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!
Thursday, September 18, 2008
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.
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