defined. It is also not clear as to how much of a rally is justified and how much is excessive. All these are difficult questions and I have always answered them too conservatively and too carefully. That is my weakness or strength. Depends on the situation.
But, that is not the issue. When in doubt, we ask questions. When we do not have clear answers, we must demand a premium for the uncertainty or the incomplete information risk. Where is that these days? People buy first and ask questions later. Or, never until it is too late.
I am not asking for fear. But caution before greed?

EI:
You know something? You just do not get it. Money is cheap; hope is good. We buy. You can watch us get richer.

IM:
Hey, I can understand that too, up to a point. But, we just had a global crisis of mammoth proportions. Trillions of dollars of wealth have been lost. People have to learn to ask more questions at least now and not believe that good times will roll on for ever. At the very least, one would expect people to be wary for some more time.

EI:
When money is cheap, asset prices have to go up. That is the only theory we know. When in doubt, buy. When not in doubt, buy more. We might have had a global crisis but look at all the stock markets this year. You might have been rightly cautious last year. But, I suspect that being cautious is the only thing you know. You probably are out of touch for the most part. But, it so happened that you got the last year or so, right. That was more of an accident. Now, good times are back and you are no longer as effective. That was a bad dream. It is over. We are back to normal now. We do not need you any more.

IM:
Left speechless, IM was last seen searching the Internet to confirm if he was the last surviving member of the dinosaur family.

The inevitable never happens; the unexpected always does!!

2009-05-20T19:32:00.001+05:30

Robert Shiller, author of Irrational Exuberance and Animal Spirits, unambiguously explains in his latest article (with the help of behavioural finance) why we should be wary of the recent run-up, “Speculative booms are driven by psychological feedback. Rising stock prices generate stories of smart investors getting rich. People become envious of others’ successes and begin to wonder if rising prices don’t portend further increases. A temptation arises to get into the market, even among people who are fundamentally doubtful that the boom will continue. So rising prices feed back into more rising prices and the cycle repeats again and again — for a while………… During a boom, people considering getting into asset markets weigh the fear of regret if they don’t against the pain of possible loss if they do. There is no authoritative answer about what the “right” decision is and no consensus among experts about the proper level of exposure to these markets………………………….. …………But one must ask what would sustain such a movement now. There seems to be no dramatic fundamental news since March other than the price increases themselves. The human tendency to react to price increases is always there waiting to generate booms and bubbles. The feedback is only an amplification mechanism for other factors that predispose people to want to get into the markets. The whole world can’t recover all of the enthusiasm of a few years ago from feedback alone, for there is a giant coordination problem: We are not all attentive to price increases at the same time, so we make decisions to buy at very different times. As a result, things happen slowly and, meanwhile, more bad news may be revealed. The only way world confidence can return dramatically is if our thinking coordinates around some inspiring story beyond that of the price increases themselves………………………………. Starting an economic recovery is like launching a new movie: Nobody knows how people will react to it until people actually get to see it and talk about it among themselves. ………………… That old story just got some excitement back with this new movie. Similarly, we have to hope that some of the same old stories that propelled us in the past — the rise of capitalism and its internationalization throughout the world economy — can somehow be dusted off and revived yet again to invigorate the animal spirits that drive economic recovery. Our efforts to stimulate the economy should be focused on improving the script for those stories, making these stories believable again. This means making capitalism work better and making it clear that there is no threat of protectionism. But the rationale must be to get the world economy out of its current risky situation, not to propel us into yet another speculative bubble.”

Nevertheless, the general elections result in India has been a game-changer for Indian economy and markets. Chetan Ahya from Morgan Stanley writes here, “We believe that this strong political mandate will allow the new government to accelerate the pace of reforms. Some of the key areas where we expect progress are: a) the government's effort to improve public finances; b) acceleration in infrastructure spending; c) augmentation of government resources through privatization (divestment of stakes in government companies); d) improvement in share of stable capital inflows; and e) implementation of some of the long-pending deregulation measures for the pension funds, banking and retail sector. Building in a potentially stronger policy response from the new government, we are upgrading our GDP growth forecasts to 5.8% from 4.4% for F2010 and 6.8% from 6.2% for F2011.”

It is still difficult to envisage what one day has done for India. The markets has already set very high expectation (Budget day will be the real test) and there seems to be little room for any disappointment as implied by current prices. Ruchir Sharma from MS succinctly puts our feelings in his latest article in WSJ, “The inevitable never happens; the unexpected always does. Nowhere is this truer than in the realm of Indian politics…….. Voters have given the Congress-led coalition even greater political capital to take India to the next level of development. To satisfy these aspirations, the new government will have to recreate the boom-like conditions the country enjoyed for much of the past five years. The key difference this time is that in the absence of strong global tailwinds, economic growth will have to be more endogenous in nature and kickstarted by domestic economic reforms. Mr. Singh and his team have a tough task ahead to meet this burden of high expectations.”
Happy Reading!!

Irrational Exuberance / The Greater Fool Theory/ Keynesian beauty contest?

2009-05-19T13:19:00.003+05:30

Are we in a state of Irrational Exuberance? Does this run-up hint to The Greater Fool Theory? It today’s principle of stock investing similar to Keynesian beauty contest?

The problem with the aforementioned approaches is that we are ignoring fundamental value, instead trying to predict ‘what the market or other investors will do’. We are focusing too much on the outcome rather than the process. Robert Rubin, Seth Klarman and many other astute investors time and again reminds us to focus on the process rather than the outcome. In the height of Bear market Seth Klarman said, “It is critical that you remind your clients, your investment team, and, as often as necessary, yourself, that you can only control your process and approach — that you cannot forecast the vagaries of the market, which in any case are an opportunity and not a problem for value investors. And then you should invest, comfortable that you’re doing the right thing, indifferent if you lose your short-term oriented clients — who will never understand what you do, or how they are their own worst enemies — and confident that when the dust settles and the crisis passes, your steadfastness and discipline will have added more value than any other approach…………………. ………………………………It’s so easy for one’s investment process to break down — and process is everything in investment firms. And today, many firms have a broken process. When investors worry about what a client will think rather than what they themselves think, the process is bad. When an investor is worried about their firm’s viability, about constant redemptions, about avoiding loss to the exclusion of finding a legitimate opportunity, the process will fail. When one’s time orientation becomes absurdly short-term, the process is compromised. When tempers flare, when recriminations abound, when second-guessing proliferates, the process cannot work properly. When investors worry about the good of the firm or its publicly-traded share price rather than the long-term best interest of the clients, the process is corrupted. When the process is broken, you can’t invest well. It’s hard enough to invest well when the process is good. So it’s crucial to have a sound process that will enable you to perform this difficult task with intellectual honesty, rigor, creativity and integrity.”

Should one change their process during period of poor performance?

James Montier, SocGen’s market strategist, pointed out in a recent piece that when athletes were asked what went through their minds just before competing in the Beijing Olympics, the response again and again was that the competitor was focused on the process, not on the outcome. The way to maximize outcome is to concentrate on the process. Montier points out those psychologists have long been aware of a phenomenon known as “outcome bias”. This is the tendency to judge a decision differently based on its outcome. For example, if a doctor performs an operation and a patient survives, the decision is rated as significantly better than if the same operation fails and the patient dies. According to Montier, during periods of poor performance, the pressure builds to change your process. But so long as the process is sound, this would be exactly the wrong thing to do.

Positive Feedback Loop ( Indian elections and its after effects)

2009-05-17T14:32:00.003+05:30

Investors are expected to give a strong thumbs-up to a stable government at the centre. Rakesh Jhunjhunwala, Manish Chokhani and Samir Arora post election views on the markets (attached below) is a must read for any investor. Probability is high that the positive feedback loop will start working for India, once again. This is how it may pan out----------- ‘worldwide investors will find it more attractive to send funds to India, given better growth outlook + stable government, vs. low returns being earned right now in mature markets. As capital starts flowing to India, rupee start appreciating which, in turn, makes it even more attractive for foreigners who wish to invest in India. This improves liquidity in the financial system and helps keep interest rates low. It also helps meet the large borrowing needs of the government as well as of corporate and retail borrowers. Credit-starved companies who then become more liquid are able to put assets into productive use, pushing both economic growth and corporate profits to a higher trajectory. GDP growth gets a boost, and corporate valuations also begin to look better since their earnings will rise.’ Higher corporate earnings (EPS) + better liquidity (higher P/E) = Higher Target Price.

Read Mr. Manish Chokhani (from Enam--one of the best investment minds in India), views on sectors to benefit from higher liquidity in India, “It is if you think of it the whole engineering, capital goods, infrastructure, real estate – I kind of see it as one pack because they are beneficiaries of liquidity which changes their business itself and when they are starved of liquidity they get completely hit on the downside. So if you do see a return of liquidity it improves the fundamentals of these businesses and as an example once the money comes into a DLF, it looks that much better for you fundamentally and that way it is a game changer for you in those industries and if you’re going to get this kind of liquidity flows back into the markets and into the system it surely is going to help all these companies.”

Risk to the abovementioned outlook is worse than expected global economic conditions worldwide in 2009 & 2010. Read Dr. Rouriel Roubini’s Green Shoots or Yellow Weeds? if you want to know how global economies are expected to fare over the next two years.

Happy Reading!!
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Here is a verbatim transcript of the exclusive interview with Rakesh Jhunjhunwala, Manish Chokhani and Samir Arora on CNBC-TV18. Also watch the accompanying video.

Q: Do we get one circuit up on Monday or do we get two circuits up?

