“The human brain is incapable of conceptualizing something vastly different from what it is today. But the big-money ideas are those where the changes are far beyond what you can conceive today. The closer you can get to conceiving those types of changes and the higher the probability they might happen, the more likely you are to find big winners.” - Lisa Rapuano, Matador Capital Management, Value Investor Insight– September 28, 2005.
Bill Miller’s 3Q commentary is a must read. Miller highlights Michael Mauboussin’s new book, Think Twice, to explain the concept of “inside” view and “outside” view in investing. The inside view considers a problem by focusing on the specific task and by using information that is close at hand. The outside view asks if there are similar situations that can provide a statistical basis for making a decision. The outside view wants to know if others have faced comparable problems, and if so, what happened. It’s an unnatural way to think because it forces people to set aside the information they have gathered.
Says Miller, “……Think Twice, the opening chapter tells the story of Big Brown, the super looking colt who’d won such impressive victories in the Kentucky Derby and the Preakness, the first two legs of racing’s Triple Crown. This is a story with a lesson that directly relates to investing, and to understanding the kind of recovery that appears to be getting underway in the U.S. economy. After winning all 5 of his starts by a combined total of almost 40 lengths, Big Brown was a 3-10 favorite to win the Belmont Stakes and become the first horse in 30 years to win the Triple Crown. Those odds indicated the “wisdom of crowds” putting a 77% probability on Big Brown’s winning the race and making horse racing history. Part of that was right: he did make horse racing history — by being the only horse to win the first two legs of the Triple Crown and finish last in the Belmont. That so many were so sure of Big Brown’s success was due to a common analytical error that manifests itself in investing as well as horse racing. That error is the neglect of base rates. Psychologists call it the “inside” view, in contrast to the “outside” view. In the case of Big Brown, taking the outside view would be to see how many horses in the past had won the first two legs of the Triple Crown and then went on to win the third. The inside view focused on Big Brown, his history, the competition he faced, the tracks he ran on and their condition, his time between races, and so on.
The outside view revealed that 29 horses had won the first two races of the Triple Crown in the 130 years it had been run, with 11 of those horses going on to win the third race. Parsing the data a little more finely showed a remarkable divergence in winning percentages. Before 1950, 8 of the 9 horses that had a shot at the Triple Crown won it. After 1950, only 3 of 20 were successful. Moreover, when Big Brown’s speed ratings were compared to the most recent 6 Triple Crown contenders (and not just to his competition in the race), he was the slowest by a wide margin. If those who were betting on the Belmont had used the outside view instead of the inside view, no one would have believed what everyone did believe, that Big Brown had a nearly 80% chance to win the Belmont.
Investors are faced with these sorts of problems constantly: if I put my money in bonds now, what rate of return should I expect over the next 5 or 10 years? What is the outlook for stocks over the next 12 months? What are the chances of a significant rise in inflation over the next few years? What kind of economic recovery will we have? Should I fire my active money manager and replace him with a passive index product? What are the chances we have a “double-dip” recession? And on and on. Faced with these sorts of questions, most people default to the inside view, and then augment its flaws with the usual assortment of behavioral biases long known to psychologists: they anchor on the most recent experience, they assume instances are representative of deeper patterns, they give more weight to vivid examples or dramatic outcomes, they place twice the weight on a dollar lost as on a dollar gained, etc. The financial crisis that is now abating has created a near perfect environment for the admixture of all of the above, and that is perhaps why what Nobel winning economist Ken Arrow called the “clouds of vagueness” seem particularly thick and forbidding just now. Taking the outside view on some of the issues facing investors won’t make an inherently unknowable future predictable, but it can improve the odds of getting things right, or getting fewer things wrong.”
