There is a psychological behaviour that humans, and especially investors fall prey to. This is referred to as the 'Conservatism bias'. Under the spell of this bias, once we make up our mind or take a view on the markets, we are unwilling to change our views. On most occassions, there is enough bullish and bearish data to hold a particular view on the markets. Once we make up our mind or take a view on market direction, we can see only data that supports our views and fail to observe contradictory evidence. We do not remain neutral and do not go with the flow of the markets. We seek information in the markets that supports our views. We stick with our views even as we keep losing money, convinced that we are right (and that the markets are wrong). After deep losses we may or may not get wiser, but we definately get poorer.
No investors would want to fall prey to this bias, I certainly dont. As investors, we want to keep an open mind and respect the market for what they are telling us. We do not want to be headstrong in the face of contradictory evidence.
In my previous blog (http://shashankcurrentissues.blogspot.com/2008/12/it-is-time-to-buy-stocks.html), I had argued that perhaps it was time to start buying stocks. Lest I should become a victim of the conservatism bias, let us examine if I could be wrong (and I certainly could be wrong) and what factors could potentially lead us to that eventuality.
PE derating and valuations:
I had argued that stocks are cheap; in fact they are as cheap as they ever were in the last 17 years. But 17 years does not constitute the history of stock markets. From the early 1980s, we had a large period of credit expansion and increasing leverage across the world, which probably ended this year in the form of the credit crunch. Now with deleveraging of the financial system, the era of cheap credit might be behind us, at least for a long long time. We might see stocks as an asset class being accorded much lower valuations in terms of PE ratios and other conventional valuation benchmarks. So what looks cheap on a historical basis could actually be normal under the new paradigm. I had written a post earlier (http://shashankcurrentissues.blogspot.com/2008/09/are-we-in-watershed-moment.html) arguing how we could be in an epoch making period which we are unable to recognise. Most market participants and advisors possess experience only from the period of financial leveraging. We have not seen financial deleveraging and what it could do to valuations. Money might not flow into emerging markets are it did earlier and this could lead to secular derating of stock markets across the world. If a PE ratio of 11 for the markets might have been cheap in the past, cheap in the new era could mean a PE of 8!
Corporate Profits:
The situation on corporate profits looks dismal, though we do not know whether the markets have fully discounted them in the price already. Corporate profits might be worse than widely anticipated. Earnings might fall going ahead making current valuations not as cheap as they optically look. In addition, costlier and scarcer money would dent demand and dent corporate profits, especially for leveraged players.
Globalisation:
Globalisation had a beneficial effect on prosperity across trading member countries over the past decades. Free trade has been widely hailed in its role towards wealth creation. But I am not sure we can take free trade for granted now. Under economic stress and compulsions to keep the citizens in better shape, we could see adhoc measures that could decrease globalisation based on free trade principles. USA differs with UK, which differs with France. Asia differs with USA and China want to keep its currency weak to stimulate exports. Such competitive devaluation of domestic currencies and protectionistic measures could get destructive for the world trade, and hence to prosperity. While world leaders are well aware of this, one can never be sure of how things might evolve on this front. Perhaps an year ago, this was unthinkable and globalisation was in full swing. Now we have to consider the possibility of globalisation slowing down as well.
Greater Regulation:
There is no doubt that the financial system will be subject to greater regulation post the current mayhem. In the developed world, the iron fist of the government might get a greater share in proceedings compared to the free hand of the markets. In developing countries, it could mean an attempt to prevent incidents similar to those that occured in the west. In either case, we could see greater regulation, less freedom, especially to finance. With fiscal simuli being thrown around like there is no tommorrow, it could lead eventually to higher taxes to make up those expenses and hence could lower earnings growth.
Terrorism:
We watched with horror, shock and dismay the events of terror in Mumbai last week. This has conflagrated into a big thing, and deservedly so. We might see the negative economic consequences to flow through over time. Decreased foreign investment could be the most obvious effect. Animal spirits of entrepreneurship could be also affected. More government money might get diverted towards preventing terror attacks in the future. Taxes could be raised to gather more money for this cause. Any conflict, either direct or indirect, reduces return on capital employed and hence reduces stock valuations.
Essentially, for whatever reasons, if earnings go down or if the PE ratio assigned to stocks by the markets goes down, stocks prices could go down. In addition, if there is a structural downward shift in the valuation metrics like the PE ratio, and if business environment remains tough, stocks could stay down for a long period.
All of us need to understand that supernormal returns are not possible across all time horizons in the real world. There always will be periods of above normal returns and periods of below normal returns. What causes these cycles could vary across such cycles. The bottomline is that over time, good and bad periods get evened out to result in normal returns. An example I always like to quote: If in the year 1000 A.D, any of our ancestors had invested Re.1 at 5% per annum, the value of that rupee would today be 45 quintillion US dollars!!! (One quintillion = a million trillion). This would be about 0.86 million (8.6 lakh) times the world's annual output! The interest at 5% per annum from this would be 42300 times the world's annual output! Over long (really long) time horizons, the return from most stock investments is zero! Capitalism ensures that. Even the East India Company eventually went bankrupt after practically ruling India for more than 100 years!
Now, no one in his right mind would look at returns over a 1000 years. Lets look at century returns. The Dow Jones Industrial average went up from a value of 71 in the year 1901 to 8500 currently. This is an annual return of only 4.5% (add another 3% for dividends). Anyone for the idea 'stocks for the long run'? Noteworthy is the period from 1982-1999 where the Dow went up from 875 to 11497 generating a CAGR of 15.3%. This period coincides with the begining of proliferation of financial leverage and massive credit expansion. That might explain the above-normal return compared to history. The greatest bull market in Japan from 1970 to 1989 saw the Nikkei go up from 2000 to 40000, a return of 16%; attractive but by no means spectacular! Maybe returns are mean reverting and revert back to normal long run values.
The short of this long story is that stocks today do look cheap when valued in the context of the existance of cheap money, high leverage and low taxes. The future might look very different from the past. Stocks might not be cheap in the context of more regulation, scarce and expensive money, less leverage and higher taxes.
How would the world evolve? Only time will tell.
Happy Investing!
Thursday, December 4, 2008
Monday, December 1, 2008
It is time to start buying stocks
“Be fearful when others are greedy, and be greedy when others are fearful” – Warren Buffet.
In reality, be greedy when others are fearful and only when there are valid reasons for being greedy.
The current environment can be best described as fearful. Investors are engulfed with fear, fear of losing money, in most case fear of losing more money. There are valid justifications of such fear. The world economy is slowing down. Many large developed nations are in recessions, people have lost so much money across asset classes. In India, there is an economic slowdown playing out. If all this was not enough, we witnessed the most terrible incidents of terrorist attacks in Mumbai that threatens to adversely impact economic prospects in the medium term. There are many valid reasons to be fearful and people are justified in being afraid of committing capital behind risky assets like stocks.
On the Indian stock markets front, they have corrected over 55-60% from their highs made earlier this year. Some stocks are down 70-90% and this includes many blue chip names as well. A spate of bad economic news has hit us and corporate results have not made us jump in excitement. We probably would continue to see more bad economic news come ahead. In the short run, stock prices are likely to go down further.
Yet, amidst all the gloom and doom, I think it is time to start buying stocks. Why? In this article, we shall look at the facts one by one and then look at the collective weight of the facts put together to try to figure out why investors should start buying stocks.
The markets have already corrected significantly. The market capitalisation:GDP ratio on the NSE now stands close to 0.6, down from its lofty value of 1.5 in Jan 2008. Prices however do not go down to zero, the productive enterprises of India are going to be valued and valuable as long as humanity exists. Yet, a large price correction is never a good enough reason alone to buy stocks. Stocks can fall and keep falling.
But at some point the fall stops as stocks get cheap and value investors step in to buy. Compounding returns by buying cheap assets is a very successful way of building wealth. Are stocks attractive now? I believe they are even as I acknowledge that what is attractive can get even more attractive.
The BSE Sensex quotes at a value of 9092 (28 Nov 2008 trading day end) implying a PE ratio of 11.62, a Price to Book Value of 2.43 and a dividend yield of 1.96% (Source: BSE Website). This compares favourably with previous lows. In fact, this is at the lower end of valuations for the Sensex since 1991. The same is the case with all other indices. The earnings yield of the Sensex stands at 8.6% which is higher than the 10 year Government of India security whose yield is around 7.2%. Stocks are yielding greater in return than government bonds. On a post tax basis, stocks are yielding more than most 1 year Fixed Deposits currently. Stock yields (earnings) rise over time but fixed deposit interests remain the same. Many stocks are currently quoting at ridiculously cheap valuations.
Over the past 17 years, there have only been 4 incidences when the Sensex got to such low valuations. This happened in Nov-Dec 1996, Aug-Oct 1998, October 2002 and April 2003. And what were the returns achieved in one years time post these periods? Here is the data:
Period________Return 1 Year hence
Nov-Dec 1996___25-30%
Aug-Oct 1998___50-75%
October 2002___70% +
April 2003_____100%
While 4 data points can hardly be a statistician’s delight to draw some inference, we have to do with whatever data we have. The data hence can only be indicative. The point to be noted however is that on every single occasion, the 1 year return has been positive, more often quite spectacular.
The PE ratios of stocks are way below their moving averages and trend lines suggesting oversold markets. Of course, you only have to look at the price to see how oversold these markets are.
India is slowing down, but the fears of an economic meltdown seem exaggerated. The last major bear market was the one between 2000 and 2003. Many blue chip stocks are currently quoting at 2003 bear market bottom valuations. And India’s GDP growth in 2002 had fallen to 3.8%. In the current turmoil, not even the most pessimistic analyst expects GDP growth to fall to those levels (although nothing can be ruled out). But stocks are already discounting an outcome as bad as that of 2002, perhaps worse. While that can still happen, it seems a trifle unlikely at this point. Yes, economic growth will be lower, but life still goes on. Good companies will not vanish. Their future profits will not go to zero; in fact they are likely to rise in the long run. We do not stop living because there is an economic slowdown. Life goes on, with some adjustments and some pain. Eventually, humans come out ahead of such circumstances. Since 1991, we have witnessed a Harshad Mehta scam in the equity markets in 1992, bomb blasts in the Bombay Stock Exchange in 1993, a boom bust cycle of 1994-97, the severe South East Asian crisis in 1997, economic sanctions on the country post Pokhran in 1998, a technology bubble meltdown in 2000, a war in Kargil, terrorist attacks on the Parliament in 2001, communal riots and plague epidemic in Gujarat, countless acts of terrorism in various cities in the country including cities like Mumbai and Delhi. And guess what? The markets still gave compounded returns of 15%+ (including dividends) over the last 17 years, even after the current crash! The Sensex still managed to move up from 999 in Jan 1991 to 9092 today! A boom follows a slowdown and at some point, things will again look up.
Let us also not forget that, generally speaking, the corporate sector is in far better shape than it was during all the previous downturns. It is perhaps better placed to endure this downturn. Be it Return on Equity or Return on Assets or other return figures, corporate India is more efficient today than it was in the past.
There are many positive macro economic factors that are going unnoticed, or perhaps being looked at with the glass half empty mindset. After the first crash in Jan 2008, the glass was half full. Now it seems half empty (or maybe almost empty). A few important macro economic variables are turning positive. First, inflation is no longer the enemy, at least for now. The central government and the RBI are trying to get more money into the financial system. This would most likely lead to lower interest rates and lower yields on debt, thereby making stocks even more attractive. A fall in interest rates boosts investments and boosts demand and also boost corporate profits by lowering their interest costs. All is positive for economic growth. Crude oil prices have come down to 2005 levels, down to 50+ USD per barrel. This is a huge boost to the India’s trade account and can perhaps counterbalance the loss in exports. Commodity prices have crashed, which though negative for commodity producers, is beneficial for commodity consumers.
So stocks look cheap on a historical basis; in fact almost as cheap as they ever were. History suggests that such occasions are infrequent but buying done at such levels rewards investors handsomely over time. In addition, today, many macro economic variables that were plaguing India since the beginning of the year have started turning benign.