Jhunjhunwala: All of us are focused on what’s going to happen on Monday but don’t forget that I am also an investor. I think what’s more important is what’s going to happen – not over the next 15 days but over the next 15 months and 15 years. I think it’s a game changer here that finally the divided polity or a divided country, I think its not come to an end but coming to an end and we are having a government in power which has last time indicated lot of reforms they wanted to do but could not because the allies did not agree. At this crucial juncture in the global scenario and in India’s history, I think this victory is very important. Important for what’s going to happen in the next four months but I think more important is what’s going to happen in the next four years and next ten years.
Continued on next page ... _PAGEBREAK_
Q: Your first thoughts on how much the initial thump from the market will be because it’s only 975 points on the Sensex because of the quarterly closing which will hit circuit?
Jhunjhunwala: Two things have happened; the Left has become meaningless and everybody is left out because I do not think the bulls have participated in this rally the way they should have for the kind of ride the market soul.
Q: Are people left out do you think?
Chokhani: I think that is absolutely right and the words you used unexpected apply to the market and now the word unexpected applies to the result, so there are lot of people left out all over the world, not just in India. So people have this feeling of having missed out on the whole rally across the world and it’s great this has come in continuation of that trend that the markets were anyway looking to make higher levels and the results are really going to help to continue that.
Q: So you think the cash which was on the side lines will get sucked in after this result?
Chokhani: I have a feeling that there is lot of desperation that people have missed out completely. The hope was that this market will correct and it will go down substantially, give people a chance to reenter, like you had that 8,000-10,000 band then people reconciled to 14,000 type of band, I guess the band is going to get that much larger and go maybe 12,000-16,000 very quickly as well.
Q: Do you think we will dash to 14,000 fairly swiftly after this kind of a result?
Arora: I think there will be a big rally because of not short covering perhaps but under weight or ignoring India, yes absolutely there will be a big one. I think we learnt last year Black Swan for bulls, this is a Black Swan for the bears, this is way out there and that is once in a 20 year thing can happen and this is a big one.
Q: So one circuit up on Monday morning do you think, 1,000 points?
Arora: I would like a little bit more time so that I can also buy but yes it will be.
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Q: What is the biggest positive as you see it – is it going to be that whole hope of constructive policy making which the government wanted to but could not do as you said over the last 5 years, now that the Left is out and Mayawati is out as well?
Jhunjhunwala: Let us look at the positives one from the market point of view, one from the long-term point of view. I think the biggest positive is Indian democracy is now maturing. I heard MJ Akbar say on TV channel that people are voting for governance -Muslims are not voting for Muslims, Hindus are not voting for Hindus, people are voting for governance. Where you get good governance you are getting votes.
I may sound theoretical but I think India is evolving perfectly the way I thought. And I think what is most positive about is this governance matter and the reforms – the pension bill, the insurance bill, consolidation of public sector banks, labour laws, I think all of this is just a matter of time.
The only thing I hope is that they are reasonable. Lots of people are crediting their victory to National Rural Employment Guarantee Scheme and to the waiver of loans. I feel we should have a National Rural Employment Guarantee Scheme; we must have it but let’s not get overboard.
Another wish that I have is they should decontrol oil price. Let us have consumers face the real cost of what we consume. Last and most important is, I will never forget Rajiv Gandhi’s words that what government spends, only 15 paise goes to the final recipient. So we have got to work on governance. I am truly excited, I am not excited so much on what would happen to markets next, I am more excited as an investor. We have a delicate fiscal situation and we require good governance and good sense. And one of the biggest ways they can raised revenue is by PSU disinvestment. So there is lot to look for to in the next 6-9 months, one-two years.

Q: Let me get back to you. What would be the general feeling amongst global investors now? Would they be happy at this result or do you see more people actually sulking at this result because they will not get the post election or post result dip which they were waiting to buy into?
Arora: I think they were not waiting to buy into that way in the sense if the market had fallen or the result had been bad, you wouldn’t have come in. So in some sense they will feel bad but this rally will be more than one day’s rally and therefore I think they will come in over time and substantially. I was in US market in our new fund last week and we said we will do it after the elections and I think the amounts that we will raise will be larger may be by a margin of 2-3 times without asking anybody or talking to anybody yet but it is obvious that people will sulk for tomorrow but this rally is not going to be one day rally. I think this seriously is a big thing for India to imagine to not see Mr. Karat on TV that itself is worth 500 points. So these kinds of things are going to be longer than just one or two days and so even though it will be up 8-10% tomorrow or whatever I hope a little less so that we can buy more. But in general this change in outlook will be bigger. Now it will be Congress’ thing to do if overtime they disappoint, now they will have a big honeymoon period and I hope as Rakesh was saying that they would deliver and don’t start saying that Mrs. Gandhi nationalize the banks – that’s how we saved India and all that.
They should now get over that talk and really deliver but they can and they have a clean slate to start in that sense.
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Q: What's your sense? Do you think this can lead to some kind of valuation premium for India as well? Is today’s event that significant?
Chokhani: No I don’t think we should read so much into results for people overseas. For India it is great thing and remember this will take time to play out and the new power equations and what personalities want what to get delivered will take time to play out and this is been really the first Congress government since Rajiv Gandhi because even Narasimha Rao had to run his government with great constraints. I am assuming lot of those constraints will get taken out and what the Congress really wants you will go through a period of some turmoil over the next six-months. Like Samir points out that there was one camp which says nationalize the banks, treat them as utilities. There is another camp which might say why don’t we get consolidation make larger banks and so on.
So the context was, we were in the middle of a large rally across the world that global rally continues. The imbalances in the world haven’t gone away. So at some point you will get a surprise again in the world and despite a great government you will still go down, nothing will change but over the course of next five-years the fact that this government can now do things unfettered and in a way get that decoupling argument going all over again and get this 5-7 point of GDP growth differential with the western markets, over the 3-5 year period our premiums will grow for our market but to say it will happen in the next three-month is wishful thinking.

Q: The skeptical view would be and that would be the view that the bears might take is that fundamentals haven’t changed. If you suddenly get a 10-20% rally because of this it should be sold into – what would you say to that contention?
Chokhani: It is not a rally to sell into because what's your case for a downside because you are not going to say earnings will evaporate. You have got a kind of a 850 kind of bearish number for this year but most people will expect India next year to be up 15-20% in earnings. So the range of earnings when you come into January of next year, you will be looking ahead at 1,000-1,100 type of earnings number, so in any case a 15,000-16,000 index difference-able six-months out from now and you are looking optimistically at the future. So you will probably rally quick and hard and then you pause for breath and say look I need some time to pass. May be we go sideways for a while but the case to say that India is going down all over again to that sub-10,000 may be even 12,000 becomes a new bottom – it is unlikely unless again a black swan blows up in the world, the world markets retest which I think they will because the imbalances haven’t gone away in the world.
So I would still treat this as a very powerful bear rally but it is not yet a bull market which India will have to reset its fundamentals hopefully with this government, get its fiscal house in order, get the earnings back in order, get other sectors all participating and there is no rush in life – you can have a bull market in 2011 or 2012 – why do we need it all in 2009?
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Q: But you’ve raised an important point. Samir I want you to come in on this – do you think sub-10,000 is history? Can you say that with confidence after today’s event?