An intriguing post in Moneycontrol board is worth a read and re-read, “If your money doubles every five years, the compounded return that you are earning on your investment is somewhere close to 15%. Similarly, if it is doubling in every four years, the compounded return is in the vicinity of 19%. Have you ever wondered how long it will take to double your money if the interest rate is as low as 0.01%? Well, you don’t have to do the math. We will save you the effort and let you know that it will take all of 6,932 years! Yes, you’ve read that right. It will take a mammoth 6,932 years to double your money if you are earning a return of 0.01%.While this may seem like a joke to you, people invested in the US money market instruments currently are earning just that, a paltry return of 0.01%. Bill Gross, who runs the world’s biggest bond fund at PIMCO, believes that it is the measly return in the US that is driving investors towards higher yielding asset classes like gold and emerging markets. But can the US Fed continue maintaining short term interest rates at such low levels, especially given the fact that the specter of bubbles is being raised in most high yielding asset classes? Indeed, says Bill Gross. According to him, Fed’s foremost worry is the recovery of the US economy. Unless the US economy recovers and its employment scenario improves dramatically, Fed will continue to hold interest rates close to zero, asset bubbles or no asset bubbles. Gross is also of the opinion that once China starts letting its currency appreciate, which it would in about six months time, asset prices might come down and hence, the US Fed should not be hasty in its decision to tighten monetary policies and put the fledgling recovery under further pressure.”
If you want to read the Chinese argument on not letting the Yuan appreciate this year and why it will allow the currency to appreciate next year, read the latest Economist article here. “…….Beijing rejects the accusation that its exchange-rate policy has given it an unfair advantage. It is true that other emerging-market currencies have risen sharply this year, but this ignores the full picture. Last year China held its currency steady against the dollar throughout the global financial crisis, while others tumbled. Since the start of 2008, the yuan has actually risen against every currency except the yen……….Nevertheless, in the long run, a stronger yuan would benefit China’s economy—and the world’s—by helping shift growth from investment and exports towards consumption. It would boost consumers’ purchasing power and squeeze corporate profits, which have accounted for most of the increase in China’s excessive domestic saving in recent years. China will probably allow the yuan to start rising again early next year. This will not be the result of foreign lobbying—indeed, China is more likely to change its policy if foreign policymakers shut up. But by early next year China’s exports should be growing again, its year-on-year GDP growth could be close to 10%, and its inflation rate will have turned positive. The arguments in favour of revaluation will then loom much larger.”
Another interesting article in Economist asks the recurrent question-- central banks are wrong to keep rates low, or markets are wrong to expect recovery? “LIKE a truck rolling downhill, the rally in risky assets is proving hard to stop. Good economic news causes share prices to rise because it indicates the recovery is robust; bad economic news also causes prices to rise because it signals that central banks will keep interest rates near zero. Those low interest rates have probably been the main driver of the rally, encouraging investors to put their cash to work in search of higher returns. But other factors have been at play. Forecasts for corporate profits have been revised steadily upwards as analysts anticipate the benefits of economic recovery…Instead, the main threat to the rally seems likely to be disappointing growth, at least in the developed world…..At some point, the central dilemma at the heart of this rally will have to be resolved. Low interest rates seem like good news for investors. But why are central banks holding rates so low? Either they are correct in assessing that the economy is still fragile, in which case corporate profits will ultimately disappoint. Or they are underestimating the strength of the recovery, in which case inflationary pressures will start to emerge (and bond yields will rise sharply). Markets will have a tricky time navigating between this Scylla and Charybdis in 2010.”
George Cooper, author of ‘The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy’ interview in DnaIndia can be read from here. Coopers says that Central banks are not genuinely independent. They are in effect slaves to the developments in the markets. “Central banks say they must ignore asset prices and change in asset prices. If that is correct, why do they act when asset prices fall? They didn’t know that they were wrong to start with — they can’t know when the prices fall. The practical aspect as to why they do it is effectively the same answer as the previous question. They respond to falling asset prices because that leads to contracting credit, contracting economic activity, higher unemployment and intense political pressure. So central banks are acting, or trying, to continuously push credit into economies for political reasons. But of course the result of that if they are successful, they push the economy to get over-indebted, which is exactly what they shouldn’t be doing. It’s essentially a war between politics and good central banking……….. What I am saying is that we have now become so indebted in the West, that were we to try to pay off the debt in the conventional manner, the degree of economic contraction would be so severe that we would find ourselves in a situation like the 1930s, the Great Depression. The alternative is that we go into something like that 1970s, when we technically monetised the debt away to create inflation. Both of those scenarios are very bad. But the 1970s scenario is less bad than the 1930s. What concerns me, however, is that if we are going through that option, it is very important that we recognise the mistakes that led up to it. We must reform the system so we do not make the same mistakes again. And that’s basically why I wrote the book. My concern is that we are going into the endgame of monetising the debt without ever admitting to ourselves that’s how we got into the problem in the first place. So we will repeat the mistake again.”