Don’t get me wrong here. I am not in any way suggesting that the pain is over. More likely that we will see many more negative data points being thrown up. I do not know when good days will be back again. I suspect markets might see some more downside ahead. So would it be a wise idea to wait till all the downslide is over? If you are an investor, the likely answer is ‘no’. Investing is a game always played with incomplete information and uncertain external conditions. One has to make a reasoned judgment and take decisions decisively. One has to accept risk and accept the possibilities of making mistakes or being proven wrong. If you keep waiting for things to clear up or wait to feel comfortable again to invest, you are most likely to miss the boat altogether. Permanent bearishness or caution (or permanent bullishness) does not serve an investor well.
It is generally observed that stock markets lead economic development, what market observers call ‘discounting’, that news gets discounted into the price. We can never know whether the market has fully discounted all future bad news or not. We have to make an educated guess and a reasoned judgment and yet run the risk of being proven wrong. But we know that markets bottom out much before all bad news comes through. Bad news is an investor’s friend. At some point, it allows the investor to buy stocks cheap. If you are an investor, you welcome bad news. And you should buy when stocks are cheap. If you do not buy then, and if stocks run away, you not only look like an idiot. You are proven to be an idiot.
Having said this, bear markets do not end one fine day and then run away like a bullet train. They offer you ample time to spread your buying over time. How long is anyone’s guess, but in my judgment, you could start buying now and keep buying in equal amounts for the next 18 months. You should avoid companies that are highly leveraged or are in weak competitive positions in the marketplace. And then invest with some method of risk control, that if you are proven wrong, you don’t get hurt too much.
For most part of this calendar year till recently, I was advocating cash as king. Perhaps cash is no longer king.
Happy Investing!
In reality, be greedy when others are fearful and only when there are valid reasons for being greedy.
The current environment can be best described as fearful. Investors are engulfed with fear, fear of losing money, in most case fear of losing more money. There are valid justifications of such fear. The world economy is slowing down. Many large developed nations are in recessions, people have lost so much money across asset classes. In India, there is an economic slowdown playing out. If all this was not enough, we witnessed the most terrible incidents of terrorist attacks in Mumbai that threatens to adversely impact economic prospects in the medium term. There are many valid reasons to be fearful and people are justified in being afraid of committing capital behind risky assets like stocks.
On the Indian stock markets front, they have corrected over 55-60% from their highs made earlier this year. Some stocks are down 70-90% and this includes many blue chip names as well. A spate of bad economic news has hit us and corporate results have not made us jump in excitement. We probably would continue to see more bad economic news come ahead. In the short run, stock prices are likely to go down further.
Yet, amidst all the gloom and doom, I think it is time to start buying stocks. Why? In this article, we shall look at the facts one by one and then look at the collective weight of the facts put together to try to figure out why investors should start buying stocks.
The markets have already corrected significantly. The market capitalisation:GDP ratio on the NSE now stands close to 0.6, down from its lofty value of 1.5 in Jan 2008. Prices however do not go down to zero, the productive enterprises of India are going to be valued and valuable as long as humanity exists. Yet, a large price correction is never a good enough reason alone to buy stocks. Stocks can fall and keep falling.
But at some point the fall stops as stocks get cheap and value investors step in to buy. Compounding returns by buying cheap assets is a very successful way of building wealth. Are stocks attractive now? I believe they are even as I acknowledge that what is attractive can get even more attractive.
The BSE Sensex quotes at a value of 9092 (28 Nov 2008 trading day end) implying a PE ratio of 11.62, a Price to Book Value of 2.43 and a dividend yield of 1.96% (Source: BSE Website). This compares favourably with previous lows. In fact, this is at the lower end of valuations for the Sensex since 1991. The same is the case with all other indices. The earnings yield of the Sensex stands at 8.6% which is higher than the 10 year Government of India security whose yield is around 7.2%. Stocks are yielding greater in return than government bonds. On a post tax basis, stocks are yielding more than most 1 year Fixed Deposits currently. Stock yields (earnings) rise over time but fixed deposit interests remain the same. Many stocks are currently quoting at ridiculously cheap valuations.
Over the past 17 years, there have only been 4 incidences when the Sensex got to such low valuations. This happened in Nov-Dec 1996, Aug-Oct 1998, October 2002 and April 2003. And what were the returns achieved in one years time post these periods? Here is the data:
Period________Return 1 Year hence
Nov-Dec 1996___25-30%
Aug-Oct 1998___50-75%
October 2002___70% +
April 2003_____100%
While 4 data points can hardly be a statistician’s delight to draw some inference, we have to do with whatever data we have. The data hence can only be indicative. The point to be noted however is that on every single occasion, the 1 year return has been positive, more often quite spectacular.
The PE ratios of stocks are way below their moving averages and trend lines suggesting oversold markets. Of course, you only have to look at the price to see how oversold these markets are.
India is slowing down, but the fears of an economic meltdown seem exaggerated. The last major bear market was the one between 2000 and 2003. Many blue chip stocks are currently quoting at 2003 bear market bottom valuations. And India’s GDP growth in 2002 had fallen to 3.8%. In the current turmoil, not even the most pessimistic analyst expects GDP growth to fall to those levels (although nothing can be ruled out). But stocks are already discounting an outcome as bad as that of 2002, perhaps worse. While that can still happen, it seems a trifle unlikely at this point. Yes, economic growth will be lower, but life still goes on. Good companies will not vanish. Their future profits will not go to zero; in fact they are likely to rise in the long run. We do not stop living because there is an economic slowdown. Life goes on, with some adjustments and some pain. Eventually, humans come out ahead of such circumstances. Since 1991, we have witnessed a Harshad Mehta scam in the equity markets in 1992, bomb blasts in the Bombay Stock Exchange in 1993, a boom bust cycle of 1994-97, the severe South East Asian crisis in 1997, economic sanctions on the country post Pokhran in 1998, a technology bubble meltdown in 2000, a war in Kargil, terrorist attacks on the Parliament in 2001, communal riots and plague epidemic in Gujarat, countless acts of terrorism in various cities in the country including cities like Mumbai and Delhi. And guess what? The markets still gave compounded returns of 15%+ (including dividends) over the last 17 years, even after the current crash! The Sensex still managed to move up from 999 in Jan 1991 to 9092 today! A boom follows a slowdown and at some point, things will again look up.
Let us also not forget that, generally speaking, the corporate sector is in far better shape than it was during all the previous downturns. It is perhaps better placed to endure this downturn. Be it Return on Equity or Return on Assets or other return figures, corporate India is more efficient today than it was in the past.
There are many positive macro economic factors that are going unnoticed, or perhaps being looked at with the glass half empty mindset. After the first crash in Jan 2008, the glass was half full. Now it seems half empty (or maybe almost empty). A few important macro economic variables are turning positive. First, inflation is no longer the enemy, at least for now. The central government and the RBI are trying to get more money into the financial system. This would most likely lead to lower interest rates and lower yields on debt, thereby making stocks even more attractive. A fall in interest rates boosts investments and boosts demand and also boost corporate profits by lowering their interest costs. All is positive for economic growth. Crude oil prices have come down to 2005 levels, down to 50+ USD per barrel. This is a huge boost to the India’s trade account and can perhaps counterbalance the loss in exports. Commodity prices have crashed, which though negative for commodity producers, is beneficial for commodity consumers.
So stocks look cheap on a historical basis; in fact almost as cheap as they ever were. History suggests that such occasions are infrequent but buying done at such levels rewards investors handsomely over time. In addition, today, many macro economic variables that were plaguing India since the beginning of the year have started turning benign.
Don’t get me wrong here. I am not in any way suggesting that the pain is over. More likely that we will see many more negative data points being thrown up. I do not know when good days will be back again. I suspect markets might see some more downside ahead. So would it be a wise idea to wait till all the downslide is over? If you are an investor, the likely answer is ‘no’. Investing is a game always played with incomplete information and uncertain external conditions. One has to make a reasoned judgment and take decisions decisively. One has to accept risk and accept the possibilities of making mistakes or being proven wrong. If you keep waiting for things to clear up or wait to feel comfortable again to invest, you are most likely to miss the boat altogether. Permanent bearishness or caution (or permanent bullishness) does not serve an investor well.
It is generally observed that stock markets lead economic development, what market observers call ‘discounting’, that news gets discounted into the price. We can never know whether the market has fully discounted all future bad news or not. We have to make an educated guess and a reasoned judgment and yet run the risk of being proven wrong. But we know that markets bottom out much before all bad news comes through. Bad news is an investor’s friend. At some point, it allows the investor to buy stocks cheap. If you are an investor, you welcome bad news. And you should buy when stocks are cheap. If you do not buy then, and if stocks run away, you not only look like an idiot. You are proven to be an idiot.
Having said this, bear markets do not end one fine day and then run away like a bullet train. They offer you ample time to spread your buying over time. How long is anyone’s guess, but in my judgment, you could start buying now and keep buying in equal amounts for the next 18 months. You should avoid companies that are highly leveraged or are in weak competitive positions in the marketplace. And then invest with some method of risk control, that if you are proven wrong, you don’t get hurt too much.
For most part of this calendar year till recently, I was advocating cash as king. Perhaps cash is no longer king.
Happy Investing!
Tuesday, November 25, 2008
Imaginary Wealth
The current fall in the stock markets has wiped out about Rs. 39 lakh crores (0.8 trillion US Dollars at current exchange rates) in market capitalisation off the National Stocks Exchange since the begining of the year. This is equivalent to the GDP of India for 2007-08. The entire output of the country has been wiped out in 10 months in the stock markets!!
If you include the fall in value of other assets like commodities, real estate, etc, the total wealth destruction could go well beyond Rs. 100 lakh crores. So many people have lost so much wealth. So many investors have had massive wealth destruction.
Or have they?
Have investors really lost wealth? I would tend to think no.
Consider the following example. Lets assume that there are 4 investors A, B, C, D, each with 500 shares of stock XYZ. The current market price of stock XYZ is Rs 100 per share. So the value of each investor's holding is Rs 50000. Collectively they own Rs 200000 worth of share XYZ.
Along comes investor E and buys just 1 share of stock XYZ from investor D at Rs 110 per share. He pays D Rs.110 and gets one share in return. This price now becomes the market price for everyone. At Rs. 110 per share, the value of the shares held by investors A, B and C becomes Rs. 55000 each. The value of shares of investor D becomes Rs, 54890 (499*110) plus he has Rs 110 as cash received from the sale of 1 share of XYZ. The sum total of the wealth held by all investors now becomes 220110 (Rs 55000 each for A, B, C, D and Rs 110 as value of share held by investor E). The total wealth went up without any productive activity.
Now for some reason, E sells off the one share he had purchased from D to another investor F at Rs 90. He accepts a loss of Rs 20 (110-90), but the new price of Rs 90 becomes the market price now. Everyone who owns any share of XYZ now has to value his shares at this price. The value of shares held by investors A, B, C now becomes Rs 45000 (500*90) each. Investor D has a worth of Rs.45020 (499*90+110). Investor E has a net worth of Rs -20 as he lost Rs 20 and investor F has a share worth Rs. 90. The total value across all investors is now 180090 (45000*3+45020-20+90)
All investors, put together, have lost Rs. 40020 (220110-180090)! Just one share sold by E to F caused wealth destruction by Rs. 40020! Does it seem right? How is it possible that such an insignificant action can result in loss of wealth by such a significant amount (20% of the initial sum of Rs 200000 together)? And where has the money gone? Surely, if someone lost, someone else would have gained that amount, right? This money has to go somewhere, right?
Wrong! The wealth has simply vanished. It has disappeared into thin air! How is that possible? How can something vanish suddenly?...unless it never existed in the first place!
Precisely! There was never any wealth to begin with (or at least not as much as dictated by prices). It was all 'maya'. Just as wealth went up when prices went up, wealth went down when prices went down. All imaginary, all an illusion.