Arora: I think it is history but before that I think this event is bigger for foreign investors than it is for Indian investors because Indian investors in the end will know that we really won’t change much so fast but the macro issues of government being confused or having participation of Left or Mayawati or stuff like that which was a scary scenario and you know foreigners they invest they scramble into it like one-month putting USD 2 billion or in one night buying USD 750 million of DLF. That is not done by Indian financial institutions. So the fast rally will be driven by foreign desperation because the Indian investors in general still have been investing all along in this quarter and the previous quarter and previous year and also India has significantly underperformed all the other three BRIC countries – Brazil, Russia and China are up 50% type numbers, even Singapore is up as much as India as of today. Taiwan is up twice. So India can go up 15-20% and then go up inline or go down inline with the world. But the first rally will be driven by foreign investors and the story for the foreigners is easier for me to tell and I am sure like me for everybody else because in between this event had to be negotiated and there was no answer to this question – what will happen? So in that sense if you can tell us a story and believe in that story then money comes.
Q: You were with me on April 1 and you said that you saw the current year calendar target or range for the Nifty between 2,700 and 4,000 – 4,000 we are Monday morning – where do we go from there?
Jhunjhunwala: Before I comment on this let me tell you one thing. The rally on Monday has not even started and we are already saying we should sell into it. So the bulls are left and they will be further left. I don’t know whether I am going to make any new target. Let us not forget one thing in all this euphoria that the international factors are going to have an equally important role to play. I would be in any large rally a circumspect buyer. I will give the market time. I wouldn’t want to jump into the market with a 1,000 gap.
Q: Now would you set the bar for the Nifty higher than 4,000 for your upper limit for the year?
Jhunjhunwala: The real resistance on the Nifty is 3,800. I won’t be surprised if during the course of the year the Nifty touches 4,500-4,600 and it is quite possible. I think it should if the governance factors and the expectations that the market silently has from the new government if they are met and if internationally things don’t go from bad to worse I think it could happen.
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Q: Let me ask you flip as well because your target was 2,700, do you want to revisit that or do you think there is a chance that maybe hit in case of adverse global circumstances during the year?
Jhunjhunwala: I would say now 2,700, I would raise that to around 3,200-3,300 should be a bottom.
Q: New range 3,300 to 4,600, correct?
Jhunjhunwala: We can predict the direction; it’s very difficult to predict the depth. I can say markets can go up. How much will they go up that I also do not know - I also watch the screen every morning. To go to the market with any preconceive thoughts that this is the top and this is the bottom. But I want to tell you that as an investor I will be highly reassured because India’s fiscal position was something to be worried about. I think that will now be partly taken care of because people may have confidence. I think we had lot of FDI (Foreign Direct Investment), we had lot of foreign capital into the country; I think this government will work for infrastructure. So from that point of view I am comforted. As an investor, if I look at an opportunity and if I were thinking three times whether I should buy or not now I will think once not that I will jump into it. So my long-term thing about Indian markets now has great sense of comfort.
Q: Will portfolios matter. Will the market think about who is Finance Minister now. Is that going to be important?
Chokhani: It’s always important and I will draw you back to some history that for e.g. in 1991 Mr Narasimha Rao comes as Prime Minister, he was an unknown quantity. Manmohan Singh at that time was considered as socialist and the market took some time to figure out what these guys are going to be up to. You fast forward even to the Third front government when Chidambaram came as the Finance Minister and gave us the best Budget we can remember and then the Asian crises caused a collapse over there and you could have situations like that still.
You come to even the NDA (National Democratic Party) regime actually 1998 to 2002 you waited with bated breath and then you get Mr. Shourie who you would never have imagined will be the person who dismantles the public sector or who works for the whole telecom sector to open up or Suresh Prabhu someone unlikely who comes in and completely reforms the power sector. So personalities are important even the previous government while it’s not very obvious to think of names but would you have imagined Praful Patel comes and transforms the aviation sector for e.g. or if Mr. Yadav had been made Railway Minister, I am sure everyone made mischievous comments on that day but railways was the turnaround story of the last years. So personalities matter and how people behave and they sit in a group and committee and whose voice dominates at that point that determines policy outcome.
All we are saying is you do not have discordant voices which will drag you down but its not an open and shut case because lot of people will take credit that this election was won because of the farm waiver package and the rural employment guarantee programme and who cares about the reformists and I do not know what the final election results were but some point I saw Mr. Chidambaram was trailing, Kamal Nath was trailing; if you go to Andhra Pradesh as well reformists over there trailing as well. So while its right to say that this is a vote for governance and Sheila Dixit wins in Delhi and Narendra Modi wins in Gujarat. It’s not yet uniform across. The great hope is Rahul Gandhi goes in; two years he spends in Uttar Pradesh, he pulls out 20-25 seats for the Congress. It just shows you directionally, you are going right.
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Q: Who would the market be most happy with in terms of a finance minister because some of the options which have been spoken about now, maybe Pranab Mukherjee has the seat or maybe a technocrat like Montek Singh Ahluwalia, what would please the market the most because it does matter at the end of the day as who is the Finance Minister?
Arora: It should be somebody important and people do matter. I think this time Dr. Manmohan Singh should lay down a philosophy or a policy because now he doesn’t have the left or others to contend with. In theory or in general I could have said that in the last five years there was a lot of disappointment and the Congress didn’t stand up, we obviously knew that the Left was troubling them but they didn’t say that this is what we really want and Dr. Manmohan Singh said politics is the art of the possible. So now that everything is possible he should lay down a stronger view and follow through in terms of who should be the Finance Minister, between these two I would think Montek Singh Ahluwalia might be a better name only because otherwise Pranab Mukherjee would then leave the External Affairs or the Foreign Ministry for which you will have to find somebody else. I don’t know in the hierarchy whether they consider finance or external affairs more powerful or important.
But it has to be an important name that we are comfortable with, somebody who has been either in Reserve Bank of India, (RBI) or somewhere where people have seen that they are forward looking and open to foreign investors and opening the economy. In general I don’t believe this is a vote for good governance, I think this is a vote for lack of choices and hope and therefore it would be a big disappointment now if it’s not delivered upon.
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Q: It would be a great five years to be a Finance Minister, no more left pulling you down, no one shackling you, you would have pretty much a clean run, who do you think would the market would want to see that on the hot seat?
Jhunjunwala: Although I agree with Manish Chokhani that personalities are very important and personalities who were expected to do very well did nothing and from those who were unknowns did very well. But I think Dr. Manmohan Singh himself would like to assert himself as the Prime Minister. As far as we know from the press reports, that he asserted that we will sign the nuclear pact. So regardless of who would be the Finance Minister, I think Dr. Manmohan Singh himself realizes what has to be done. A good Finance Minister liked by the market who reforms things, would be welcome and the biggest relief is that The Communist Party of India (Marxist) CP-M manifesto is now going to be burnt, it’s the biggest relief. Because if you saw the manifesto then we would all have to go and live with Samir Arora in Singapore. So atleast we won’t have a Finance Minister from the CP-M but personally they will get a bureaucrat, a technocrat as a Finance Minister. It will not be a politician.
Q: Someone like Montek Singh or Dr Rangarajan?
Jhunjunwala: Yes maybe.
Q: Do you think the market after the initial flurry is done, whatever gap up we open with, will it then start thinking about he first Budget because this is the first unfettered unshackled Budget in the five years that we may have, could there be some sense of a constructive move towards the first Union Budget?
Chokhani: I am not sure because the backdrop to which you will come into the Budget will be really a bad fiscal situation. We have the excise duties which were cut to give the fiscal stimulus, the question is do you continue it or bring back to parity and do you bring back the service tax rates and therefore innovates a reverse stimulus given that India seems to be going along well and we don’t need that kind of stimulus anymore. And also I don’t know if they have the timeframe to get their thoughts together - the first one may just be holding fort and then going forward and therefore the first euphoria which we are facing that or maybe you don’t get those announcements so quickly and it is the second one comes in February, which could be much more eagerly anticipated.
Which is why I am saying, the scenario of a 15,000-16,000 type Index atleast at that time, is far more plausible than something which goes up immediately and continues rallying, that is more justifiable because you would probably make the first rush to 14,000-14,500 very quickly and then gradually creep up depending on where the world goes. At some point and I hope to be proven wrong that the world doesn’t get into a mess sometime this year and you go back and revisit because you have some jitters in the world nothing to do with India but you have the jitters all the same but irrespective you come back and end the year more like 15,000-16,000 rather than closer to 12,000.
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Q: What is your justification of how much this event itself can drive the market up in the near-term and where you are mapping any kind of a floor, even if there is a sharp retracement because of global factors?
Arora: This event then followed by Budget. So before the Budget day, the markets will be up 15-20% and the Budget will be important and for this Budget its easier for the Congress to do reforms and if reforms are being hard or difficult things instead of delaying it by another six months because right now you can actually say that the world is bad, we had constraints and now we had the opportunities. So in some sense this Budget will be important and if they say this Budget we didn’t have time to think, that would be ridiculous because they have been in power for five years and they had series of issues which they couldn’t deliver upon so they can start announcing them in the first round itself. There is no reason for them to say that we are drawing a big picture on what India needs or what is needed, they already have a pending list of things and out of that some would be still politically difficult to suddenly come back and do.
Q: So 14,000 is your development or thereabouts what’s the floor according to you?
Arora: I don’t think the world can change us in the short- term unless the world really falls apart. If suppose the US falls 3% tomorrow, I don’t think it would matter to us on Tuesday. If it obviously falls 5-10% then you may stall but right now there is a catching up there has to be done, I myself have to do that catching up, there is too much catching up to be done and although I also don’t like it but it will be up much more than I would have been comfortable with for one day but beyond that, that’s the way it is.
Q: So you will have to significantly change your net long positions right now?
Arora: Yes, we are about 40 net and ideally we would like to be 60 net. Its like George Soros said, if market is going up no position is large enough and if the market is going down no position is small enough. So we maybe happy with 40 right now but we would have been much happier with 60.
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Q: I want to bring you in on the point which Samir just mentioned, that the government might actually be very aggressive in pushing for policy changes now because that was the hope which a lot of people spoke about when the vote of confidence happened that now the Left is out of the out of the government, Manmohan Singh would move really fast but not much happened, do you think finally the government might actually unleash a lot of pent up policy reforms in the next month or two with the Budget?
Jhunjhunwala: I think, there were three bills which the Left was not allowing to go through and the Congress before the elections didn’t want to create any controversy according to me, one is about pension reforms, one is about insurance, one is about he foreign education bill, where foreign universities were to be allowed in India and I think in this country we need investment in education. So, I think these three things the government will push through immediately and things like labour laws, consolidation of public sector banks.