Other good articles worth exploring are:
What if a Recovery Is All in Your Head?-Robert Shiller
The Phantom Menace-Paul Krugman
Monday, November 23, 2009
The “inside” view and the “outside” view
Tuesday, November 10, 2009
Liquidity- its benefits and pitfalls
Excess liquidity, its benefits and pitfalls, continue to remain at the centre-stage of debate amongst most intellectual illuminati, especially in the field of economics and finance. Below are highlighted two articles on the topic, one from Paul McCulley of PIMCO and other from Ruchir Sharma of Morgan Stanley. Happy Reading!
Paul McCulley’s (PIMCO) latest article is a must read. It will immediately struck a cord with those grounded in deep fundamental analysis. Mr. McCulley highlights the contradiction between what equity markets is currently discounting (V-shaped recovery) and treasury bond markets (U or W-shaped recovery) and explains that, although seemingly irrational, the tie that binds them is the Fed’s policy of "exceptionally low levels of the Federal funds rate for an extended period." Mr. McCulley also highlights that markets can stray quite far from "fundamentally justified" values if Fed maintains it current ultra-loose policies for an extended period and, ironically, the strongest case for risk assets holding their ground is that the big-V doesn't unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed.
Says Mr. MaCulley, “But, you retort, this can't go on forever – at some point, risk assets will have to capitulate to reality if the big-V does not unfold, no? Yes, but it is not quite as simple as that. Without the big-V, Treasuries will tend to bull flatten, soothed by rational expectations of an extended period of the Fed funds rate pinched against zero. In turn, such a path for Treasuries would provide valuation support for risk assets. How so? All risk asset prices are analytically the Net Present Value of expected growth in cash flows, discounted by the appropriate-duration risk-free rate plus a risk premium. Thus, expectations of a friendly-for-longer Fed policy would be supportive of risk assets, as they (1) tend to pull down long-duration risk-free rates, while also (2) pulling down the market-required risk premium (which moves inversely with investors' animal-spirited risk appetite, which moves inversely with fears of Fed tightening). To be sure, this fundamental valuation framework – known as the Gordon Model – also implies that in real terms, the positive P/E effect of low long-term risk-free rates is moderated to the extent that the non-big-V scenario also implies lower growth in real profits. There are no free lunches. But since real long-term Treasury rates trade in real time, while "new-normalized" real growth rates are uncertain, subject to animal-spirited conjecture, friendly real long-term interest rates will tend to dominate the formulation of P/Es. Thus, ironically, the biggest intermediate-term risk for risk assets is not that the big-V doesn't unfold, but that it does, inciting the Fed to bring the extended period of a near-zero policy rate to a close. But again, you retort, doesn't that imply that in the absence of the big-V, risk asset prices could levitate into bubble valuation space? Yes, it does mean that. And that is a very, very uncomfortable proposition for those grounded in fundamental analysis, as I am.”
Ruchir Sharma’s latest article in ET is worth pondering over as he talks how excess liquidity heading towards unproductive assets could derail the current market momentum. How? Mr. Sharma points out the significant increase in commodity price and explains that prices are unusual high at this stage of the economic cycle given that the underlying demand and supply fundamentals are still so weak. Thus, if Oil and other commodities (especially food items) continue their relentless march upwards led by liquidity rather than fundamentals, then we could see the Central Bankers tightening before current market expectation, which could be negative for equity markets. The aforesaid point once again reminds us that there is no point in chasing risky assets from current valuation levels.
Other key points from McCulley’s article that’s worth noting are:
• Thus, as we look forward, a huge amount of humility is warranted in projecting asset returns on the basis of tight bands around what "fundamentals" suggest constitute fair value. Yes, there is no substitute for fundamental analysis; it remains at the core of investment management. But asset values can stray far, very far, away from their putative "fair" levels, much, much further than was the case during the middle-aged years of the Great Moderation. The efficient market hypothesis may not be dead, but it is most assuredly in retreat.