Asset prices rise even if just one buyer and one seller agree on that price. This impacts all those who hold the asset even as they do nothing to influence this price. Conversely, just one buyer and one seller who agree on a lower price of an asset are enough to get down the wealth of all others who hold that asset. We see this all the time in the markets. When markets have gap-up or gap-down openings, it is usually only one buyer and one seller who make the market.
The wealth that an investor holds lies merely in the mind of that investor and in the minds of those who agree with him. When the point of agreement changes, so does the value of the holdings in the assets. Wealth instantaneously turns into thin air. Looking at it in another way, in reality, the investor never has any wealth. All his wealth is merely illusionary, based on what others thought the wealth to be. And when others think what your wealth is, it can disappear in the blink of an eye.
So in the current meltdown, Mukesh Ambani did not lose 40 billion Dollars. He never had that to lose. K.P.Singh (DLF promoter) did not lose 85% of his wealth. He never had that to lose.
Consumerism is good. But comsuming using wealth that never exists is potentially dangerous. As people in the USA have discovered. Rising home prices gave an illusion of wealth increase. People capitalised on this 'wealth' by borrowing money from banks against this 'increase in wealth'. Banks also lent out on such illusion. Now the magic trick is over and everyone has begun to realise that all that wealth against which consumers borrowed and banks lent, actually never existed except in their minds. The ill effects are there for all to see.
Wealth is not the value of the assets we hold. Indeed, wealth is something that we value in our life and not the money in our bank account or the value of our homes and stocks. Wealth is created by productive activity and its voluntary exchange for something else, and not by a series of passing the assets' parcel at higher and higher prices. When a car manufacturer processes raw materials, manufactures a car and sells it to a consumer, wealth is created for the car manufacturer (and not to the owner of the car). When a plumber fixes a leak on our request, he creates wealth for himself. When the government taxes us to pay its unproductive employees who do nothing, wealth is destroyed.
Here's to more productive activity! Here's to more wealth for everyone!
If you include the fall in value of other assets like commodities, real estate, etc, the total wealth destruction could go well beyond Rs. 100 lakh crores. So many people have lost so much wealth. So many investors have had massive wealth destruction.
Or have they?
Have investors really lost wealth? I would tend to think no.
Consider the following example. Lets assume that there are 4 investors A, B, C, D, each with 500 shares of stock XYZ. The current market price of stock XYZ is Rs 100 per share. So the value of each investor's holding is Rs 50000. Collectively they own Rs 200000 worth of share XYZ.
Along comes investor E and buys just 1 share of stock XYZ from investor D at Rs 110 per share. He pays D Rs.110 and gets one share in return. This price now becomes the market price for everyone. At Rs. 110 per share, the value of the shares held by investors A, B and C becomes Rs. 55000 each. The value of shares of investor D becomes Rs, 54890 (499*110) plus he has Rs 110 as cash received from the sale of 1 share of XYZ. The sum total of the wealth held by all investors now becomes 220110 (Rs 55000 each for A, B, C, D and Rs 110 as value of share held by investor E). The total wealth went up without any productive activity.
Now for some reason, E sells off the one share he had purchased from D to another investor F at Rs 90. He accepts a loss of Rs 20 (110-90), but the new price of Rs 90 becomes the market price now. Everyone who owns any share of XYZ now has to value his shares at this price. The value of shares held by investors A, B, C now becomes Rs 45000 (500*90) each. Investor D has a worth of Rs.45020 (499*90+110). Investor E has a net worth of Rs -20 as he lost Rs 20 and investor F has a share worth Rs. 90. The total value across all investors is now 180090 (45000*3+45020-20+90)
All investors, put together, have lost Rs. 40020 (220110-180090)! Just one share sold by E to F caused wealth destruction by Rs. 40020! Does it seem right? How is it possible that such an insignificant action can result in loss of wealth by such a significant amount (20% of the initial sum of Rs 200000 together)? And where has the money gone? Surely, if someone lost, someone else would have gained that amount, right? This money has to go somewhere, right?
Wrong! The wealth has simply vanished. It has disappeared into thin air! How is that possible? How can something vanish suddenly?...unless it never existed in the first place!
Precisely! There was never any wealth to begin with (or at least not as much as dictated by prices). It was all 'maya'. Just as wealth went up when prices went up, wealth went down when prices went down. All imaginary, all an illusion.
Asset prices rise even if just one buyer and one seller agree on that price. This impacts all those who hold the asset even as they do nothing to influence this price. Conversely, just one buyer and one seller who agree on a lower price of an asset are enough to get down the wealth of all others who hold that asset. We see this all the time in the markets. When markets have gap-up or gap-down openings, it is usually only one buyer and one seller who make the market.
The wealth that an investor holds lies merely in the mind of that investor and in the minds of those who agree with him. When the point of agreement changes, so does the value of the holdings in the assets. Wealth instantaneously turns into thin air. Looking at it in another way, in reality, the investor never has any wealth. All his wealth is merely illusionary, based on what others thought the wealth to be. And when others think what your wealth is, it can disappear in the blink of an eye.
So in the current meltdown, Mukesh Ambani did not lose 40 billion Dollars. He never had that to lose. K.P.Singh (DLF promoter) did not lose 85% of his wealth. He never had that to lose.
Consumerism is good. But comsuming using wealth that never exists is potentially dangerous. As people in the USA have discovered. Rising home prices gave an illusion of wealth increase. People capitalised on this 'wealth' by borrowing money from banks against this 'increase in wealth'. Banks also lent out on such illusion. Now the magic trick is over and everyone has begun to realise that all that wealth against which consumers borrowed and banks lent, actually never existed except in their minds. The ill effects are there for all to see.
Wealth is not the value of the assets we hold. Indeed, wealth is something that we value in our life and not the money in our bank account or the value of our homes and stocks. Wealth is created by productive activity and its voluntary exchange for something else, and not by a series of passing the assets' parcel at higher and higher prices. When a car manufacturer processes raw materials, manufactures a car and sells it to a consumer, wealth is created for the car manufacturer (and not to the owner of the car). When a plumber fixes a leak on our request, he creates wealth for himself. When the government taxes us to pay its unproductive employees who do nothing, wealth is destroyed.
Here's to more productive activity! Here's to more wealth for everyone!
Friday, October 24, 2008
Market crash, cry babies and cheap valuations
There seems to be no end to the current stock market crash.
Today, the Indian stock markets as represented by the BSE Sensex and the NSE Nifty-50 crashed by over 10%. Some stocks fell much harder...Unitech fell 50%! If you owned Unitech yesterday, you would be half as rich today on Unitech.
Current market conditions and the crash are truly unprecedented. A great change seems to be afoot. And in times of great change, there are obvious winners and losers. So far, the bears have been winning and the bulls have been losing big time.
Some battered bulls are now crying out for help. These are not the average investors but many are so called experts that you see so many times on business channels. Many such bulls have lost money and continue to lose money. It is obviously hurting. And hence these people are calling for help from all corners.
Some people cry for a ban on short selling.
Others want rate reductions and easier money.
Some want the government to do something, as if it were the job of the government to protect asset prices in some way.
Some want hte government to set up a market stabilisation fund to prop up the markets.
Some want a change in the way futures are settled on settlement day.
Some are angry that there is no level playing field between local investors and FIIs.
Some desperately seek any kind of silver lining in bad news.
People simply want the markets to go up again and for better times to return.
I was amused to see the remarks of one such celebrated fund manager and CIO of Reliance Mutual Fund, Madhu Kela. He seemed to have anguish in his voice complaining that mutual funds are not allowed to go short in any signficant manner while FIIs are allowed to do anything. He added that he would have loved to short the market as well given a choice. I found it quite amusing.
For one, a mutual fund is not a hedge fund. It is designed as a vehicle for the average investor to participate in the stock market. Short selling has a greater risk than long only buying and it requires greater skill. By not allowing short selling in any big way, the average investor is protected against incompetence of the fund manager, if any, to sell short.
Also, if someone finds stocks cheap, he/she should go ahead and buy. Reliance mutual fund is saying on the one hand that stocks are cheap and then stating on the other hand that they are waiting with a lot of money to buy when markets stop falling. By abstaining from buying, is Reliance Mutual fund not also contributing to the fall?
And assume if mutual funds were allowed to short sell as well? Would the markets have not gone down faster as mutual funds would have come around to shorting the markets instead of the buying that some have been doing?
And speaking generally, when the markets were going up, no one was complaining about anything. Everyone was happy when the markets went up 50% in 2-3 months in Sep-Nov 2007. Now that the markets are crashing, these experts are now crying for help and lamenting about how things are biased against them.
They are behaving like cry babies. Where is the personal accountability? Anyone who made a loss, made it because they chose to invest in the markets. They and they alone are responsible for their losses. Period! They lost money because they made a bad choice and were blind to extreme events occuring.
There is no point in cribbing and complaining. There is no point in whining. Yes, there might be genuine issues with the markets and all the problems that these experts talk about might be valid. But these have existed and are not something that have been thrust upon them overnight. They were aware of these issues when the markets were going up, and hence should not complain how these caused them losses.
Markets go up and markets go down. A downcycle is a way of cleaning out all excesses of the previous cycle. Just like a jungle fire, it cleans out all existing vegetation and new life begins. When people want to sell, they will sell regardless of external artificial measures. Interfering with natural processes create dislocations in other areas and create new problems to deal with.
Having said that, till very recently, I was arguing that markets were not cheap yet. Now the picture might have changed. The markets do look attractive now, based on traditional measures.
The BSE Sensex (8701) now trades at a PE of 10.63, Price to Book Value (PBV) of 2.25 and Dividend Yield of 2.12%.
The BSE Midcap index has the same values at 8.02, 1.46 and 2.46%
The BSE SmallCap index has the same values at 5.62, 0.91, 2.78%
Same is the case with NSE indices.
Historically, these are in line (by and large) with previous lows.
But before we jump ahead and buy, we don't know how future earnings would be. We dont know whether earnings will rise, fall or stay stagnant. If they rise, how much they would rise by? And what PE multiples would the markets give the markets? So even though stocks optically look attractive, this could be an illusion as earnings fall short of expectations. But, generally speaking, stocks might be worth buying into starting now...with a caveat that I could be wrong, earnings could disappoint, markets could go down...and hence you should invest in a manner that if you are wrong, you dont lose much.
Looking at the current picture, there is no hurry to buy anyways. The next few years could turn out to be an investor's delight. He would get stocks cheap, perhaps very cheap, and would not be in any hurry to buy. Keep cash handy.
Happy Investing!
Today, the Indian stock markets as represented by the BSE Sensex and the NSE Nifty-50 crashed by over 10%. Some stocks fell much harder...Unitech fell 50%! If you owned Unitech yesterday, you would be half as rich today on Unitech.
Current market conditions and the crash are truly unprecedented. A great change seems to be afoot. And in times of great change, there are obvious winners and losers. So far, the bears have been winning and the bulls have been losing big time.
Some battered bulls are now crying out for help. These are not the average investors but many are so called experts that you see so many times on business channels. Many such bulls have lost money and continue to lose money. It is obviously hurting. And hence these people are calling for help from all corners.
Some people cry for a ban on short selling.
Others want rate reductions and easier money.
Some want the government to do something, as if it were the job of the government to protect asset prices in some way.
Some want hte government to set up a market stabilisation fund to prop up the markets.
Some want a change in the way futures are settled on settlement day.
Some are angry that there is no level playing field between local investors and FIIs.
Some desperately seek any kind of silver lining in bad news.
People simply want the markets to go up again and for better times to return.
I was amused to see the remarks of one such celebrated fund manager and CIO of Reliance Mutual Fund, Madhu Kela. He seemed to have anguish in his voice complaining that mutual funds are not allowed to go short in any signficant manner while FIIs are allowed to do anything. He added that he would have loved to short the market as well given a choice. I found it quite amusing.
For one, a mutual fund is not a hedge fund. It is designed as a vehicle for the average investor to participate in the stock market. Short selling has a greater risk than long only buying and it requires greater skill. By not allowing short selling in any big way, the average investor is protected against incompetence of the fund manager, if any, to sell short.