I think the goods and service tax (GST) on April 1, 2010 now is a given. Mr. Kelkar says it will add 1.2% to India’s GDP. I know from companies which I have investments which will save 1% of turnover if you have the GST in logistics costs. So I think the government is going to aggressively reform, maybe Dr. Manmohan Singh doesn’t do it now, he will never be able to do it, its now or never. He asserted himself on the nuclear deal, see, he is not interested in any wealth and essentially the center of power lies elsewhere, so to be a Prime Minister of this country, also when he looks back in history retrospectively he would like to see what he has done. So I think they will reform. He has not become the Prime Minister to earn money, he is the most honest man, he realizes what has to be done, and if they don’t do it now with all the support when will they do it.
Q: Would that include disinvestment because now there is clean chit, I mean they can go ahead with it particularly with the fiscal situation?
Chokhani: Disinvestment yes, I don’t think privatization but disinvestment I think is a way inevitable and you need it any way for fiscal clean up.
Q: So you think PSUs might move in the next few days?
Chokhani: Very likely. In any case the banking index is very heavy with PSU banks, so anyway banking is the sector which is going to probably just take-off.
Q: Why do you say specifically banking?
Chokhani: You will expect insurance reform to happen because that was the most resisted bill by the Left. So that’s very likely to happen. Also if money has to come into India if you just go down the sectors you cannot put that much more into oil and gas. You’re very unlikely do into technology – what's the most under owned bet for the foreigners? Most FII limits are open in the banking sector, I think the biggest flow is going to be in the banking space.
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Q: But with what expectation that the government might even cut its own ownership?
Chokhani: It may not cut ownership but first let me get like Samir said to equal weight over there because a lot of people just aren’t there. Second is you have the expectations that something positive is going to happen in banking, now whether it means consolidation, whether it means opening up for insurance and so on. So there is enough activity likely to happen there and then you go down the list obviously you will go for infrastructure and then you will probably look at 3G and therefore some money goes into telecoms. How many do you play there and then real estate, we saw a billion dollars raised by the two largest companies. So all the sectors where liquidity is important in a way get rerated very quickly leads to rupee going up, leads to a lot of these beaten down sectors where you are worried about liquidity because money is available and the other thing which is very likely is in the next 50-60 days you will see lot of QIPs or flurry of paper coming as well to the market.
So in a sense demand supply at some point in June-end or July will converge. So you have 45 days to party let us enjoy that first and then worry.
Q: We haven’t spoken about disinvestment for five-years now. Do you think it can come back to the main stage and would that go down very well with foreigners?
Arora: I don’t understand how if the government wants to sell stock in public sector companies the price of that company stock price should go up before because you are just saying that I am going to sell you more. It is not that we are strategically selling these companies to some strategic investors. So all they are saying is you want 85% of ONGC, now we will own 80%. So why should be celebrate that in terms of stock price going up before. They will do it because that’s the way from a fiscal point of view. But it doesn’t change that company and why should we celebrate from a stock market point of view, not from a fiscal point of view, that they are going to sell 5% more ONGC, so let me buy more right now. I don’t think we have reached even with this mandate privatization. It will be disinvestment. So I really don’t care for it – it just a form of money raising by the government. So from that angle you can take it as a positive but it doesn’t really change that company and there should be no excitement from that.
The other thing what financial, although we also like financials is the natural buyers of financial in terms of companies aboard or insurance companies aboard don’t have really any money. Our market caps are bigger than many of these companies around the world. I think what we need is infrastructure and governance rather than reforms. In my theory China has no reforms. It only has infrastructure. We have no infrastructure, we have all the reforms. We have foreign channels that are allowed, foreign media is allowed, foreign telecom is allowed – none of this is allowed in China but they call it better because I think they have invested in infrastructure and they deliver in a sense you can it governance. So India has enough of that which it can do – don’t sell off these telecom licenses to real estate companies and don’t delay on 3G. All this is form of raising money and infrastructure. It is not really a reform but it is okay that’s what we need and we can do easily.
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Q: Do you think the liquidity problem might get sorted out now because that was one key concern about many companies that they won’t have access to liquidity? Do you think now with more investors looking at India which they are already doing probably with a couple of QIPs placements which have happened, do you think that money problem might just get alleviated a little bit?
Jhunjhunwala: A lot of foreign capital will flow into India. If the PSUs are disinvested it will not really create liquidity but the question is if foreign capital comes into India it really creates liquidity. So I think a lot of foreign capital will come into India both in terms of FII investment and FDI investment and I think the rupee will gain 2% on Monday itself because there has been such bearish forecast for the rupee and the rupee in the last one-and-half –month has underperformed all the BRIC currencies and all the emerging market currencies. So I think liquidity will be addressed to a large extent.
Q: Do you think rupee does 45-46?
Chokhani: It is very likely. That’s our forecast anyway irrespective of a government and more to do with what's happening the world and at some point we will correct our fiscal excesses – that’s really the hope and with this government it is more likely than not.
Q: But that caps some of the upside and some of the exporting sectors right?
Chokhani: Of course. Tech and pharma obviously which are much more oriented towards those markets you will be that much more concerned there and which is why you have a natural cap to how much the markets can go up as well and which sectors can attract disproportionate flows as well.
Q: Because 20-25% on the index won’t participate? So there will there be divergence?
Chokhani: Yes there will be divergence and its great because this is what you want to be a stock picker, go and pick the right sectors and the right stocks and just focus on that and how the politics play out and how the world plays out, you have less control but atleast the environment for you to do stuff and understand is now much more conducive. So it’s really a good time.
Q: You must be relishing that prospect that the rupee appreciates again finally, those woes have gone?
Arora: We have seen 2008, we need these kinds of breaks and this is a big one. This will revive quite a few things.
Q: Do you think it will top up your performance by 4-5% in the next month?
Arora: We were doing so well so far in this month but the main thing is that now you will get new flows. So far we were all basically working with a closed end fund in the last 4-5 months because the redemptions had stopped by December-January and since then there was no excitement. Now there will be some excitement and we want investors to also call us that what is happening instead of us calling the investors, so I think we will get a few calls now and we will have much more fun now in terms of the relationship with your own investor.
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Q: You want to come in on that one, the rupee?
Jhunjhunwala: Most of corporate India has already covered the rupee at 40-41, so this rise from Rs 40 to Rs 50 has not really benefitted corporate India. The gain in the rupee could affect a lot of commodity stocks because the commodities will become cheaper in India. I pity the fund managers because most of the fund managers didn’t sell until 3,000, so they went into cash from 3,000 to 2,700 and then they didn’t buy on the upsides, if I was their client I would commit suicide. You didn’t sell on the downside and when the market went up, you didn’t participate, what did I give you fees for? So this is an unenviable job today.
Q: You think that holds particularly true of the domestic mutual funds as well and not just the foreign guys, they have also been sitting on a pile of cash?
Jhunjhunwala: I don’t know much about the foreign guys but the local people are not so much on cash but they are 15-20%, in face of a 40% rise and what I find most alarming is every fund manager just wants to sell what he bought at the bottom. I met some fund managers saying I bought some at Rs 120 and its at Rs 160 I am out, I bought it at Rs 80 and it’s at Rs 120 I am at out, so nobody had any long term commitment. When I also think of the international factors and when I buy I say to myself what am I doing, I have that underlying fear every time but the fact is the market is performing and money will pour into India.
Whether FDI or FII, if they are not going to invest here, where are they going to invest? And India needs so many investments in terms of infrastructure and power plants etc.
Q: The constant refrain has been that for most of the fund managers that we speak to, that post 11,000 no body had conviction that risk reward has turned against us, how do they approach the market now because they didn’t buy at 10,500-11,000, it will be suddenly 13,000-14,000, so does that money come in or just stay out with agonize?
Chokhani: First, it’s not a problem unique to India; the markets all over the world have got up. This year, year to date, China and Russia are up 100%, Brazil is up 75% but India is up just 50%, so its not a problem unique to us all markets are going to go up. Most people across the world have missed the rally, most people are still trying to catch up and go back in and chase, everyone is chasing it knowing that it’s a bear rally with lurking fear that something has to give and you cant just pump money back into a system which was bust and life is back to normal. So at some point we will give these gains away, am I the first off the block on the way in and off the block on the way out as well and will it last 3 or 6 months.
Given where the world is right now, its very unlikely that this rally just breaks in the next 2-3 months and if you are a fund manager, you have flows then you have to go and invest and what was history, you can always justify and say, three months ago I thought that the Left is going to come and be part of the government, rules and fundamentals have changed and I can go back in now. So let’s look at the next 2,000 points rather than worry about the last 2,000 which we lost.
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Q: Typically that would you expect to see, would those people who have missed out or who are not invested to the extent they would love to still say, okay we missed this one but let the next 15% go globally again we will get a correction and I am going to buy after that correction which will still bring me below where I am today?
Arora: How casually Manish said this is a bear market rally, how does anyone know, the point is that the money flow is there then the money has to go somewhere, so what if US falls, we realized last year that we were all being coupled with US and this year US is up 2% and we are all up 25% and saying we have underperformed Brazil, how did we know it’s a bear market rally or a rally. The bear market lasted two years, they lasted two years, in 1929 it fell down 50%, it fell down 50%, in Asian crisis in Asia, the markets fell 50%, here in the US crisis, Asian markets fell 50%, so who is to say this is a bear market rally or a new bull market or whatever.
The bottom-line is there is money and the only lesson that I keep saying and it works in my hedge funds., this is from JAANE BHI DO YAARON (Hindi movie), thoda khao thoda pheko, you have to be thoda in and thoda out in life and you are never all in or all out to say this is a bear market rally or a bull market rally. You are always in and you make some, if you feel a little more, you make it more but you are never out of the game and that is how it works and that is how in the end investors still give 2 and 20 whatever they want to give but in general you cant say this is a bear market, so I am playing for 2,000 points, if you think like that then you will not buy and I don’t see how anyone knows it’s a bear market.
Q: How much money can get sucked in very quickly do you think – that momentum chasing, performance chasing kind of money after this breakout which we expect on Monday – do you think we could get USD 2-3 billion in quickly?
Arora: The only problem in that is some of it these guys might do their QIPs. So that is in a sense a negative if you want to call it or you may say at least India will get that much money but I think the problem is that the QIP ‘Q’ is very big and I hope they don’t takeaway everything but the market will have to go up for that QIP to succeed and then since the market is going up first but there is too much of these QIPs as in USD 3-– I am only drawing this conclusion from how I saw DLF happen. It happened in four hours to USD 750 million and get oversubscribed and all that, it means that there is real wiliness and this event had to be negotiated and it has not only been negotiated it is way beyond that. Therefore it will be strong. Even flows will be strong.