• And the envelope between those two modes of theorizing is the fact that the future is inherently uncertain. That might not sound like a profound assertion, and it isn't. We all intuitively know that. But the efficient market hypothesis conveniently assumes away that reality, in what is technically called the "ergodic axiom" – that past and current relationships between variables are reliable predictors of future relationships between variables. This assumption holds in astronomy, which is why astronomers can forecast with incredible accuracy when the next lunar eclipse will unfold. This assumption also holds in calculating the risk of any given hand in a defined card game – there are 52 cards in the deck and it is quite possible to calculate with great precision the odds of winning the game, such as Blackjack or Poker. That doesn't mean that you can know with precision whether you will win, simply that you can forecast the odds of any given player winning, given the cards in their hands and other players' hands, in the context of what cards are left in the deck. Indeed, I find it amusing when television shows broadcasting such games flash up the odds of any player winning after each card is dealt. There is risk, but not uncertainty – we know there are 52 cards in the game and we know what constitutes a winning hand. The ergodic axiom holds. In investment markets, however, the ergodic axiom doesn't hold, even though it is implicitly assumed in the efficient market hypothesis (but ironically, not in the legal disclaimers of all investment presentations, which state that past results are not necessarily indicative of future results!). In investment markets, genuine uncertainty exists: We can't assume that we know how many cards will be in the future deck or what will constitute a winning hand. That's not risk, but rather uncertainty.
• And how do we deal with it? "Certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. How then are these highly significant daily, even hourly, revaluations of existing investments carried out in practice? In practice, we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – though it does not, of course, work out so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not really mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance; errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads us to absurdities. We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematically expectation. In point of fact, all sorts of considerations enter into market valuations which are in no way relevant to the prospective yield.
• Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention. For if there exist organized investment markets and if we can rely on maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence. Thus investment becomes reasonably 'safe' for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are 'fixed' for the community are thus made 'liquid' for the individual." Those few paragraphs, my friends, are the foundation of modern behavioral economics and finance. Human beings, including investment managers, face both risk and uncertainty, and deal with uncertainty by resorting to conventions, notably that yesterday is the best predictor of today, and that today is the best predictor of tomorrow. George Soros calls it reflexivity.
• But when that comforting convention is overwhelmed by a new reality, all hell breaks loose. Uncertainty can no longer be simply assumed away. And when that happens, human beings tend to disengage, eschewing investment in favor of building up cash reserves. And if this proclivity becomes both widespread and profound, we find ourselves in Keynes' Liquidity Trap – there is plenty of money around, but risk-averse investors, infected with uncertainty, refuse to "put it to work" – on either Wall Street or Main Street. Such was the case a year ago, following the fateful decision to let Lehman Brothers fall into a watery grave.
• We here at PIMCO think it will, but only in a muted way, not a big-V way. We also recognize, however, that markets can stray quite far from "fundamentally justified" values, if there is a strong belief in a friendly convention, one with staying power. And right now, that convention is a strong belief in a very friendly Fed for an extended period. Thus, the strongest case for risk assets holding their ground is, ironically, that the big-V doesn't unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed. Simply put, big-V'ers should be wary of what they wish for. U'ers, meanwhile, must be mindful of just how bubbly risk asset valuations can get, as long as non-big-V data unfold, keeping the Fed friendly. But that's no reason, in our view, to chase risk assets from currently lofty valuations. To the contrary, the time has come to begin paring exposure to risk assets, and if their prices continue to rise, paring at an accelerated pace.
Other key points from Mr. Sharma’s article that’s worth noting are:
• Oil and agricultural commodity prices typically tend to rise sharply during the late stages of an expansion when supply becomes tight following strong demand for many years. Commodity bulls spin the story that prices are rising due to relatively better growth prospects of China and other commodity-consuming emerging economies. Hard numbers just don’t back that claim: inventories for many commodities from aluminium to zinc are at multi-decade highs. Massive inflows of financial capital are propelling commodity prices higher as investors and speculators buy the asset class to just make an anti-dollar play or because cheap money has their speculative juices flowing.