Also, if someone finds stocks cheap, he/she should go ahead and buy. Reliance mutual fund is saying on the one hand that stocks are cheap and then stating on the other hand that they are waiting with a lot of money to buy when markets stop falling. By abstaining from buying, is Reliance Mutual fund not also contributing to the fall?
And assume if mutual funds were allowed to short sell as well? Would the markets have not gone down faster as mutual funds would have come around to shorting the markets instead of the buying that some have been doing?
And speaking generally, when the markets were going up, no one was complaining about anything. Everyone was happy when the markets went up 50% in 2-3 months in Sep-Nov 2007. Now that the markets are crashing, these experts are now crying for help and lamenting about how things are biased against them.
They are behaving like cry babies. Where is the personal accountability? Anyone who made a loss, made it because they chose to invest in the markets. They and they alone are responsible for their losses. Period! They lost money because they made a bad choice and were blind to extreme events occuring.
There is no point in cribbing and complaining. There is no point in whining. Yes, there might be genuine issues with the markets and all the problems that these experts talk about might be valid. But these have existed and are not something that have been thrust upon them overnight. They were aware of these issues when the markets were going up, and hence should not complain how these caused them losses.
Markets go up and markets go down. A downcycle is a way of cleaning out all excesses of the previous cycle. Just like a jungle fire, it cleans out all existing vegetation and new life begins. When people want to sell, they will sell regardless of external artificial measures. Interfering with natural processes create dislocations in other areas and create new problems to deal with.
Having said that, till very recently, I was arguing that markets were not cheap yet. Now the picture might have changed. The markets do look attractive now, based on traditional measures.
The BSE Sensex (8701) now trades at a PE of 10.63, Price to Book Value (PBV) of 2.25 and Dividend Yield of 2.12%.
The BSE Midcap index has the same values at 8.02, 1.46 and 2.46%
The BSE SmallCap index has the same values at 5.62, 0.91, 2.78%
Same is the case with NSE indices.
Historically, these are in line (by and large) with previous lows.
But before we jump ahead and buy, we don't know how future earnings would be. We dont know whether earnings will rise, fall or stay stagnant. If they rise, how much they would rise by? And what PE multiples would the markets give the markets? So even though stocks optically look attractive, this could be an illusion as earnings fall short of expectations. But, generally speaking, stocks might be worth buying into starting now...with a caveat that I could be wrong, earnings could disappoint, markets could go down...and hence you should invest in a manner that if you are wrong, you dont lose much.
Looking at the current picture, there is no hurry to buy anyways. The next few years could turn out to be an investor's delight. He would get stocks cheap, perhaps very cheap, and would not be in any hurry to buy. Keep cash handy.
Happy Investing!
Not protecting yourself
You buy motor insurance for your cars. That is mandatory by law.
You are wise and buy life insurance and medical insurance (If you don't, you should)
But what about investment insurance?
For most of our lives, things keep going along the same way they always do. Today is much like yesterday and tommorrow will be most like today. And we believe that the future will be like the past.
But there comes a time when the world changes upon us, at least in the investing world. The future is hardly like the past.
When such incidences occur, past experiences do not count. Asset prices crash and crash hard. A collosal amount of wealth is lost. This has happened in the past and will continue to happen in the future...one such time is now. A massive wealth destruction has occured in the almost all asset markets, especially in the stock markets.
While we are never able to predict such events, their timing or their magnitude. But we can stay awake to the possibility of such events occuring...and have a plan to protect our wealth when they do occur.
Else, paper gains do not take time to erode into huge losses...and into horror stories.
Look at the kind of damage many bluechip stocks (all are Nifty 50 stocks) have had over this year from their highs, and especially this month (data as on 23 Oct 2008 market closing):
Stock---------Fall
ABB Ltd.------64%
BHEL---------59%
Bharti---------45%
DLF-----------78%
Grasim--------70%
Hindalco-------71%
ICICI Bank----75%
Idea-----------74%
Infosys--------46%
L&T-----------63%
Ranbaxy------62%
Rel Comm-----72%
Rel Infra------83%
Rel Petro------67%
SAIL----------71%
Siemens-------73%
Sterlite--------78%
Suzlon---------83%
Tata Motors---78%
Tata Steel-----78%
TCS-----------59%
Unitech-------89%
And falling....
Not to mention many smaller companies that have seen greater damage.
Clearly, the need to protect your investment is never more clear than in the current environment. Of course, protection should have been deployed much earlier.
Wise investors manage risk and protect themselves when things go bad. There are many ways to minimise losses. One is to risk small. The other is to stay out of large downtrends (recognise it first naturally) by either staying with cash or using derivatives as hedges.
Regardless of which method an investor chooses to use, every investor should learn how to protect his/her portfolio...and learn not to live in hope and blind optimism.
You are wise and buy life insurance and medical insurance (If you don't, you should)
But what about investment insurance?
For most of our lives, things keep going along the same way they always do. Today is much like yesterday and tommorrow will be most like today. And we believe that the future will be like the past.
But there comes a time when the world changes upon us, at least in the investing world. The future is hardly like the past.
When such incidences occur, past experiences do not count. Asset prices crash and crash hard. A collosal amount of wealth is lost. This has happened in the past and will continue to happen in the future...one such time is now. A massive wealth destruction has occured in the almost all asset markets, especially in the stock markets.
While we are never able to predict such events, their timing or their magnitude. But we can stay awake to the possibility of such events occuring...and have a plan to protect our wealth when they do occur.
Else, paper gains do not take time to erode into huge losses...and into horror stories.
Look at the kind of damage many bluechip stocks (all are Nifty 50 stocks) have had over this year from their highs, and especially this month (data as on 23 Oct 2008 market closing):
Stock---------Fall
ABB Ltd.------64%
BHEL---------59%
Bharti---------45%
DLF-----------78%
Grasim--------70%
Hindalco-------71%
ICICI Bank----75%
Idea-----------74%
Infosys--------46%
L&T-----------63%
Ranbaxy------62%
Rel Comm-----72%
Rel Infra------83%
Rel Petro------67%
SAIL----------71%
Siemens-------73%
Sterlite--------78%
Suzlon---------83%
Tata Motors---78%
Tata Steel-----78%
TCS-----------59%
Unitech-------89%
And falling....
Not to mention many smaller companies that have seen greater damage.
Clearly, the need to protect your investment is never more clear than in the current environment. Of course, protection should have been deployed much earlier.
Wise investors manage risk and protect themselves when things go bad. There are many ways to minimise losses. One is to risk small. The other is to stay out of large downtrends (recognise it first naturally) by either staying with cash or using derivatives as hedges.
Regardless of which method an investor chooses to use, every investor should learn how to protect his/her portfolio...and learn not to live in hope and blind optimism.
Tuesday, October 14, 2008
Obsessed with bottoms
Have we hit the bottom in the stock markets?
These days people seem to be obsessed about finding bottoms. Television anchors keep asking so called experts about whether we have hit rock bottom and whether prices will now stop falling.
Some think that we made market bottom last friday. Others think that the bottom is not yet made. So far, the no-sayers are winning the battle as markets have kept going down.
Bottom seekers live with the hope that if the market bottom has been identified, they can start buying again and avoid losses.
But I have a few things to say.
First, bottoms can only be identified in hindsight. Much later than today, when we look back at what happened, we should be able to say whether markets did make a bottom on 10th October 2008 or not. Sitting in the present, it is impossible to call a bottom except by pure luck.
No one can spot a bottom except in hindsight, after it has been formed. Trying to find bottoms is a meaningless exercise, an exercise in futility.
Secondly, we invest to make money, not to not lose money. While not losing a part of the game, the basic idea is to make money.
So the key issue is whether we should be able to make money regardless of whether a bottom is made or not, identified or not. Even if we are able to call a bottom correctly, if prices do not go up after we buy, we are not going to make money. In fact, we would pay an opportunity cost of not having deployed the same money into other investments like say fixed deposits (which currently are offering 10-11% returns).
What we as investors should focus on is the prospects of gains rather than finding bottoms. If we think that prices are not headed up, it does not make sense to buy even if we buy at the bottom.
Look at the prospects of gains in preference to finding market bottoms. Keep observing the market with an open mind and look for signs that the markets are headed higher.
It is better to wait for a bottom and then let the markets tell you that it is possibily going up. This is an easier task and more profitable one than trying to find bottoms.
These days people seem to be obsessed about finding bottoms. Television anchors keep asking so called experts about whether we have hit rock bottom and whether prices will now stop falling.
Some think that we made market bottom last friday. Others think that the bottom is not yet made. So far, the no-sayers are winning the battle as markets have kept going down.
Bottom seekers live with the hope that if the market bottom has been identified, they can start buying again and avoid losses.
But I have a few things to say.
First, bottoms can only be identified in hindsight. Much later than today, when we look back at what happened, we should be able to say whether markets did make a bottom on 10th October 2008 or not. Sitting in the present, it is impossible to call a bottom except by pure luck.
No one can spot a bottom except in hindsight, after it has been formed. Trying to find bottoms is a meaningless exercise, an exercise in futility.
Secondly, we invest to make money, not to not lose money. While not losing a part of the game, the basic idea is to make money.
So the key issue is whether we should be able to make money regardless of whether a bottom is made or not, identified or not. Even if we are able to call a bottom correctly, if prices do not go up after we buy, we are not going to make money. In fact, we would pay an opportunity cost of not having deployed the same money into other investments like say fixed deposits (which currently are offering 10-11% returns).
What we as investors should focus on is the prospects of gains rather than finding bottoms. If we think that prices are not headed up, it does not make sense to buy even if we buy at the bottom.
Look at the prospects of gains in preference to finding market bottoms. Keep observing the market with an open mind and look for signs that the markets are headed higher.
It is better to wait for a bottom and then let the markets tell you that it is possibily going up. This is an easier task and more profitable one than trying to find bottoms.
Sunday, October 12, 2008
A few lessons from the crash
The stock markets have crashed big time. I dont think we have ever seen such dramatic collapses in the Indian markets. This is highlighted by the worst ever weekly performance ending this week. And the week had only 4 trading days!
But first, let me apologise for what I am going to say next. I almost am tempted to say, "I told you so". Readers would have noticed the very cautious slant in my previous blogs and mails since March of this year. Of course, I never dreamt of such intensity, but I had sounded caution. So an apology is in order if I sound self-congratulatory here.
But what lessons can we, as investors, derive out of the current crisis? While there are many and I would like to highlight a few ones.
(1). The fault, dear Brutus, is not in our stars, But in ourselves, that we are underlings.
(William Shakespeare - Julius Caesar I.ii.)
No one has the ability to totally comprehend our economic world. The world is far too complex and has unimaginable linkages for us to get an idea of how one parameter would change what others and by how much. What started as a country specific (USA) problem in one sector of the economy (housing) has now become a world wide credit crisis that threatens to undermine the entire financial system of the world. First it was housing prices, then investment banks, then mortgage lenders to commercial banks to now trade financing (the latest is on letters of credit or LCs). All assets are getting decimated, stocks, commodities, real estate...except the US dollar and precious metals like Gold. Seemingly insulated countries like India are witnessing high linkages via capital flows.
The lesson to draw is that unexpected things do happen in the world, things that so beyond the ordinary that they change the future. While no one can really predict what and how intense such changes would be, it a wise idea to be aware that they can happen and more importantly, be prepared to protect your wealth or create wealth for yourself when such events occur.
The typical market expert has a standard advise. Hold stocks for the long run, or use a SIP to invest, etc. Such advise of ok in normal times. In extraordinary times, such advise causes a lot of pain and hardship. Investors should learn how to avoid such large losses when unprecedented events occur. Avoiding large losses in bad times is good both for our financial and physical health.
(2.) Common sense is not so common afterall.
After 5 years (2003-2007) of a boom, people started taking things for granted: that India will keep growing at 9% for the next 50 years, that capital will keep flowing in forever because our country is so great, that stocks will keep returning 25% per annum ad infinitum. Guess what? Trees dont grow to the skies. In the big boom, the GDP expanded at higher than historic rates, EPS bases became bigger. Inflation set in and interest rates rose higher. Common sense mandated that the future would not be anything like the past. Common sense mandated that growth will slow down and earnings growth will slow down. But who cares for acquiring common sense when dreams and hopes abound? And when past experience suggested that good times would stay forever. The person who acted with common sense would have been able to protect his/her wealth better than the others, including many experts who are not feeling all that rich anymore.