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Q: Forget DLF, Unitech had USD 1.2 billion book.
Arora: Unitech had a lot of pre-marketing. DLF looked out of the blue and we participated in both. But the point is it was way beyond anybody would have imaged. So the appetite is there right now.
Q: Do you expect this to happen that because of this sudden window and flurry of excitement a lot of companies may line up to quickly milk it?
Jhunjhunwala: I think people are in serious trouble – projects are stuck, people are in debt position, difficult position but I think a lot of offerings will come but I don’t necessarily feel that is going to cause a blockade in the market because when the markets go up the kind of shares they can absorb and very much on the screen who is the seller. Today the foreigners did not buy. The main buyers were the insurance companies. The insurance companies also have a commitment where they may sell today and they would have to buy back after a month or two – it is all long-term money. The mutual funds are net in cash. The Indian public did not participate in this rise, so I don’t think that just because the offerings will come and there will be some anxiety for offerings in the first month or two month. Then when people see they are getting absorbed there will be some relief. People are going to buy rubbish I hope.
Q: Do you expect that to happen that a lot of these what people like to call high beta names, stocks which are not of great quality suddenly run up quite a bit riding on the back of this development?
Jhunjhunwala: I think a lot of stocks which should not really get the money will be able to raise money but that’s the way of the markets – what can be done? But finally quality speaks. For me today the most reassuring thing is that I as an investor I am reassured. I am not concerned about what's going to happen one-month or two or even four months but I think India today has the wherewithal to go into the second leg of growth. I think it is a game changer.
Q: You have been an investor in the infrastructure sector for a long time with stocks like Punj, Praj etc. Do you think this development has any material positive ramifications for that sector because that will run on Monday as well?
Jhunjhunwala: I hope they appoint a good minister for highways so the NHAI can start working and I think if you get money I think the biggest area where the foreigners can really invest is in infrastructure. There is a lot of money available, so Indian promoters who have reasonable valuations will get a lot of foreign money for equity and lot of debt money can also come in. Also the government if it is a more stable and a more cohesive government, it can push in a lot of infrastructure projects. I think the government realizes the urgency of these matters. I also think in the last government there was some pull in politics among the various ministries and the Planning Commission and all that. I hope this time it will not be there. So the decision making will be much faster.
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Q: You said real estate as well – do you think that will be material beneficiary of what happened today in terms of pure liquidity flows?
Chokhani: It is if you think of it the whole engineering, capital goods, infrastructure, real estate – I kind of see it as one pack because they are beneficiaries of liquidity which changes their business itself and when they are starved of liquidity they get completely hit on the downside. So if you do see a return of liquidity it improves the fundamentals of these businesses and as an example once the money comes into a DLF, it looks that much better for you fundamentally and that way it is a game changer for you in those industries and if you’re going to get this kind of liquidity flows back into the markets and into the system it surely is going to help all these companies.
Q: The big two have raised money – DLF and Unitech – do you think others might also be successful?
Chokhani: That’s very likely. I would be very surprised if they don’t.
Q: They will be successful in attracting money?
Chokhani: I think so.
Q: Will that squeeze out some of the money which can come directly into the market?
Chokhani: You can always like Samir said eat some and throw some – so why don’t you use the same analogy here. So you make your money where you like and let someone else make money where he likes and if the market meets – demand and supply meets and if it doesn’t they don’t get the money. So at least let us worry about the first month where markets going up. Then we see what happens to the cabinet and who the personalities are then you worry about the QIPs but why are we not willing to take the first month of enjoyment and then take it from there.
Q: That’s been your other India bet – infrastructure – and you concede that enough has been done out there. Do you think this one is sentiment positive for the sector which will run out in a week or do you think materially different?
Arora: It should be materially different because the main issue with these infrastructure companies was that the new capital is not coming so many projects were not getting done and therefore your orders are there but will the companies get financial closure – all of them needed equity and I think there will be many equity raisings which in one sense you may say bad for the market but overall good for the country and in an indirect sense good for everybody.
But you were talking about QIPs – I think the QIPs this week, the first week at least there will be two QIPs.
Chokhani: You need board resolutions and AGMs so the process takes time.
Arora: One of them we already know. One has already been announced, which is another real estate company.
Q: Bit of sparing which went on between Samir and Manish on the bear market rally phase. Have you reached that point where you reconsider whether the game has changed or are we still in the confines of a structural bear market?
Jhunjhunwala: If I look at it I think internationally, I do not think the downturn has ended or is going to end in the next six-nine months especially in the Western world. The question to my mind as long as we have lower commodity prices and our software export grow, I see no reason why India cannot actually decouple because if our software export grow at 10-15% and day before yesterday there was an article in the Wall Street Journal that tech spending is now bottoming. So if commodity prices are low and software exports grow, I do not see why India cannot be in a structural bull market again and if accelerate investment in infrastructure why cannot India go back to 9-10% growth and you will have capital from the world flowing here. We have stable good government.
I am not saying that that’s happened; I am only saying that internationally the downturn is not over surely in my opinion despite that if our software exports holds and commodity prices are low, I don’t see why India cannot grow 10% and there is humongous domestic money waiting. I think we are giving unnecessary importance to these FIIs (Foreign Institutional Investor) they bought everyday from 14,000 to 20,000 non-stop and the index went back to 8,000 and then they sold everyday non-stop – October to January to February to March and the index went back and as predicted came back to 14,000. I will not rule out that India goes into a bull market despite the world being in a slowdown.
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Q: You think that’s likely or unlikely that eventually after this rally is done we go back to pretty much tracking the globe?
Chokhani: The facts are that we have tracked the globe because the world sentiment has improved our markets have improved and lets face it while I will love it that our software exports grow at 15%. It’s tough to make the case when the market which they service in such severe depression also I think unless you have bull market in commodities our markets do not perform that well because the largest stock in our country in terms of absolute profit, if you take Reliance and you take the metals pack and then you take the others over there that leads to then the multiplier for capital goods and so on as well. I would love that Rakesh is right – turnaround and straightaway go into a bull market. But facts are its going to be tough for the whole oil and gas, petrochemicals metals space to create that money for the whole technology sector to create that money and that’s 50% of the index almost and again by extension – it’s difficult I am not ruling it out but when the facts will change I will change my view. I have no position to hold. As of now it looks to me it’s difficult, the world just gets out of jail free because governments have unleashed money and it will be slower, longer, painful but I am more hopeful of a bull market - but at least lets play what’s going on for now and then we will worry.
Jhunjhunwala: I was telling Manish one thing that already the emerging markets have outperformed; all the Western markets were at new lows in January and February, the emerging markets did not. I think that sending a message and second thing is where we have seen the benefits of lower commodity prices and if you look at what is weight in the index you are pricing in Reliance and gas prices, oil at USD 50-55 per bbl current prices, what is ONGC’s valuation, what could affect SAIL and Tata Steel and maybe Sterlite – they do not have much weight. So I see no reason why India cannot have a bull market and the world still in an economics downturn maybe it will take 12-18-24 months to differentiate, time will tell but let’s not rule it out. Don’t forget one thing that anybody who out perform money will just pour in. Taiwan took 17-18% in three days. so if you outperform the kind money that will flow in cannot be estimated easily.
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Q: The point on relative performance - is it conceivable to you that because of this verdict because of what happens to liquidity flows into India, we get back to 7% kind of growth in the next six-nine months run rate and that leads to better relative performance in India compared to other markets which draws in FII money. Is it likely, possible and unrealistic in your eyes?
Arora: Always realistic; just look at it for the last many years, last 1 to 20 years, India has outperformed US over every period. US is now at ten year back level whereas we are three year back. So, in terms of saying that we all follow the globe? We don’t. We are only at 2006 levels in index and the US is at 1996 levels. So we do not follow the globe except that we followed it last year and that also we actually more than followed, we went down more than others.
Q: Not India versus US but India versus other markets; other competing markets which compete with India for capital?
Arora: Manish’s point was US has a problem; nobody said Brazil has a problem. He didn’t say Russia has a big problem or China has. The problem that we talk about is a US real estate, US consumer problem and that’s why we say that the world is not yet repaired. In the emerging markets we are not so clearly better but since we have underperformed we can catch-up but in general if you outperform anything the amount of money that can come in is very large and what Rakesh said is absolutely right and my example for that is, if a tiger is running after you and there are five of you running, you don’t have to run faster than the tiger, you have to run faster than your friend. So if we outperform anybody there is a huge flow of relative amount that can come in i.e. relative fund managers and that is enough then drive absolute performance but in general once again we have not followed the world for the last one-ten years and world is basically the US because anyways its 50% of the indices.
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Q: When people call you on Monday morning and say they feel bad they got left out, so what do I do know, what will you tell them because they would probably staring at a circuit then?
Chokhani: Taking Samir as an example, we are saying Samir we have no choice but to go and buy- what are you going to buy? – You are going to buy banks, you are going to buy infrastructure, you are probably going to buy telecoms, real estate as well and then you wait for the rest of the market to catch up because the question now you are really asking is where do I get the out performance? And whether it’s a bull market or bear market rally I frankly don’t care, the market is going up that is all I know, in that which sector do I want to catch and which stock I am really interested in?
If I am an investor I care about absolute returns, I do my homework and I buy those stocks. If I am a fund manager who has to allocate money over here, I want relative out performance and these are typically the four sectors which will outperform – banks, infrastructure, telecom, and real estate in my view and in our house view.
Q: One can also short, so which will be the under performers?
Chokhani: The under performers you will probably get the defensives, in the context of the rising rupee and more flows coming in it is more likely that you will get significant performance from technology, pharma also the defensives, the FMCG, how much are you going to make there if the market is going to rally 20-25%. So they will all participate, they will all go up but what they are looking for is that out performance then narrow your gap of what you missed from the market.
Q: Does that seem like reasonable advice to you, the long and short of it?
Arora: On this one I agree with Manish 100%.
Q: But you never had love for sectors like FMGC in the past, but do you include real estate in that because you have not been terribly fond of that, till you participated in Qualified Institutional Placement (QIPs)?
Arora: No I have been fond now; I have now 3 real estate companies in our portfolio for the last two months. I think the stock market problems of real estate are sort of gone, only the real problems are still there but as long as you get financing, those problems can be solved.
Q: You think IT might under perform now with rupee?
