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!
Sunday, October 12, 2008
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...
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