(3). The lesson we learn from history is that we learn nothing.
How many of us have seen past debacles? At least we have heard about them or read about them, if not experienced them. Be it the bull market in 1985 (VP Singh cut direct taxes), Harshad Mehta time in 1992, FII driven optimism (1994) or the technology bubble in 2000, large rises over short periods are unsustainable. In each bust, stock markets fell 50% or more. That is the very nature of capitalism. Sudden booms bring in their own problems which invariably lead to a reverse cycle. But in each boom we feel it is different. There are always very plausible and logical sounding reasons for why it is different each time. In reality, it never is different. Capitalism makes super-normal returns disappear in no time. To think otherwise is a folly.
While we can never exactly say when the cycle will reverse, we can say with confidence that it will. While I do believe that the Indian stock markets are in a secular bull phase, cyclical downturns are to be expected (unless there is a systemic collapse, in which case all bets are off) and one should be prepared for such.
So, in closing I would like to state a few things:
-Seek competant advise, not the advise that is dished out to the masses. If every expert gives the same advise, how many among them would truly be competant?
-Learn to sell. Selling is the key to outperformance
-Get real. Expect the unexpected and have a plan to deal with it if the unexpected comes about. Do not live in denial
-Above all, have a plan. Period! Much pain comes because people do not have an investing plan, but rather invest haphazardly.
Happy investing!
But first, let me apologise for what I am going to say next. I almost am tempted to say, "I told you so". Readers would have noticed the very cautious slant in my previous blogs and mails since March of this year. Of course, I never dreamt of such intensity, but I had sounded caution. So an apology is in order if I sound self-congratulatory here.
But what lessons can we, as investors, derive out of the current crisis? While there are many and I would like to highlight a few ones.
(1). The fault, dear Brutus, is not in our stars, But in ourselves, that we are underlings.
(William Shakespeare - Julius Caesar I.ii.)
No one has the ability to totally comprehend our economic world. The world is far too complex and has unimaginable linkages for us to get an idea of how one parameter would change what others and by how much. What started as a country specific (USA) problem in one sector of the economy (housing) has now become a world wide credit crisis that threatens to undermine the entire financial system of the world. First it was housing prices, then investment banks, then mortgage lenders to commercial banks to now trade financing (the latest is on letters of credit or LCs). All assets are getting decimated, stocks, commodities, real estate...except the US dollar and precious metals like Gold. Seemingly insulated countries like India are witnessing high linkages via capital flows.
The lesson to draw is that unexpected things do happen in the world, things that so beyond the ordinary that they change the future. While no one can really predict what and how intense such changes would be, it a wise idea to be aware that they can happen and more importantly, be prepared to protect your wealth or create wealth for yourself when such events occur.
The typical market expert has a standard advise. Hold stocks for the long run, or use a SIP to invest, etc. Such advise of ok in normal times. In extraordinary times, such advise causes a lot of pain and hardship. Investors should learn how to avoid such large losses when unprecedented events occur. Avoiding large losses in bad times is good both for our financial and physical health.
(2.) Common sense is not so common afterall.
After 5 years (2003-2007) of a boom, people started taking things for granted: that India will keep growing at 9% for the next 50 years, that capital will keep flowing in forever because our country is so great, that stocks will keep returning 25% per annum ad infinitum. Guess what? Trees dont grow to the skies. In the big boom, the GDP expanded at higher than historic rates, EPS bases became bigger. Inflation set in and interest rates rose higher. Common sense mandated that the future would not be anything like the past. Common sense mandated that growth will slow down and earnings growth will slow down. But who cares for acquiring common sense when dreams and hopes abound? And when past experience suggested that good times would stay forever. The person who acted with common sense would have been able to protect his/her wealth better than the others, including many experts who are not feeling all that rich anymore.
(3). The lesson we learn from history is that we learn nothing.
How many of us have seen past debacles? At least we have heard about them or read about them, if not experienced them. Be it the bull market in 1985 (VP Singh cut direct taxes), Harshad Mehta time in 1992, FII driven optimism (1994) or the technology bubble in 2000, large rises over short periods are unsustainable. In each bust, stock markets fell 50% or more. That is the very nature of capitalism. Sudden booms bring in their own problems which invariably lead to a reverse cycle. But in each boom we feel it is different. There are always very plausible and logical sounding reasons for why it is different each time. In reality, it never is different. Capitalism makes super-normal returns disappear in no time. To think otherwise is a folly.
While we can never exactly say when the cycle will reverse, we can say with confidence that it will. While I do believe that the Indian stock markets are in a secular bull phase, cyclical downturns are to be expected (unless there is a systemic collapse, in which case all bets are off) and one should be prepared for such.
So, in closing I would like to state a few things:
-Seek competant advise, not the advise that is dished out to the masses. If every expert gives the same advise, how many among them would truly be competant?
-Learn to sell. Selling is the key to outperformance
-Get real. Expect the unexpected and have a plan to deal with it if the unexpected comes about. Do not live in denial
-Above all, have a plan. Period! Much pain comes because people do not have an investing plan, but rather invest haphazardly.
Happy investing!
Thursday, September 18, 2008
Black Swan
Nassim Nicolas Taleb writes about 'Black Swans' in his book "The Black Swan".
For most of humanity people thought all swans were white in colour...till a black coloured swan was discovered in Australia.
Black swans, Taleb says, are low-probability high-impact events that are very consequential.
They are high impact events that cause a major shock, either positive or negative.
Black swans are inherently unpredictable. Our limited understanding on the world means we cannot predict when or where such events would take place. Of course, when they occur, in hindsight, they look so obvious that we wonder why no one thought them earlier.
For most days, the sacrificial lamb is well fed and looked after. The lamb continues to expect the future to be like the past. For most days this is true...until till the day the lamb is sacrificed. Most investors and experts alike expect the future to be more or less like the past. Till one day there is a black swan event that changes the course of the future.
Black Swan events can be positive as well as negative. A positive black swan is the internet. No body planned for the internet, we did not know what internet was before it came up, we did not know where or when the internet would develop and did not know how it would transform the world. A negative black swan was the world war 1 or the Great Depression in the 1930s.
What we are witnessing in the financial markets today in the USA is a black swan event. A huge negative black swan event that is changing the investment landscape, perhaps permanently, with huge implications for all world markets. Icons on Wall Street are going bust virtually every week. Stock markets are tumbling like nine pins and there is blood on the streets.
What does it mean for the Indian stock market?
1.) Generally, the current turmoil would mean a lot less money coming into countries like India. Maybe money would keep going out. Every rise might be sold into. Valuations for stocks are likely to to go down and stocks might get lower PE ratios in general.
2.) Investors should be prepared towards the possibility of black swans (both positive and negative). In terms of downsides, invest with protection. We have our cars insured, we buy life insurance, but most retail investors dont think about investment insurance or how to protect capital from major declines.
3.) Do not fall into the 'value' trap. The market is the final arbiter of value and in such an environment, there is no hurry to get in. Remember the time period from 2000-2002/3. The markets really tested the patience of investors while giving no returns.
4.) Return expectations from stocks will need to be reduced significantly. The fancy returns from stocks that we saw over the last 5 years are a thing of the past. There is still a lot of 'buy-on-dips' optimism out there.
5.) Do not think that India's great fundamentals will automatically mean good stock market performance in the longer run. Most analysts opine that fundamentals are great. This might be the case, or fundamentals might detoriate. In any event, the economy needs liquidity to grow, stocks need liquidity to perform. Foreign capital is in doubt. No athlete, however capable, can perform in an oxygen deficient environment.
Here is wishing you wise investing!
For most of humanity people thought all swans were white in colour...till a black coloured swan was discovered in Australia.
Black swans, Taleb says, are low-probability high-impact events that are very consequential.
They are high impact events that cause a major shock, either positive or negative.
Black swans are inherently unpredictable. Our limited understanding on the world means we cannot predict when or where such events would take place. Of course, when they occur, in hindsight, they look so obvious that we wonder why no one thought them earlier.
For most days, the sacrificial lamb is well fed and looked after. The lamb continues to expect the future to be like the past. For most days this is true...until till the day the lamb is sacrificed. Most investors and experts alike expect the future to be more or less like the past. Till one day there is a black swan event that changes the course of the future.
Black Swan events can be positive as well as negative. A positive black swan is the internet. No body planned for the internet, we did not know what internet was before it came up, we did not know where or when the internet would develop and did not know how it would transform the world. A negative black swan was the world war 1 or the Great Depression in the 1930s.
What we are witnessing in the financial markets today in the USA is a black swan event. A huge negative black swan event that is changing the investment landscape, perhaps permanently, with huge implications for all world markets. Icons on Wall Street are going bust virtually every week. Stock markets are tumbling like nine pins and there is blood on the streets.
What does it mean for the Indian stock market?
1.) Generally, the current turmoil would mean a lot less money coming into countries like India. Maybe money would keep going out. Every rise might be sold into. Valuations for stocks are likely to to go down and stocks might get lower PE ratios in general.
2.) Investors should be prepared towards the possibility of black swans (both positive and negative). In terms of downsides, invest with protection. We have our cars insured, we buy life insurance, but most retail investors dont think about investment insurance or how to protect capital from major declines.
3.) Do not fall into the 'value' trap. The market is the final arbiter of value and in such an environment, there is no hurry to get in. Remember the time period from 2000-2002/3. The markets really tested the patience of investors while giving no returns.
4.) Return expectations from stocks will need to be reduced significantly. The fancy returns from stocks that we saw over the last 5 years are a thing of the past. There is still a lot of 'buy-on-dips' optimism out there.
5.) Do not think that India's great fundamentals will automatically mean good stock market performance in the longer run. Most analysts opine that fundamentals are great. This might be the case, or fundamentals might detoriate. In any event, the economy needs liquidity to grow, stocks need liquidity to perform. Foreign capital is in doubt. No athlete, however capable, can perform in an oxygen deficient environment.
Here is wishing you wise investing!
Monday, September 8, 2008
Are we in an watershed moment?
Those who have been following the developments in the economies and the financial markets of the developed world, especially USA, would not fail to recognise that such developments might actually be some kind of watershed events. Some might even say that we are at an epochal moment in the investment world, just like the period after the Great Depression (1929), or the secular fall in interest rates (1982). These were events that changed the entire landscape of investing and meant new things for investments and returns therefrom.
The bursting of the housing bubble and the credit cruch, the boom in commodities and the ramifications it has for prices and inflation, the impact of the credit crunch on interest rates and on countries in need of (preferably cheap) capital (like India), the impacts of events such as these would need to be understood carefully as they unfold. There has been a confluence of a number of factors that threaten to change the characteristics of financial markets and our expectations from them.
We humans have our limitations. We rarely are able to see such changes while being a part of them. We cannot see a dislocation while being subject to it. For example, in 1930, no one expected the Great Depression to take place. In the early 1980s, the general expectation in the USA was that interest rates would remain high and stocks were a dead investment. By 2000, we thought that technology would revolutionise the world and technology stocks were cheap by any yardstick. By 2003, we were not able to see how a surge in liquidity would innundate asset markets worldover and bring about a boom in stocks, real estate, commodities, and other assets. Most people miss change as it occurs. It takes time for people to realise that change has occured.
We base our expectations of the future based on our experience of the past. So we assume, often linearly, that past trends will more or less continue into the future, sometimes naively, into the indefinate future. The world seldom works in a linear fashion. High impact transformational events happen unexpectedly to create a very different future. And major changes have occured in the developed world which would have serious impacts on the developing world.
What could it mean for The Indian stock market?
First, the era of cheap and easily available capital is over. India's GDP had shown what in my opinion was an above-potential growth of 9% over the last few years, on the back of copius amounts of foreign money flowing into the country (topping USD 110 billion, about 11% of our GDP in 2007). In the absence of such sums, growth is very likely to be lower than the lowered expectations of many people. A lower demand would mean a lower PE multiple for the stock markets.