Arora: IT we have been playing as if they will under perform but they haven’t, so we will continue with that under weight.
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Q: You also had very strong views about the real estate sector- do you buy this argument that with fresh inflow of liquidity expected, the woes of that sector are probably over?
Jhunjhunwala: I look at it in the way that they won’t drown now. How much they will swim and how much they will save, my personal feeling is and I reserve the right to be wrong that the real estate stocks are to be bought at these valuations.
Q: Across the board?
Jhunjhunwala: I don’t know across the board but I don’t find them attractive. I don’t think that the retail space and the commercial space is going to revive easily. Residential by cutting prices there is a very good market but for retail even by cutting rents, I don’t think you are getting tenants. Also in the commercial space there is lot of oversupply. The debt that they have, I don’t know.
The question is all those land banks turned out to be just banks without any money. I am not very bullish on real estate. Maybe there could be one-two companies which are good investment but in general I am not very bullish.
Q: What about the oil sector, last time I was speaking to you; you were saying good things about a few oil marketing companies, valuations- do you think anything fundamentally can change now with this new government in place with the oil sector?
Jhunjhunwala: My personal feeling is that don’t touch the oil companies as long as they decontrol it. Ones they decontrol they are going to be big money spinners. Because the kind of marketing network they have and I were to decide I would free the oil prices. As a country, as an economy we have to face it, how long can we go on paying the subsidy? – One lakh four thousand crore was the subsidy last year. Eventually we are paying it, whether customer is paying it or not, the government is paying, so I, you all of us are paying.
So if they do the decontrol then I think they are great buys and I would give it a 30-40% chance that it will be decontrol.
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Q: Since now there is no Left parties howling at every single oil price hike etc do you think that reform can happen?
Jhunjhunwala: Let the market decide the price why do you need the government to decide the price. You already have it for the jet fuel. And I don’t know whom you are supplying kerosene at Rs 10-11 and who is consuming it.
Q: Likely reform for oil sector?
Chokhani: It would be too soon, I would hope for it and I agree with Rakesh Jhunjhunwala completely but unlikely, but if it happens we will be happy and positively surprised.
Q: What reform sensitive sector do you think one can play because those are the kind of questions punters will ask on Monday morning?
Chokhani: It is likely that the whole financial landscape is possible to do because a lot of it was unionized and therefore Left leaning therefore you probably had resistance in the insurance space. Lot of banking consolidation even if it’s within the public sector may be possible to do now and it is something which the Finance Minister had talked off for the last round and then that was held back. It is also very likely that you see the 3G auctions and therefore whether domestics or people form overseas participate.
The obvious one ofcourse is infrastructure. No one in any political party can oppose doing something right for infrastructure. And given the liquidity conditions and the fact that people want to give money to India, the next Sunil Mittal in India is going to come out of infrastructure space. Whether it will be a GMR or whether it will be JVK or Reliance Infra, I don’t know but that is the kind of sweet spot for the next 3-4 years for India atleast.
Jhunjhunwala; I beg to disagree; I think the next Sunil Mittal is going to come from organized retailing.
Chokhani: I don’t disagree with that.
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Q: Organized retailing?
Jhunjhunwala: I think organized retailing has got biggest ability to grow. Today 5-7-8% retailing is organized. India’s retailing market grows by 10-12% a year and if this 5-7% is going to go to 20-25% then what kind of market we are looking at 5-7 years hence.
Q: A broader question – you have never been a fan of PSU companies and your belief has been that whatever the market does is despite the government but not because of it. Do you think that might change over the next few years because now there is a great opportunity for some erstwhile reforms to do something really serious?
Arora: My problem is I am not 100% convinced that the Congress and its heart is a reformist. Dr. Manmohan Singh will have to be strong and lay it down but I don’t think the whole overall Congress party is reformist in nature. I think they are Left leaning although they are not supported by the Left now. So I am not overly sure that even on this oil decontrol will happen immediately. So that is why I was saying instead of reforms let’s do governance and infrastructure which is not really reform. It is just investment and making sure that polices are made for it but it is not really a “reform”. It will only say that sell an Indian bank to foreign banks because anyway there are not enough of those foreign banks left or foreign insurance companies of any size. So let us just do governance and prove and get this 3G license but is not really reform but that’s what we need to do.
But before that I must intervene I disagree with Rakesh on his previous thing and agree with Manish.
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Q: Which is?
Arora: Which is that organized retailing there is no billionaire that is going to come up or a USD 10 billion guy. It will be in infrastructure.
Chokhani: I didn’t disagree with retail.
Arora: I disagree with both of you.
Chokhani: Retail is also infrastructure in my view. You cannot grow India without retail.
Arora: Because normally in many of these sectors where people have grown they have grown where the market has grown not by just taking over. In all these other businesses where people have grown they have grown where they were alone for 3-5 years. Here about 10 guys have simultaneously started in organised retailing and third is India doesn’t have the infrastructure, the air conditioning, the refrigeration at home for you to go and do bulk buying of anything. You don’t have car to take things home. So you just go there and eat at food courts and come home and basically go for free air conditioning. That is not going to make you billionaires.
Q: You must be itching to respond to that?
Jhunjhunwala: Let us not get an argument. Let us agree to disagree. Time will prove us right or wrong.
Q: I just want to ask a macro question to you because for the last six to nine months there have been a lot of concerns for several classes of investors about India’s fiscal deficit situation and when that will get corrected. Now in the light of what has happened today what moves would you expect to see from the government along those lines and do you think that will be a key determinant of any kind of revaluation premium that India might get because of the new government being sworn in today?
Jhunjhunwala: One thing I want to tell Mr. Arora I have a prediction that there will be a USD 10 billion market cap company in retailing in India in five-six years. I won’t name it when I’ll meet him I’ll tell him. Second thing I want to tell you is that in the macro picture, the only way you can immediately bring down the fiscal deficiency is I think through disinvestment and I think then with a combination of disinvestment and with growth coming in, taxes coming back, tax collections improving and growth rates going up, I think we will handle the macro situation. We have handled it earlier; we will handle it this year.
Don’t forget that the government faces once in 5-6 years a big rise in government salaries and then they don’t rise as much every year. So we have faced that year and I also feel that the GST will be a big kicker. As far as growth goes all this foreign forecast are bearish because foreign capital was not coming. India was saving as much because after all growth is what is investment and the productivity of that investment. So with a lot of solid investment coming in I think capital will be available. With the lower oil prices, the macro situation has changed dramatically. I think with the confidence lot of capital will come. I think they will be better governance because better governance cannot come in a day. There will be better and faster in execution of projects and I also think that this government will work actively in the electricity sector. If India has got 18% peak power shortage, I don’t know if you can match that in 3-4 years and I don’t think it is an impossible task. I don’t know what kind of return that will give to the economy.
I also feel that there is a lot of low hanging fruit in the Indian economy which can be tapped in a time horizon of 3-4 years and which can make significant difference to the economy and the markets.
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Q: Is it only divestment or can anything else can be done in the current budget which can change the whole fiscal deficit outlook substantially?
Chokhani: There is no easy lunch so the substantial part of it I guess has to be from converting your capital account to your P&L and fixing it through that and really actually there is no ideological opposition to saying that why is the government in so many businesses and there is no reason for you to own 80-90-100% of them. Even if you own 50% and you said I don’t want to nationalize, at least go down to 51% in number of those and given that you want to use the money for productive resources and whether to create rural infrastructure or education or health, and they had put together a national consolidated fund to use to proceeds of disinvestment. So I don’t why disinvestment won’t happen and in a substantial way and that can help to mend the government finances as well. So it is a very likely outcome and again I would be surprised if it doesn’t happen.
Q: Let me end by asking you guys a bit about the liquidity situation starting with you. Do you think now the hedge funds will readjust their positions but do you sense a lot of long only type money which is also under invested which might begin to come by after this development?
Arora: I think that the first round the money that is coming in I don’t think end investors are giving. It is the fund manager who is changing his net position whether he is long only or hedge fund and over time the end investor should give new flows which normally couldn’t have happened in a two month period – it was a rally which happened so fast – so that will happen as long as they can see that the rally is getting sustained and they don’t have obvious reason to doubt it and therefore this event is very important. It was not that whether Mayawati would have done something wrong but how would you have explained it to the investor or the Left will do or not do. Now those issues have gone and the other concerns were anyway having been addressed in the last 3-6 months, I think end investors are still not invested and they will.
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Q: Which is what I was asking you – do you think event changes perceptions even if it just not change things materially beyond a point?
Arora: Yes absolutely. We are going to go all out from Monday evening once the US guys open and all. This is a big event. As I told you we expect ourselves without any over analysis that we will get 2-3 times what we would have got in our fund that we are launching next month. It changes lives, it changes flows for fund mangers and clients because they were all underweight and under represented in India.
Q: Does it change for a lot of companies which needed capital to grow and also for bankers like you?
Chokhani: As we spoke sectors which were starved of liquidity, they get the liquidity, money comes into the country. It helps the overall economy to grow it therefore creates the ripple effect and gives you a further leg up. So yes for all of them it is extremely positive.
Q: But you’re not convinced that this in itself is such a big game changer or turf changer for the market?
Chokhani: It takes its times. Even the previous governments when they were reformist you didn’t turnaround the next two months and started a perpendicular rise up. It takes time, you need the personalities to come into to get their hands sunk in and see first time I have got this kind of freedom what all can I roll out now and then for the markets to absorb it and then end of the day markets are demand supply. So while there is great demand there is supply as well available over here and some of it is great some of it will be bad but the market will find its own course. In the immediate term all we are saying is it is very likely to make the 20% move which means you cover up the gap which you had missed against the rest of the BRIC countries. You probably go close to 14,500 and then slowly in a scared manner you go towards may be 15,500-16,000 and then you start really getting nervous and then you hope to god that everything keeps continuing well in the world and people don’t get into risk aversion mode all over again and the government mends the fiscal deficit and they come with a good budget and all of those questions start coming at those prices. But if all those events play out well then you can start discussing yes all the stars are aligned. You could have a continuation from here and it could still be a bull market.
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Q: If we do get to 14,000-15,000 Sensex do valuations justify the market still remaining in good shape at that point or would you start worrying then about valuations?
Jhunjhunwala: Now I am looking at the rise. I’ll start worrying once it reaches there and one thing I want to end the programme by saying that remember George Soros Theory of Reflexivity when all of us said Mayawati will become Prime Minister. But it was the realms of fantasy. As far as market goes let them reach 15,000 and then we’ll worry about them. First let us enjoy the ride.