• The US dollar and commodity prices have shared a very high degree of inverse correlation ever since the Fed started easing monetary policy in the second half of 2007 when global economic activity was at its peak as was the associated oil demand. The price of oil at that time was trading at around $70 a barrel. Oil prices then doubled between August 2007 and June 2008 due largely to speculation and the resultant monetary tightening by several central banks in developing economies arguably contributed to the global recession last year. It is incredible that oil and many other commodity prices are now trading well above the average price that prevailed during the 2003-07 economic boom even though demand is yet to recover. Global spare capacity is currently running at 8% and in the past, oil prices have only risen when spare capacity was below 5%. Indeed, world oil demand is set to contract in 2009 for the first time since 1983.
• A commodity price rally during the initial stages of the economic recovery was not in the script of policymakers. Food and energy prices — the biggest contributors to inflation in many countries — usually remain relatively low so early in an economic upturn. Central banks then do not have to worry about inflation until the recovery is well entrenched.
• During previous expansion phases in the US dating back to 1970, the stock market on an average rose 30% six months after hitting a bottom while commodity prices were more or less flat over that period. This time around, prices of metals and oil have risen by almost the same magnitude as the already outsized 50% jump in the US stock market from its March lows.
• Nearly $35 billion has flown into commodity Exchange Traded Funds or ETFs that are a popular way for investors to gain exposure to commodities. The number of commodity ETFs outstanding has surged to 12 million securities compared to just three million in February this year. Speculative turnover in the commodity markets is also huge. Estimates put the daily trading volume of futures contracts in the energy space at a staggering 15 times underlying demand. The norm, just five years ago, for trading volumes of various commodities was four to five times actual demand.
• It is remarkable to see how emboldened speculators in commodities have become all over again just a year after the rout they faced when the bubble burst. ‘Echo bubbles’ are hardly uncommon in history. In several instances bubbles in the same asset class have resurfaced shortly after the original boom-bust cycle as it takes a long time for an idea to die and easy money conditions created to deal with the slump often end up reflating the same old notion. However, echo bubbles typically tend to be of a lesser magnitude as the original bubble. While both policymakers and market participants are slow to learn lessons from their previous mistakes, they do not completely forget the painful consequences of the previous boom-bust experience, suggesting the current run up in commodity prices will not be anywhere as large as the move seen during the 2003-07 bubble phase. In addition, any surge in commodities has to be self-limiting.
• If the easy money-driven economic recovery rolls on in its present form then oil prices will soon be back at close to $100 a barrel. Such a price shock will be too much for the global economy to handle; oil close to $100 a barrel will have the same debilitating effect on consumer balance sheets as oil at $150 a barrel had last year. Consumer incomes in many economies have shrunk from when oil traded close to $150 a barrel; at $80 a barrel now, oil is already draining away more resources from consumer wallets than at most points in history and offsetting much of benefit from the stimulus plans. Food and energy account for one-third of the consumer basket in developing countries and with prices of various agricultural commodities from vegetables to sugar also joining the commodity party, inflation worries are surfacing rather prematurely in the economic recovery cycle.
• The concerted and vigorous actions of policymakers across the world to revive the global economy are now doing more to reflate asset prices rather than lift economic growth. The realisation that easy money alone cannot create economic growth and the adverse consequences of just pumping liquidity into the system are likely to dawn upon investors and policymakers alike in the months ahead.
Paul McCulley’s (PIMCO) latest article is a must read. It will immediately struck a cord with those grounded in deep fundamental analysis. Mr. McCulley highlights the contradiction between what equity markets is currently discounting (V-shaped recovery) and treasury bond markets (U or W-shaped recovery) and explains that, although seemingly irrational, the tie that binds them is the Fed’s policy of "exceptionally low levels of the Federal funds rate for an extended period." Mr. McCulley also highlights that markets can stray quite far from "fundamentally justified" values if Fed maintains it current ultra-loose policies for an extended period and, ironically, the strongest case for risk assets holding their ground is that the big-V doesn't unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed.