People think that high interest rates will bite. They sure will. Add to that a much lower capital inflow will mean lower money available for projects and higher cost of capital and hence lower profits, especially for companies that require capital for growth. Earnings into the future would not be anywhere near what we have witnessed over the past few years.
Secondly, the currency weakening would mean more expensive imports and cheaper exports. While cheaper exports would mean a good thing, one should consider the slowing demand situation in the developed world which could nullify the advantage of cheaper exports.
Take into account the fact that stock valuations in general are not cheap though optimism for stocks for a longer period abounds. I still hear many voices saying how stocks will give good returns over 12 months plus time horizon. I would be vary since stocks would probably correct more than what we expect to make them cheap again. This could occur either by markets going down, or remaining sideways for a long period or both. There will not be that momentum money to drive our markets higher and higher even though at lower levels support might come in.
Many advisors are, in my opinion, guilty of forecasting past trends into the future. There have been instances in the past where returns from stocks for substantial periods ranging upto 3 years have been negative. Reasons were various, but the end result was that investors lost money. The current phase could just be one.
Optimism is good, but blind optimism with no regard to potential risks is foolish. Blindly relying on India's fundamentals and India's story is not sound investing. Blindly believing that stocks would give supernormal returns in your retirement account is being unrealistic.
The unfolding of current events leaves the future quite unclear. I do not know how it would unfold. Maybe the end game would make me look foolish and markets might do well. Or maybe not! In any event, I think it is better to wait and watch how the picture develops.
When times are tough and the environment uncertain, it is wise to risk little. You may walk through a jungle infested with wild animals and come out unharmed. Yet that very act is stupid. The downside to investing now is that you would lose money, much more than you could think. And at least lose the opportunity cost of 10-11% you can get on debt.
So trade by all means if you can trade. But for investing, the risk:reward ratio is not attractive.
PS: No analysis of the investing world can incorporate all data or make correct judgements all the time. Needless to say that my analysis could be wrong. You could make your own call.
The bursting of the housing bubble and the credit cruch, the boom in commodities and the ramifications it has for prices and inflation, the impact of the credit crunch on interest rates and on countries in need of (preferably cheap) capital (like India), the impacts of events such as these would need to be understood carefully as they unfold. There has been a confluence of a number of factors that threaten to change the characteristics of financial markets and our expectations from them.
We humans have our limitations. We rarely are able to see such changes while being a part of them. We cannot see a dislocation while being subject to it. For example, in 1930, no one expected the Great Depression to take place. In the early 1980s, the general expectation in the USA was that interest rates would remain high and stocks were a dead investment. By 2000, we thought that technology would revolutionise the world and technology stocks were cheap by any yardstick. By 2003, we were not able to see how a surge in liquidity would innundate asset markets worldover and bring about a boom in stocks, real estate, commodities, and other assets. Most people miss change as it occurs. It takes time for people to realise that change has occured.
We base our expectations of the future based on our experience of the past. So we assume, often linearly, that past trends will more or less continue into the future, sometimes naively, into the indefinate future. The world seldom works in a linear fashion. High impact transformational events happen unexpectedly to create a very different future. And major changes have occured in the developed world which would have serious impacts on the developing world.
What could it mean for The Indian stock market?
First, the era of cheap and easily available capital is over. India's GDP had shown what in my opinion was an above-potential growth of 9% over the last few years, on the back of copius amounts of foreign money flowing into the country (topping USD 110 billion, about 11% of our GDP in 2007). In the absence of such sums, growth is very likely to be lower than the lowered expectations of many people. A lower demand would mean a lower PE multiple for the stock markets.
People think that high interest rates will bite. They sure will. Add to that a much lower capital inflow will mean lower money available for projects and higher cost of capital and hence lower profits, especially for companies that require capital for growth. Earnings into the future would not be anywhere near what we have witnessed over the past few years.
Secondly, the currency weakening would mean more expensive imports and cheaper exports. While cheaper exports would mean a good thing, one should consider the slowing demand situation in the developed world which could nullify the advantage of cheaper exports.
Take into account the fact that stock valuations in general are not cheap though optimism for stocks for a longer period abounds. I still hear many voices saying how stocks will give good returns over 12 months plus time horizon. I would be vary since stocks would probably correct more than what we expect to make them cheap again. This could occur either by markets going down, or remaining sideways for a long period or both. There will not be that momentum money to drive our markets higher and higher even though at lower levels support might come in.
Many advisors are, in my opinion, guilty of forecasting past trends into the future. There have been instances in the past where returns from stocks for substantial periods ranging upto 3 years have been negative. Reasons were various, but the end result was that investors lost money. The current phase could just be one.
Optimism is good, but blind optimism with no regard to potential risks is foolish. Blindly relying on India's fundamentals and India's story is not sound investing. Blindly believing that stocks would give supernormal returns in your retirement account is being unrealistic.
The unfolding of current events leaves the future quite unclear. I do not know how it would unfold. Maybe the end game would make me look foolish and markets might do well. Or maybe not! In any event, I think it is better to wait and watch how the picture develops.
When times are tough and the environment uncertain, it is wise to risk little. You may walk through a jungle infested with wild animals and come out unharmed. Yet that very act is stupid. The downside to investing now is that you would lose money, much more than you could think. And at least lose the opportunity cost of 10-11% you can get on debt.
So trade by all means if you can trade. But for investing, the risk:reward ratio is not attractive.
PS: No analysis of the investing world can incorporate all data or make correct judgements all the time. Needless to say that my analysis could be wrong. You could make your own call.
Tuesday, August 26, 2008
Does investing in actively managed mutual funds make sense?
Actively managed mutual funds are supposed to beat their benchmark indices. If the index returns 10%, an actively managed mutual fund should return more than 10%. Similarly if the index loses 10%, the fund should lose less than 10%. You pay a small management fee to the mutual fund for managing your money and outperforming a benchmark index. Else why them money for their services; you could well buy an index fund which is passively managed.
For the uninitiated, in an actively managed fund, the fund manager creates a portfolio and buys and sells stocks depending upon his/her judgement, experience, ability and skill. In contrast, in a passive fund, the portfolio mimics a particular index, the stocks and the percentages in the portfolio are the same as those in the benchmarked index.
So do actively managed funds actually beat their respective indices?
Consider the Nifty-50 index that comprises 50 large cap stocks.
Over the last 3 years, the Nifty has risen at 23% compounded (as on 22 August 2008 day end).
Over the same period, only 22 out of 108 diversified equity funds that have existed for more than 3 years have given a return higher than 23%!
86 out of 108 funds have not been able to beat the Nifty index.
That's 80% of all such funds!
So why should the management fee be paid for managing money?
The percentage is similar for returns over 1 year. 82% (152 out of 184) diversified equity funds could not even garner a return of 5.1% given by the Nifty.
There are reasons for such underperformance. But the end result is, that over the last 3 years, 80% actively managed diversified mutual funds have not been able to beat the common index.
A similar trend exists in developed markets as well. For example, in the USA, 80% funds fail to beat their benchmark indices.
Mutual funds often become victims of their own success. When a particular fund outperforms, a lot of fresh money flows into it, chasing past performance. With larger assets under management, maintaining the same level of performance becomes difficult.
When mutual funds as an industry becomes too big, they tend to become a sizeable portion of the markets themselves. It then becomes difficult to beat the market since mutual funds start representing, in a very significant manner, the market itself!
Add to that the management fees and transaction costs. That takes away a little from the returns. At least in India, management fees are small. In the USA, this is not always the case.
The famous investor, John Bogle, an ardent advocate of index funds and does not think actively managed mutual funds can outperform an index over a long period of time.
In India, over the longer run, actively managed mutual funds have indeed beated the Nifty and the Sensex. For example, over the last 5 years, 41 out of 61 funds beat the Nifty returns. But one has to understand that mutual funds have proliferated in the last 3-4 years. There are only a handful of funds that have existed for over 10 years! Mutual funds that have a long history have been much smaller in size earlier. It is easier to beat an index with lesser capital under management. Size often becomes a hinderance for success.
For the uninitiated, in an actively managed fund, the fund manager creates a portfolio and buys and sells stocks depending upon his/her judgement, experience, ability and skill. In contrast, in a passive fund, the portfolio mimics a particular index, the stocks and the percentages in the portfolio are the same as those in the benchmarked index.
So do actively managed funds actually beat their respective indices?
Consider the Nifty-50 index that comprises 50 large cap stocks.
Over the last 3 years, the Nifty has risen at 23% compounded (as on 22 August 2008 day end).
Over the same period, only 22 out of 108 diversified equity funds that have existed for more than 3 years have given a return higher than 23%!
86 out of 108 funds have not been able to beat the Nifty index.
That's 80% of all such funds!
So why should the management fee be paid for managing money?
The percentage is similar for returns over 1 year. 82% (152 out of 184) diversified equity funds could not even garner a return of 5.1% given by the Nifty.
There are reasons for such underperformance. But the end result is, that over the last 3 years, 80% actively managed diversified mutual funds have not been able to beat the common index.
A similar trend exists in developed markets as well. For example, in the USA, 80% funds fail to beat their benchmark indices.
Mutual funds often become victims of their own success. When a particular fund outperforms, a lot of fresh money flows into it, chasing past performance. With larger assets under management, maintaining the same level of performance becomes difficult.
When mutual funds as an industry becomes too big, they tend to become a sizeable portion of the markets themselves. It then becomes difficult to beat the market since mutual funds start representing, in a very significant manner, the market itself!
Add to that the management fees and transaction costs. That takes away a little from the returns. At least in India, management fees are small. In the USA, this is not always the case.
The famous investor, John Bogle, an ardent advocate of index funds and does not think actively managed mutual funds can outperform an index over a long period of time.
In India, over the longer run, actively managed mutual funds have indeed beated the Nifty and the Sensex. For example, over the last 5 years, 41 out of 61 funds beat the Nifty returns. But one has to understand that mutual funds have proliferated in the last 3-4 years. There are only a handful of funds that have existed for over 10 years! Mutual funds that have a long history have been much smaller in size earlier. It is easier to beat an index with lesser capital under management. Size often becomes a hinderance for success.
Also, over the last 5 years, till 2005, midcap stocks that go seriously undervalued during the period 2000-2003, gained more than largecap stocks. Moreover, an economic upturn helps the performance of smaller companies more than those of larger companies.
Consequently, most funds outperformed the Nifty during the period 2003-2005.
Three years ago, actively managed mutual funds could easily have been declared superior to index fund investing. But in view of their recent underperformance compared to index investing, the jury on whether investing in actively managed mutual funds is better than passive index funds investing, is still out.
Only time will be the judge!
Thursday, August 21, 2008
Is the Indian stock market now cheap?
Has the Indian stock market become cheap after the fall this year?
But first, as I have said in the past, the concept of cheap or expensive depends upon the investor's time horizon and his/her return requirement. What is expensive for one investor can be cheap for another.
Having said that, sometimes we agree to some ballpark measure of cheap and expensive. So is the Indian stock market cheap now as many 'experts' and fund managers opine?
Here are some facts for you to decide yourself:
-As on 20 August 2008 closing, the BSE Sensex level was 14678 with a PE ratio of 18.22, Price:Book Value (PBV) at 3.80 and a dividend yield of 1.26%. All other things being equal, the lower the PE and PBV, the cheaper are stocks. The higher the dividend yield, again the cheaper are stocks.
-The corresponding figures for the Nifty 50 are 18.43, 4.02 and 1.27% respectively.
-The BSE 200 index comprising 200 stocks, had a PE of 18.52, PBV of 3.53 and Dividend Yield of 1.15%.
-Let us look at history to get an idea about this. Here is the data for the same during past lows:
Index: BSE 200
Date------------PE------PBV----Dividend Yield(%)
23 Oct 1998----10.74----1.2------2.68
24 Apr 2003----9.86----1.42-----3.42
17 May 2004---12.17----2.14-----2.6
11 Jun 2006----14.80---3.21-----1.75
20 Aug 2008---18.52---3.53-----1.15 (Current)
Compare this with the current valuations mentioned above.