Is it inevitable?

2009-05-15T09:05:00.001+05:30

Dr. Nouriel Roubini asks the inevitable questions, are we entering the Asian century, dominated by a rising China and its currency?. Dr. Roubini says that historically empires that hold the global reserve currency are net foreign creditors and net lenders and with US running huge budget and trade deficits, its creditors might feel jittery about accumulating even more dollar assets.

Dr. Roubini goes on to say, “If China and other countries were to diversify their reserve holdings away from the dollar — and they eventually will — the United States would suffer. We have reaped significant financial benefits from having the dollar as the reserve currency. In particular, the strong market for the dollar allows Americans to borrow at better rates. We have thus been able to finance larger deficits for longer and at lower interest rates, as foreign demand has kept Treasury yields low. We have been able to issue debt in our own currency rather than a foreign one, thus shifting the losses of a fall in the value of the dollar to our creditors. Having commodities priced in dollars has also meant that a fall in the dollar’s value doesn’t lead to a rise in the price of imports. Now, imagine a world in which China could borrow and lend internationally in its own currency. The renminbi, rather than the dollar, could eventually become a means of payment in trade and a unit of account in pricing imports and exports, as well as a store of value for wealth by international investors. Americans would pay the price. We would have to shell out more for imported goods, and interest rates on both private and public debt would rise. The higher private cost of borrowing could lead to weaker consumption and investment, and slower growth…. This decline of the dollar might take more than a decade, but it could happen even sooner if we do not get our financial house in order.”

Richard Berner & David Greenlaw from Morgan Stanley, writes that Bear market in Treasuries is underway. Here it is important to harp ( despite the risk of being repetitive) at Russell Napier point once again ( important for global equity markets), “The bear market in Treasuries may be a few years away, but this yield adjustment will most likely drive the final down leg in the 2000-14 equity bear market. Initially, the rising yields will be seen as a “normalisation” as the risk of deflation passes. However as yields continue to rise inexorably through 2009, 2010 and into 2011, there will finally be a negative impact on equity valuations……….Then the bottom for the US market should be 400 on the S&P.”

Happy Reading!!

A New Normal

2009-05-14T09:48:00.001+05:30

PIMCO conducted its annual Secular Forum, last week, where the focus was on defining the secular (3–5 year) guardrails for the higher frequency investment analyses. (http://www.pimco.com/LeftNav/PIMCO+Spotlight/2009/Secular+Outlook+May+2009+El-Erian.htm ).
Important conclusion from the meet was that, “Markets will revert to a mean, but it will not look anything like that of recent years. Relative to where it is coming from, the financial system will be de-levered, de-globalized, and re-regulated. Global growth will be lower and unemployment higher, notwithstanding the continued rotation of dynamism away from industrial countries and toward emerging economies. Price formation in many markets will be influenced by the legacy and, in some cases, continuation of direct government involvement. Burden sharing will feature more prominently, being one feature of the heavier hand of government in economic life. For a financial industry known for its famously short memory (and related infrastructures and behavior), this will feel like a new normal. Adaptations will be needed as the configuration of risks and returns shift, government debt balloons, and capital structures potentially migrate toward a simplified structure consisting just of equity and senior debt instruments. Business models will need to be retooled, and investment management vehicles made more responsive and robust.”

Other important highlights:

In the process, they (the government) resort to unconventional responses that, by definition, are uncertain in their effectiveness yet consequential in disrupting some long-standing relationships. Think of this as the economic equivalent of a drug trial being applied to huge populations: there is a case for the medicine, yet there also remains considerable uncertainty about effectiveness, lags and side effects.
It was clear to us that, despite the very high hurdle that we always apply to such a statement, the world has changed in a manner that is unlikely to be reversed over the next few years. Put another way, markets are recovering from a shock that goes way, way beyond a cyclical flesh wound.
This is not to say that the global economy has no defenses. It has. Policymakers are fully engaged in an effort to avoid another Great Depression. The secular forces of productivity gains and entrepreneurial dynamism will not disappear. And there are pockets of considerable economic and social flexibility, high self-insurance, and even some global policy coordination. Yet, while these factors help reduce the risk of a deflationary depression, they are not strong enough for a return to the high growth and low inflation that characterized 2002–07. Simply put, there are insufficient demand buffers and fast-acting structural reforms to provide for a spontaneous and sustainable recovery in the global economy.
No wonder we have characterized the financial crisis as a crisis of the global system (as opposed to a crisis within the system). Lacking endogenous circuit breakers, the system will not reset quickly and without permanent changes (and some would argue that even if it could, it should not). For markets that are highly conditioned by the most recent periods of “normality,” this will feel like a new normal. Indeed, it will be a major shock to those that are trapped by an overly dominant “business-as-usual” mentality.
In the next few years, the historical pace of growth in potential output will face many headwinds. Excessive regulation, higher taxation, and government intervention will be among the factors that will constrain the growth of potential (non-inflationary) output. There is also the loss of endogenous credit factories that, especially in their overheated 2004–07 phases, fooled people into believing that the increase in leverage-based economic activities was sustainable.
The most animated discussion in our Forum related to another aspect that will govern inflation dynamics in the new normal: whether the massive amount of fiscal and monetary stimulus adopted by the U.S. authorities will erode confidence in the public goods that the country provides to the rest of the world – namely, the dollar as the world’s reserve currency, and deep and predictable financial markets to intermediate excess savings. In its weakened state, the U.S. can ill afford a reduction in the “implicit rents” it collects for providing such public goods. Otherwise, inflation will take off much earlier than recent history would suggest. Even more consequential, over time the U.S. would retain less control over its economic and financial destiny, thereby slowly assuming the characteristics of what economists label as “small open economies.” This is a fundamentally unattractive possibility not only for the U.S. but also for most other countries.
Positioning for the eventuality of renewed depreciation of the dollar, keeping in mind that the magnitude of depreciation against other currencies could potentially be outpaced by that vis-à-vis real assets
Recognizing that the equity risk premium will now reflect a permanently higher threat of subordination.

Happy Reading!!

Solutions to China’s dollar trap

2009-05-13T10:33:00.000+05:30

Domingo Cavallo & Joaquín Cottani offers a solution to China’s “dollar trap” (http://voxeu.org/index.php?q=node/3551 ), “Fortunately, there is an easier and better way to protect the value of emerging market reserves while reducing the risk of resurgence in world inflation. This is to reduce the incentive of the US government to “inflate its way out of debt.” For this to happen, all US creditors need to do is demand that the US government swap nominal US Treasury bills, notes, and bonds for inflation-adjusted instruments (TIPS) on demand. ……..”.

Fred Bergsten, “How to Solve the Problem of the Dollar,” in Financial Times is also a good read on the issue. (http://www.ft.com/cms/s/0/75cb5f2e-a729-11dc-a25a-0000779fd2ac,Authorised=true.html ). Fred writes, “There is only one solution to this dilemma that would satisfy all parties: creation of a substitution account at the International Monetary Fund through which unwanted dollars could be converted into special drawing rights, the international money created initially by the fund in 1969 and of which $34bn-worth now exists. Such an account was worked out in great detail in 1978-1980 during an earlier bout of currency diversification and free fall of the dollar that closely resembled today’s circumstances……………………………………………………..The idea of a substitution account is simple. Instead of converting dollars into other currencies through the market, depressing the former and strengthening the latter, official holders could deposit their unwanted holdings in a special account at the IMF. They would be credited with a like amount of SDR (or SDR-denominated certificates), which they could use to finance future balance-of-payment deficits and other legitimate needs, redeem at the account itself or transfer to other participants. Hence the asset would be fully liquid. The fund’s members would authorise it to meet the demand by issuing as many new SDR as needed, which would have no net impact on the global money supply (and hence on world growth or inflation) because the operation would substitute one asset for another. The account would invest the dollar deposits in US securities. If additional backing were deemed necessary, the fund’s gold holdings of $80bn would more than suffice. All countries would benefit. Those with dollars that they deem excessive would receive an asset denominated in a basket of currencies (44 per cent dollars, 34 per cent euros, 11 per cent each yen and sterling), achieving in a single stroke the diversification they seek along with market-based yields. They would avoid depressing the dollar excessively, minimising the loss on their remaining dollar holdings as well as avoiding systemic disruption. The US would be spared the risk of higher inflation and potentially much higher interest rates that would stem from an even sharper decline of the dollar. Such consequences would be especially unwelcome today with the prospect of subdued US growth or even recession over the next year or so.”

Other good article on the issue, ‘China Tries to Wriggle Out of the US Dollar Trap’, is here http://yaleglobal.yale.edu/display.article?id=12311

In an earlier post (http://harishbihani.blogspot.com/2009/04/endgame.html), I had written,

China’s appetite for American debt may continue (and reserves will continue to rise) so long as China runs a large current-account surplus. In order to keep the yuan weak against the dollar, a large chunk of those reserves will end up in greenbacks. However, the current crisis could force China to pursue consumption-led growth from the present export-led growth model (given that ~40% of world’s population realizes that they can’t get rich selling stuff to just 14% of the world. According to Mr. Russell Napier, “The final leg of the bull market in Treasuries, which began in September 1981, is now underway, driven by domestic investors’ fear of deflation and bureaucrats’ continued automatic buying of Treasuries. The long bear market in these instruments will begin when the US economy is recovering and inflation is picking up and when the consumption boom in China is underway. Any move towards domestic consumption-driven growth by 40% of the world’s population is likely to have significant implications for inflation, undermining faith in fixed-interest securities in general. The bear market in Treasuries may be a few years away, but this yield adjustment will most likely drive the final down leg in the 2000-14 equity bear market. Initially, the rising yields will be seen as a “normalisation” as the risk of deflation passes. However as yields continue to rise inexorably through 2009, 2010 and into 2011, there will finally be a negative impact on equity valuations.”