Says Mr. MaCulley, “But, you retort, this can't go on forever – at some point, risk assets will have to capitulate to reality if the big-V does not unfold, no? Yes, but it is not quite as simple as that. Without the big-V, Treasuries will tend to bull flatten, soothed by rational expectations of an extended period of the Fed funds rate pinched against zero. In turn, such a path for Treasuries would provide valuation support for risk assets. How so? All risk asset prices are analytically the Net Present Value of expected growth in cash flows, discounted by the appropriate-duration risk-free rate plus a risk premium. Thus, expectations of a friendly-for-longer Fed policy would be supportive of risk assets, as they (1) tend to pull down long-duration risk-free rates, while also (2) pulling down the market-required risk premium (which moves inversely with investors' animal-spirited risk appetite, which moves inversely with fears of Fed tightening). To be sure, this fundamental valuation framework – known as the Gordon Model – also implies that in real terms, the positive P/E effect of low long-term risk-free rates is moderated to the extent that the non-big-V scenario also implies lower growth in real profits. There are no free lunches. But since real long-term Treasury rates trade in real time, while "new-normalized" real growth rates are uncertain, subject to animal-spirited conjecture, friendly real long-term interest rates will tend to dominate the formulation of P/Es. Thus, ironically, the biggest intermediate-term risk for risk assets is not that the big-V doesn't unfold, but that it does, inciting the Fed to bring the extended period of a near-zero policy rate to a close. But again, you retort, doesn't that imply that in the absence of the big-V, risk asset prices could levitate into bubble valuation space? Yes, it does mean that. And that is a very, very uncomfortable proposition for those grounded in fundamental analysis, as I am.”
Ruchir Sharma’s latest article in ET is worth pondering over as he talks how excess liquidity heading towards unproductive assets could derail the current market momentum. How? Mr. Sharma points out the significant increase in commodity price and explains that prices are unusual high at this stage of the economic cycle given that the underlying demand and supply fundamentals are still so weak. Thus, if Oil and other commodities (especially food items) continue their relentless march upwards led by liquidity rather than fundamentals, then we could see the Central Bankers tightening before current market expectation, which could be negative for equity markets. The aforesaid point once again reminds us that there is no point in chasing risky assets from current valuation levels.
Other key points from McCulley’s article that’s worth noting are:
• Thus, as we look forward, a huge amount of humility is warranted in projecting asset returns on the basis of tight bands around what "fundamentals" suggest constitute fair value. Yes, there is no substitute for fundamental analysis; it remains at the core of investment management. But asset values can stray far, very far, away from their putative "fair" levels, much, much further than was the case during the middle-aged years of the Great Moderation. The efficient market hypothesis may not be dead, but it is most assuredly in retreat.
• And the envelope between those two modes of theorizing is the fact that the future is inherently uncertain. That might not sound like a profound assertion, and it isn't. We all intuitively know that. But the efficient market hypothesis conveniently assumes away that reality, in what is technically called the "ergodic axiom" – that past and current relationships between variables are reliable predictors of future relationships between variables. This assumption holds in astronomy, which is why astronomers can forecast with incredible accuracy when the next lunar eclipse will unfold. This assumption also holds in calculating the risk of any given hand in a defined card game – there are 52 cards in the deck and it is quite possible to calculate with great precision the odds of winning the game, such as Blackjack or Poker. That doesn't mean that you can know with precision whether you will win, simply that you can forecast the odds of any given player winning, given the cards in their hands and other players' hands, in the context of what cards are left in the deck. Indeed, I find it amusing when television shows broadcasting such games flash up the odds of any player winning after each card is dealt. There is risk, but not uncertainty – we know there are 52 cards in the game and we know what constitutes a winning hand. The ergodic axiom holds. In investment markets, however, the ergodic axiom doesn't hold, even though it is implicitly assumed in the efficient market hypothesis (but ironically, not in the legal disclaimers of all investment presentations, which state that past results are not necessarily indicative of future results!). In investment markets, genuine uncertainty exists: We can't assume that we know how many cards will be in the future deck or what will constitute a winning hand. That's not risk, but rather uncertainty.