Valuations seem twice as expensive as they were in April 2003. Ok, you might say that the frontline stocks are not cheap. How about the midcaps and small caps?
The NSE Midcap index quotes at a PE of 13.09. The PBV is 2.32 and a dividend yield at 1.64%. A PE of 13.09 does not seem expensive...looks cheap in fact!
Except that midcap companies are exactly that. They do better than large caps in good times and poorer during bad times.
To know what cheap really means, have a look at the same values for the same index in April 2003: PE = 6.28, PBV = 0.93, Dividend Yield = 4.67%!
So while the midcaps might have been very cheap in 2003, current valuations, though not expensive, are not as cheap and can get cheaper. Again, today midcaps are twice as expensive as they were in Apr 2003!
-The market capitalization (value of all stocks traded) of Indian stocks to GDP ratio (Market Cap:GDP ratio) currently stands at close to 1.1
-Market Cap:GDP ratio stood at 0.25 in April 2003, at 0.42 in May 2004, at 0.32 in March 1979
-The higher this ratio, the more richly stocks are valued.
Mutual fund managers and experts will have us believe anything. They give an example showing how the BSE sensex went up 18% compounded since 1979. So they advise people to buy stocks and mutual funds (so that they can get their Rs. 1 crore bonuses). They however forget that the starting point in 1979 was low (market cap:GDP = 0.32).
Had the market cap to GDP been 1.1 (current levels), Sensex in 1979 would have been at 340 and the compounded returns till date would have been 14% and not 18%! Still good, but much lesser than 18%.
Consider a few more facts:
-The period from 2003 onwards was characterised by low inflation and low interest rates. Inflation now is above 12%. High inflation is not good for stocks.
-The yield on a 10 Year Government of India security ranged between 5.8% to 7%. Currently it is close to 9.5%. Generally, PE values and interest rates are inversely related.
-High interest rates are not good for stocks. High interest rates reduce corporate earnings, slow down growth, make fixed income securities more attractive and hence reduce the attractiveness of stocks.
-The world is slowing down and so is the Indian economy
-Foreign money is the primary driver of Indian stock markets. From 2003 to 2007, the rupee appreciated from R.48/USD to Rs.39/USD, an appreciation of 23%. This added to the gains of foreign investors. This year alone, the rupee has depreciated more than 10%, adding to losses of foreign investors.
-India has a large trade deficit. With high oil prices, the deficit has widened and is unlikely to be filled up by a net capital inflows. A net negative balance puts downward pressure on our currency, making it depreciate and hence a poor choice for foreign investors. Also, unlike China, a large chunk of our foreign reserves are not owned by us but is kept on behalf of foreigners.
-India has a large fiscal deficit (including the off balance sheet items like oil bonds). A high fiscal deficit tends to push up government borrowing and hence push up interest rates, not good for companies and stocks. With a world credit crisis and foreign money unlikely to be available as easily as earlier, it could well 'crowd out' some private investment and cause further slowing down in the economy.
-With the bursting of a long 25 year credit bubble in the developed world, things for the investing arena have changed. Credit is unlikely to be anywhere as free or cheap in the coming years. Tremendous changes are occuring in the developed countries, particularly USA, which is altering the investing landscape. It is not wise to extrapolate past trends blindly into the future.
-Stocks had a wonderful environment to perform over the last few years. High growth, low interest rates, low inflation, cheap credit, excess capacities, all contributed to a the superior performance of stocks. Good times do not last forever (neither do bad times) and conditions now are the reverse of earlier ones.
There is a Chinese saying that goes something like this: "There is a time to cast your net and there is a time to dry your net."
The time for fishing got over when storms appreared earlier this year. The time to go fishing again has, in my opinion, not yet arrived. It is time to dry you nets, wait for the storm to blow over and for the fish to come back closer to your shores.
But first, as I have said in the past, the concept of cheap or expensive depends upon the investor's time horizon and his/her return requirement. What is expensive for one investor can be cheap for another.
Having said that, sometimes we agree to some ballpark measure of cheap and expensive. So is the Indian stock market cheap now as many 'experts' and fund managers opine?
Here are some facts for you to decide yourself:
-As on 20 August 2008 closing, the BSE Sensex level was 14678 with a PE ratio of 18.22, Price:Book Value (PBV) at 3.80 and a dividend yield of 1.26%. All other things being equal, the lower the PE and PBV, the cheaper are stocks. The higher the dividend yield, again the cheaper are stocks.
-The corresponding figures for the Nifty 50 are 18.43, 4.02 and 1.27% respectively.
-The BSE 200 index comprising 200 stocks, had a PE of 18.52, PBV of 3.53 and Dividend Yield of 1.15%.
-Let us look at history to get an idea about this. Here is the data for the same during past lows:
Index: BSE 200
Date------------PE------PBV----Dividend Yield(%)
23 Oct 1998----10.74----1.2------2.68
24 Apr 2003----9.86----1.42-----3.42
17 May 2004---12.17----2.14-----2.6
11 Jun 2006----14.80---3.21-----1.75
20 Aug 2008---18.52---3.53-----1.15 (Current)
Compare this with the current valuations mentioned above.
Valuations seem twice as expensive as they were in April 2003. Ok, you might say that the frontline stocks are not cheap. How about the midcaps and small caps?
The NSE Midcap index quotes at a PE of 13.09. The PBV is 2.32 and a dividend yield at 1.64%. A PE of 13.09 does not seem expensive...looks cheap in fact!
Except that midcap companies are exactly that. They do better than large caps in good times and poorer during bad times.
To know what cheap really means, have a look at the same values for the same index in April 2003: PE = 6.28, PBV = 0.93, Dividend Yield = 4.67%!
So while the midcaps might have been very cheap in 2003, current valuations, though not expensive, are not as cheap and can get cheaper. Again, today midcaps are twice as expensive as they were in Apr 2003!
-The market capitalization (value of all stocks traded) of Indian stocks to GDP ratio (Market Cap:GDP ratio) currently stands at close to 1.1
-Market Cap:GDP ratio stood at 0.25 in April 2003, at 0.42 in May 2004, at 0.32 in March 1979
-The higher this ratio, the more richly stocks are valued.
Mutual fund managers and experts will have us believe anything. They give an example showing how the BSE sensex went up 18% compounded since 1979. So they advise people to buy stocks and mutual funds (so that they can get their Rs. 1 crore bonuses). They however forget that the starting point in 1979 was low (market cap:GDP = 0.32).
Had the market cap to GDP been 1.1 (current levels), Sensex in 1979 would have been at 340 and the compounded returns till date would have been 14% and not 18%! Still good, but much lesser than 18%.
Consider a few more facts:
-The period from 2003 onwards was characterised by low inflation and low interest rates. Inflation now is above 12%. High inflation is not good for stocks.
-The yield on a 10 Year Government of India security ranged between 5.8% to 7%. Currently it is close to 9.5%. Generally, PE values and interest rates are inversely related.
-High interest rates are not good for stocks. High interest rates reduce corporate earnings, slow down growth, make fixed income securities more attractive and hence reduce the attractiveness of stocks.
-The world is slowing down and so is the Indian economy
-Foreign money is the primary driver of Indian stock markets. From 2003 to 2007, the rupee appreciated from R.48/USD to Rs.39/USD, an appreciation of 23%. This added to the gains of foreign investors. This year alone, the rupee has depreciated more than 10%, adding to losses of foreign investors.
-India has a large trade deficit. With high oil prices, the deficit has widened and is unlikely to be filled up by a net capital inflows. A net negative balance puts downward pressure on our currency, making it depreciate and hence a poor choice for foreign investors. Also, unlike China, a large chunk of our foreign reserves are not owned by us but is kept on behalf of foreigners.
-India has a large fiscal deficit (including the off balance sheet items like oil bonds). A high fiscal deficit tends to push up government borrowing and hence push up interest rates, not good for companies and stocks. With a world credit crisis and foreign money unlikely to be available as easily as earlier, it could well 'crowd out' some private investment and cause further slowing down in the economy.
-With the bursting of a long 25 year credit bubble in the developed world, things for the investing arena have changed. Credit is unlikely to be anywhere as free or cheap in the coming years. Tremendous changes are occuring in the developed countries, particularly USA, which is altering the investing landscape. It is not wise to extrapolate past trends blindly into the future.
-Stocks had a wonderful environment to perform over the last few years. High growth, low interest rates, low inflation, cheap credit, excess capacities, all contributed to a the superior performance of stocks. Good times do not last forever (neither do bad times) and conditions now are the reverse of earlier ones.
There is a Chinese saying that goes something like this: "There is a time to cast your net and there is a time to dry your net."
The time for fishing got over when storms appreared earlier this year. The time to go fishing again has, in my opinion, not yet arrived. It is time to dry you nets, wait for the storm to blow over and for the fish to come back closer to your shores.
Friday, August 1, 2008
Have Crude Oil prices peaked out?
Crude oil, which seems to be the bug bear of most world economies and stock markets, has corrected from its high of around US $148 to about US $118.
Many believed that such high crude oil prices were unsustainable and crude was in a bubble. So their faith in their views seems to have been vindicated.
So has crude oil made an eventual top and has its price peaked out?
First some quick fundamentals that are known to everyone:
On the demand side:
-North America and Europe account for about half of the total oil consumption in the world.
-Asia and Middle east account for about 30% of the total oil consumption.
-But Asia and Middle East contribute 60% to the increase in demand for oil while North America and Europe contribute 20%. Clearly, additional demand is coming from Asia and Middle East.
-China consumes about 7.7 million barrels of oil per day, and growing at 7%
-India consumes about 2.75 million barrels of oil per day, and growing at 5%
-Together, the 2 countries consume 10.5 million barrels per day and growing at 6.5% per annum.
-Oil consumption is seeking higher levels, mainly on account of developing countries.
On the supply side:
-World production is declining. Almost all oil fields are in decline. USA, Saudi, Iran, UK, Russia, Mexico, Indonesia, are facing production constraints. Countries like Nigeria are facing security issues. It is estimated that the total production is now going down at the rate of about 3 million barrels/day.
-There has not been a single large oil field that has been discovered in over 30 years.
-World oil production in 2007 was 84.6 million barrels per day, less by 30000 produced in 2005. -Crude oil production is lower than oil consumption.
-Excess 0il demand is being met by reduction in stockpiles.
-And a small amount comes from ethanol.
-Oil produced by current technology is on the wane. Someone will have to find a new oilfield pretty quickly to keep pace with demand.
So demand is high and rising. Supply is falling quite rapidly.
Of course, everyone is aware of this. And prices have already gone sky high moving up from about US $100 at the begining of the year.
Also, shouldn't higher prices drive down demand?
Yes, they would. Some demand destruction will take place on account of higher prices.
But only in countries where oil is freely priced.
In countries like India, where prices are administered, retail prices do not reflect the scarcity value of oil. Hence demand is unlikely to come down.
Across Asia, prices are controlled.
Hence demand from this region will keep rising.
As an example, the US consumes about 20 million barrels of oil per day. A 5% decline in oil consumption is equivalent to less than 2 years' increase in oil demand from China and India alone!
What about alternative sources of energy? Will we not have substitution?
Yes, we will. But it will take time.
It takes time for habits to change.
We change our habits when pain is intense.
And right now, the pain is not intense.
And nothing major seems to be on the horizon currently.
So over the long run, demand is seen outstripping supply significantly.
We do not have an alternative in the pipeline.
But is all of this already discounted in the price? Have we seen the peak for oil prices?
I don't think so.
First, commodity bubbles do not end like this.
There is a lot of buying before the end.
Most people get convinced that high prices are here to stay. Currently there are many skeptics who might think that we are in a bubble.
A lot of investment starts pouring into the sector.
Investors are gung ho about the prospects of the asset under consideration.
Prices stay high for a long period before starting their move down.
There is intense pain for those badly affected by high prices.
We have not seen such signs yet. Prices have come off their highs pretty quickly.