Given that the aforementioned issue will be very important for the world economy, we need to carefully watch how all parties involved in this transaction will find a solution to this issue.

Happy Reading!!

Cyclical Bull in a structural Bear market

2009-05-12T11:30:00.001+05:30

Despite the rally (cyclical bull within a structural downtrend), we continue to remain in a structural bear market. Historically, in a structural bear market, one has witnessed sharp rally of 25-50% from over-sold levels with the emergence of ‘green shoots’. However, in a structural downtrend, the road to revulsion can be quite sharp. Hence, caution is the order of the day.
The odds that negative will continue to outweigh the positive is still very high. Post the stress-test result (a confidence building exercise), markets has again started focusing on real economic issues. US continues to remain in a mess, Euroland worse and Chinese data released yesterday (China’s consumer prices fell by 1.5% YoY in April, the third consecutive month of deflation) shows that all is not as hunky-dory as expected. India’s fiscal deficit is expected to reach over 12% in 2009E.

Detractors will point that given the stimulus, economic bottom is near and markets have accordingly bottomed 6-8 months before. Hope is a hard thing to kill. However, given that we are in a constant state of flux, calling the top or bottom is in itself fraught with significant danger. Working on probabilistic outcome and accordingly forming a strategy is the right thing to do.

Some excellent articles on the aforementioned topic are given below.

Happy Reading!!

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http://www.newsweek.com/id/195725 (Ruchir Sharma)

http://www.hussmanfunds.com/wmc/wmc090511.htm ( Dr. John P. Hussman)

http://www.livemint.com/2009/05/11205144/Overdone-and-overdue.html(V.Anantha Nageswaran)

http://thepriceofeverything.typepad.com/files/a-bull-market-that-few-are-buying.pdf (Tim Price)

http://www.rgemonitor.com/roubini-monitor/256694/ten_reasons_why_the_stress_tests_are_schmess_tests_and_why_the_current_muddle-through_approach_to_the_banking_crisis_may_not_succeed (Dr. Nouriel Roubini)

http://www.arpllp.com/core_files/The%20Absolute%20Return%20Letter%200509.pdf ( The absolute-return letter May,2009)

http://www.nytimes.com/2009/05/08/opinion/08krugman.html ( Dr. Paul Krugman)

http://online.wsj.com/article/SB124174706382899483.html ( Wall Street Journal)

http://www.ft.com/cms/s/1/af3fc7a0-3bd8-11de-acbc-00144feabdc0,Authorised=true.html?_i_location=http%3A%2F%2Fwww.ft.com%2Fcms%2Fs%2F1%2Faf3fc7a0-3bd8-11de-acbc-00144feabdc0%2CAuthorised%3Dtrue.html&_i_referer= ( Financial Times)

Of probabilities rather than certainties!!

2009-05-11T11:08:00.001+05:30

Reading Jeremy Grantham’s 1Q newsletter, ‘The Last Hurrah and Seven Lean Years’ (http://www.gmo.com/websitecontent/JGLetter_1Q09.pdf), several times over the weekend reminded me of Robert Rubin (http://www.amazon.com/Uncertain-World-Choices-Street-Washington/dp/0375505857). Mr. Rubin thinks that all decision making is about probabilities rather than certainties, which should lead us to uncover and engage with the full array of complexities around making the best decisions.
Mr. Rubin in his Harvard Commencement Address, 2001, said, “Individual decisions can be badly thought through, and yet be successful, or exceedingly well thought through, but be unsuccessful, because the recognized possibility of failure in fact occurs. But over time, more thoughtful decision-making will lead to better overall results, and more thoughtful decision-making can be encouraged by evaluating decisions on how well they were made rather than on outcome”

Mr. Grantham starts the newsletter by saying, “Normally there are, of course, no near certainties in investing. Life is not meant to be that easy” and goes on to prove that if we had thought of the situation, which prevailed 5-6 months back, in terms of probabilities rather than certainties, we would not have missed the recent sharp rally in equity markets ( by being overweight cash). Pg-8 of his newsletter gives detailed probabilistic outlook of various scenarios that could pan out over the next few years.

Important highlights of his newsletter are as follows:

The Presidential Cycle—“what it has taught us about the power of stimulus and moral hazard to move the stock market many multiples of their modest effects on the real economy……. ……….First, we assume that stock markets are far more sensitive to financial stimulus than is the battleship GDP. The liquidity and other financial encouragement required to move the battleship a degree or two is apparently enough to have a very material effect on stocks. Stocks are simply much more sensitive to stimulus than the economy. The second guess is that the Fed’s moral hazard is far more important than we realize, and is far more effective at moving markets than the modest fi nancial adjustments………… Never underestimate the power of the Fed……………. In a rally to 1000 or so, the normal commercial bullish bias of the market will of course reassert itself, and everyone and his dog will be claiming it as the next major multi-year bull market. But such an event – a true lasting bull market – is most unlikely. A large rally here is far more likely to prove a last hurrah … a codicil on the great bullishness we have had since the early 90s or, even in some respects, since the early 80s. The rally, if it occurs, will set us up for a long, drawn-out disappointment not only in the economy, but also in the stock markets of the developed world.”

Why this Bear market is different from other Bear markets? –“One group (the U.K. and the U.S. in 1974 and the U.S. in 1982) had very high interest rates providing formidable short-term competition with stocks. (In the long term, the Fed Model logic is simply false, but in the short term – up to a year – it does work for behavioral reasons.) These markets also had very high inflation, which in the short to intermediate term has a compelling planatory power for P/E ratios. To keep it simple, high inflation rates typically come with lower than average P/Es and vice versa. A third factor in all three cases was a crisis in oil supply and the accompanying much higher oil prices. So without these extra negative factors, the current market seems unlikely to overcorrect below fair value quite as badly as these prior bear markets have.”

Current Crisis: Any resemblances to Great Depression or Japanese crisis? “Both came with low rates and deflationary pressures, and each had extremely serious economic setbacks, with the wheels falling off the economic machine, a condition that certainly does apply this time. On the other hand, in neither case did they receive massive international stimulus. In Japan, the authorities delivered reluctant piecemeal stimulus. Interestingly, they now strongly warn against other countries copying their strategy, which they now deem an expensive failure, both in terms of growth and time. In 1932 the stimulus in the U.S. was on-again/off-again, on a trial and error basis, and usually with some elements offsetting others so that the stimulus program is judged to have been a partial or even substantial failure. In comparison, the response to today’s crises is the first time that there has been even an attempt at a coordinated global policy. In some cases, including that of the U.S., the degree of stimulus far exceeds any previous efforts. It has also been initiated quite quickly despite the criticisms. So the effect of the stimulus might well kick up in time to clip off the last stage of the bear market, and this is what I think will happen.”

THINK IN TERMS OF PROBABILITY—“ My March note suggested that it is psychologically very difficult to reinvest any cash once a crash in the market and the economy has really frightened you. The antidote is to have a simple battle plan of determining levels at which to reinvest and to stick to it absolutely. We could call that Plan A. It is ideal for dealing with a market meltdown, which should be any asset allocator’s dream: to be able to make wonderfully cheap investments. Investors, though, also need a Plan B for investing if the market bounces back up but stays either cheap – that is to say below fair value, currently at 880 on the S&P in our view – or close enough that investors can still expect a decent return that is far in excess of cash. Our Plan B is to move our equity investments up to neutral weight steadily over 9 to 12 months. ……………….. But for those formerly in rigor mortis who were left behind and are now praying for a pull-back, this steady investing process is critical. You have missed some great investment opportunities, and now you have a psychological commitment to another major fall to add to any intellectual reasons you may have had. The market may well oblige by coming down sharply again in the near future, and I for one continue to believe there is still about a 1 in 3 chance it will do so. There is also perhaps a 1 in 5 chance that the market will come down much further in the future to a new low, but if it does not and it continues to rise, extended praying may not make you as much money as you would like. Plan C gets to be a particularly speculative prospect, and that is what to do if the market, fueled by liquidity and hopes from the stimulus program and the usual morally hazardous promises from the Fed, soars way over fair value, say to the 1000 to 1100 range, which I begin to think is quite likely by the end of the year, whether or not there is another near-term fall.”

An extended period of below average P/Es—“expect that, at least for the seven lean years and perhaps longer, the developed world will have to settle for about 2% real GDP growth (perhaps
2.25%) down from the 3.5% to which we used to aspire in the last 30 years. Together with all the readjustment problems and quite possibly with some accompanying higher infl ation, this is likely to lead to an extended period of below average P/Es. As I have often written, extended
periods of above average P/Es, particularly those ending in bubbles, are usually followed by extended periods of below average P/Es. This is likely to be just such a period and as such historically quite normal. But normal or not, it makes it very unlikely with P/Es, profi t margins, and GDP growth all lower than average that we will get back to the old highs in the stock market in real terms anytime soon – at least not for the seven lean years – and perhaps considerably longer.

The VL Recovery-“So we’re used to the idea of a preferred V recovery and the dreaded L-shaped recovery that we associate with Japan. We’re also familiar with a U-shaped recovery, and even a double-dip like 1980 and 1982, the W recovery. Well, what I’m proposing could be known as a VL recovery (or very long), in which the stimulus causes a fairly quick but superficial recovery, followed by a second decline, followed in turn by a long, drawn-out period of sub-normal growth as the basic underlying economic and financial problems are corrected.”

Happy Reading!!