A look at the charts suggests that oil has a long way to go. Sure, in the short term, prices can come down significantly. Which, if they do, will lull everyone into a sense of comfort. And things will keep moving nicely for a while.
But over the long run, prices are very likely to rise.
To what levels is impossible to say.
My sense is that they will be much higher than recent highs.
The world faced a similar oil shock in the decade of the 1970s.
Oil went up from about US $1.5/barrel to US $42/barrel, a rise of 28 times.
And India and China (with their now 2.3+ billion population) were very marginal consumers unlike today where they consume one eight of total consumption.
Oil is in a secular bull market.
It peaked out at UD $42 in 1981.
A secular bear market ensued for oil from 1981 to its low in 1999 at US $11.
Thereafter it started another secular bull phase.
It has gone up 13 times till its peak in its current phase.
Can it go up 19 times to US $200? Sure it can over time.
Can it go higher still? Sure it can.
When a bubble forms, no prices seems too high.
Till the bubble bursts.
So my sense is that we have not yet seen the ultimate highs for crude oil.
Unless someone finds a large oil field quickly, something not achieved for over 30 years.
Unless someone finds out a profitable method of extracting shale oil.
Unless someone finds a quick alternative to oil as energy.
At some stage we could see oil back to US $50.
But that, in my opinion, would be after we have seen it at much higher levels.
So is oil a buy on dips? Or perhaps oil stocks?
Many believed that such high crude oil prices were unsustainable and crude was in a bubble. So their faith in their views seems to have been vindicated.
So has crude oil made an eventual top and has its price peaked out?
First some quick fundamentals that are known to everyone:
On the demand side:
-North America and Europe account for about half of the total oil consumption in the world.
-Asia and Middle east account for about 30% of the total oil consumption.
-But Asia and Middle East contribute 60% to the increase in demand for oil while North America and Europe contribute 20%. Clearly, additional demand is coming from Asia and Middle East.
-China consumes about 7.7 million barrels of oil per day, and growing at 7%
-India consumes about 2.75 million barrels of oil per day, and growing at 5%
-Together, the 2 countries consume 10.5 million barrels per day and growing at 6.5% per annum.
-Oil consumption is seeking higher levels, mainly on account of developing countries.
On the supply side:
-World production is declining. Almost all oil fields are in decline. USA, Saudi, Iran, UK, Russia, Mexico, Indonesia, are facing production constraints. Countries like Nigeria are facing security issues. It is estimated that the total production is now going down at the rate of about 3 million barrels/day.
-There has not been a single large oil field that has been discovered in over 30 years.
-World oil production in 2007 was 84.6 million barrels per day, less by 30000 produced in 2005. -Crude oil production is lower than oil consumption.
-Excess 0il demand is being met by reduction in stockpiles.
-And a small amount comes from ethanol.
-Oil produced by current technology is on the wane. Someone will have to find a new oilfield pretty quickly to keep pace with demand.
So demand is high and rising. Supply is falling quite rapidly.
Of course, everyone is aware of this. And prices have already gone sky high moving up from about US $100 at the begining of the year.
Also, shouldn't higher prices drive down demand?
Yes, they would. Some demand destruction will take place on account of higher prices.
But only in countries where oil is freely priced.
In countries like India, where prices are administered, retail prices do not reflect the scarcity value of oil. Hence demand is unlikely to come down.
Across Asia, prices are controlled.
Hence demand from this region will keep rising.
As an example, the US consumes about 20 million barrels of oil per day. A 5% decline in oil consumption is equivalent to less than 2 years' increase in oil demand from China and India alone!
What about alternative sources of energy? Will we not have substitution?
Yes, we will. But it will take time.
It takes time for habits to change.
We change our habits when pain is intense.
And right now, the pain is not intense.
And nothing major seems to be on the horizon currently.
So over the long run, demand is seen outstripping supply significantly.
We do not have an alternative in the pipeline.
But is all of this already discounted in the price? Have we seen the peak for oil prices?
I don't think so.
First, commodity bubbles do not end like this.
There is a lot of buying before the end.
Most people get convinced that high prices are here to stay. Currently there are many skeptics who might think that we are in a bubble.
A lot of investment starts pouring into the sector.
Investors are gung ho about the prospects of the asset under consideration.
Prices stay high for a long period before starting their move down.
There is intense pain for those badly affected by high prices.
We have not seen such signs yet. Prices have come off their highs pretty quickly.
A look at the charts suggests that oil has a long way to go. Sure, in the short term, prices can come down significantly. Which, if they do, will lull everyone into a sense of comfort. And things will keep moving nicely for a while.
But over the long run, prices are very likely to rise.
To what levels is impossible to say.
My sense is that they will be much higher than recent highs.
The world faced a similar oil shock in the decade of the 1970s.
Oil went up from about US $1.5/barrel to US $42/barrel, a rise of 28 times.
And India and China (with their now 2.3+ billion population) were very marginal consumers unlike today where they consume one eight of total consumption.
Oil is in a secular bull market.
It peaked out at UD $42 in 1981.
A secular bear market ensued for oil from 1981 to its low in 1999 at US $11.
Thereafter it started another secular bull phase.
It has gone up 13 times till its peak in its current phase.
Can it go up 19 times to US $200? Sure it can over time.
Can it go higher still? Sure it can.
When a bubble forms, no prices seems too high.
Till the bubble bursts.
So my sense is that we have not yet seen the ultimate highs for crude oil.
Unless someone finds a large oil field quickly, something not achieved for over 30 years.
Unless someone finds out a profitable method of extracting shale oil.
Unless someone finds a quick alternative to oil as energy.
At some stage we could see oil back to US $50.
But that, in my opinion, would be after we have seen it at much higher levels.
So is oil a buy on dips? Or perhaps oil stocks?
Wednesday, July 30, 2008
The silver lining in rising interest rates
The RBI hiked the repo rate (by 0.5%) and the CRR (by 0.25%) yesterday.
For those who might not know, simply put, the repo rate is the short-term interest rate at which the RBI lends to banks. The Cash Reserve Ratio (CRR) is the percentage of bank deposits that the bank have to maintain in cash.
A higher CRR means less money available for lending and hence lesser money in the economy. A higher interest rate means lower demand for credit. Both measures are meant to contain demand and hence bring down inflation.
The RBI move appeared to have surprised most market watchers. After all, the argument went, the RBI has very recently raised repo rates and the CRR, the impact of which would be felt in some time to come. So most people thought that the RBI would wait and watch before it decides what to do next.
I wonder why people were surprised. Inflation was clearly much above the RBI's comfort zone, having reached 13 year highs. Credit growth was still above RBI objectives. After the UPA won the confidence vote in the parliament, its focus would have clearly been on killing inflation. Those who follow the current RBI governor, Dr. Reddy, would have known how he operates. So a rate hike and a CRR hike was to be expected...and I think it will continue for a while unless something changes drastically that brings down inflation.
So less money and higher interest rates will have an impact on the economy. Growth is likely to slow down further, especially after 5 years of fantastic growth rates, as the tightening measures come through. Corporate earnings growths would also come down as will their stock prices. Not good news if you are an equity investor.
But there is a silver lining in all these rate hikes. Continuing interest rate hikes will make stock valuations very cheap sometime down the road. At some point, inflation will (hopefully) turn around and head down. Interest rates will also head down concomittantly. And that would provide a fillip to the stock markets. So, patient investors can wait for stocks to become really cheap to buy.
A similar process happened in USA in the early 1980s. Inflation went up to as high at 12% in the USA and the economy was hurting. It was the then Federal Reserve Governor (equivalent to our RBI governor), Paul Volker, who kept raising interest rates and brought down inflation (which was followed by drop in interest rates). What ensued was a 18 year mega bull market (because of many other factors as well) in the USA till the 2000 technology bubble.
So wait patiently and watch for stocks to become cheap again...
For those who might not know, simply put, the repo rate is the short-term interest rate at which the RBI lends to banks. The Cash Reserve Ratio (CRR) is the percentage of bank deposits that the bank have to maintain in cash.
A higher CRR means less money available for lending and hence lesser money in the economy. A higher interest rate means lower demand for credit. Both measures are meant to contain demand and hence bring down inflation.
The RBI move appeared to have surprised most market watchers. After all, the argument went, the RBI has very recently raised repo rates and the CRR, the impact of which would be felt in some time to come. So most people thought that the RBI would wait and watch before it decides what to do next.
I wonder why people were surprised. Inflation was clearly much above the RBI's comfort zone, having reached 13 year highs. Credit growth was still above RBI objectives. After the UPA won the confidence vote in the parliament, its focus would have clearly been on killing inflation. Those who follow the current RBI governor, Dr. Reddy, would have known how he operates. So a rate hike and a CRR hike was to be expected...and I think it will continue for a while unless something changes drastically that brings down inflation.
So less money and higher interest rates will have an impact on the economy. Growth is likely to slow down further, especially after 5 years of fantastic growth rates, as the tightening measures come through. Corporate earnings growths would also come down as will their stock prices. Not good news if you are an equity investor.
But there is a silver lining in all these rate hikes. Continuing interest rate hikes will make stock valuations very cheap sometime down the road. At some point, inflation will (hopefully) turn around and head down. Interest rates will also head down concomittantly. And that would provide a fillip to the stock markets. So, patient investors can wait for stocks to become really cheap to buy.
A similar process happened in USA in the early 1980s. Inflation went up to as high at 12% in the USA and the economy was hurting. It was the then Federal Reserve Governor (equivalent to our RBI governor), Paul Volker, who kept raising interest rates and brought down inflation (which was followed by drop in interest rates). What ensued was a 18 year mega bull market (because of many other factors as well) in the USA till the 2000 technology bubble.
So wait patiently and watch for stocks to become cheap again...
Tuesday, July 29, 2008
Is this reform?
The UPA government survived the vote of confidence in the Lok Sabha
Hopes have been raised that there would now be more reforms since the left parties no longer can hobble the government.
So the stock markets rallied (maybe) on the back of such hopes.
Business channels have been discussing whether foreign ownership in Indian insurance companies will now be increased to 49%.
Or whether voting reforms or foreign stake increase reforms in Indian banks will go through.
What is the reform in this?
What reform occurs if foreign insurance companies own 49% stake rather than 26%?
What enhanced processes and knowledge does a 49% stake bring in that a 26% stake does not bring in?
Is the additional capital not available in India?
And what about banking reform?
We all are witnessing how foreign banks took unmanageable risks and lost billions of dollars in the USA and continue to lose more.
We are witnessing how there are now bank failures coming through in the developed world.
Are foreign banks really better than Indian banks?
We do need reform, real reform.
Allow public sector banks the ability to compete with private banks in all matters.
Give them total autonomy to run their operations
Reform the compensation structure to attract talent
Allow them to hire and fire depending upon market conditions
We need much more...
We need reform in oil PSUs
We need reform in LIC and GIC and other government isurance companies
We need reform in power
We need real reform, quickly.
Not just token measures that give, at best, marginal benefits...
Hopes have been raised that there would now be more reforms since the left parties no longer can hobble the government.
So the stock markets rallied (maybe) on the back of such hopes.
Business channels have been discussing whether foreign ownership in Indian insurance companies will now be increased to 49%.
Or whether voting reforms or foreign stake increase reforms in Indian banks will go through.
What is the reform in this?
What reform occurs if foreign insurance companies own 49% stake rather than 26%?
What enhanced processes and knowledge does a 49% stake bring in that a 26% stake does not bring in?
Is the additional capital not available in India?
And what about banking reform?
We all are witnessing how foreign banks took unmanageable risks and lost billions of dollars in the USA and continue to lose more.
We are witnessing how there are now bank failures coming through in the developed world.
Are foreign banks really better than Indian banks?
We do need reform, real reform.
Allow public sector banks the ability to compete with private banks in all matters.
Give them total autonomy to run their operations
Reform the compensation structure to attract talent
Allow them to hire and fire depending upon market conditions
We need much more...
We need reform in oil PSUs
We need reform in LIC and GIC and other government isurance companies
We need reform in power
We need real reform, quickly.
Not just token measures that give, at best, marginal benefits...
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