• And how do we deal with it? "Certain classes of investment are governed by the average expectation of those who deal on the Stock Exchange as revealed in the price of shares, rather than by the genuine expectations of the professional entrepreneur. How then are these highly significant daily, even hourly, revaluations of existing investments carried out in practice? In practice, we have tacitly agreed, as a rule, to fall back on what is, in truth, a convention. The essence of this convention – though it does not, of course, work out so simply – lies in assuming that the existing state of affairs will continue indefinitely, except in so far as we have specific reasons to expect a change. This does not really mean that we really believe that the existing state of affairs will continue indefinitely. We know from extensive experience that this is most unlikely. The actual results of an investment over a long term of years very seldom agree with the initial expectation. Nor can we rationalize our behavior by arguing that to a man in a state of ignorance; errors in either direction are equally probable, so that there remains a mean actuarial expectation based on equi-probabilities. For it can easily be shown that the assumption of arithmetically equal probabilities based on a state of ignorance leads us to absurdities. We are assuming, in effect, that the existing market valuation, however arrived at, is uniquely correct in relation to our existing knowledge of the facts which will influence the yield of the investment, and that it will only change in proportion to changes in this knowledge; though, philosophically speaking, it cannot be uniquely correct, since our existing knowledge does not provide a sufficient basis for a calculated mathematically expectation. In point of fact, all sorts of considerations enter into market valuations which are in no way relevant to the prospective yield.
• Nevertheless the above conventional method of calculation will be compatible with a considerable measure of continuity and stability in our affairs, so long as we can rely on the maintenance of the convention. For if there exist organized investment markets and if we can rely on maintenance of the convention, an investor can legitimately encourage himself with the idea that the only risk he runs is that of a genuine change in the news over the near future, as to the likelihood of which he can attempt to form his own judgment, and which is unlikely to be large. For, assuming that the convention holds good, it is only these changes which can affect the value of his investment, and he need not lose his sleep merely because he has not any notion what his investment will be worth ten years hence. Thus investment becomes reasonably 'safe' for the individual investor over short periods, and hence over a succession of short periods however many, if he can fairly rely on there being no breakdown in the convention and on his therefore having an opportunity to revise his judgment and change his investment, before there has been time for much to happen. Investments which are 'fixed' for the community are thus made 'liquid' for the individual." Those few paragraphs, my friends, are the foundation of modern behavioral economics and finance. Human beings, including investment managers, face both risk and uncertainty, and deal with uncertainty by resorting to conventions, notably that yesterday is the best predictor of today, and that today is the best predictor of tomorrow. George Soros calls it reflexivity.
• But when that comforting convention is overwhelmed by a new reality, all hell breaks loose. Uncertainty can no longer be simply assumed away. And when that happens, human beings tend to disengage, eschewing investment in favor of building up cash reserves. And if this proclivity becomes both widespread and profound, we find ourselves in Keynes' Liquidity Trap – there is plenty of money around, but risk-averse investors, infected with uncertainty, refuse to "put it to work" – on either Wall Street or Main Street. Such was the case a year ago, following the fateful decision to let Lehman Brothers fall into a watery grave.
• We here at PIMCO think it will, but only in a muted way, not a big-V way. We also recognize, however, that markets can stray quite far from "fundamentally justified" values, if there is a strong belief in a friendly convention, one with staying power. And right now, that convention is a strong belief in a very friendly Fed for an extended period. Thus, the strongest case for risk assets holding their ground is, ironically, that the big-V doesn't unfold, because if it were to unfold, it would break the comforting conventional presumption of an extended friendly Fed. Simply put, big-V'ers should be wary of what they wish for. U'ers, meanwhile, must be mindful of just how bubbly risk asset valuations can get, as long as non-big-V data unfold, keeping the Fed friendly. But that's no reason, in our view, to chase risk assets from currently lofty valuations. To the contrary, the time has come to begin paring exposure to risk assets, and if their prices continue to rise, paring at an accelerated pace.
Other key points from Mr. Sharma’s article that’s worth noting are:
• Oil and agricultural commodity prices typically tend to rise sharply during the late stages of an expansion when supply becomes tight following strong demand for many years. Commodity bulls spin the story that prices are rising due to relatively better growth prospects of China and other commodity-consuming emerging economies. Hard numbers just don’t back that claim: inventories for many commodities from aluminium to zinc are at multi-decade highs. Massive inflows of financial capital are propelling commodity prices higher as investors and speculators buy the asset class to just make an anti-dollar play or because cheap money has their speculative juices flowing.
• The US dollar and commodity prices have shared a very high degree of inverse correlation ever since the Fed started easing monetary policy in the second half of 2007 when global economic activity was at its peak as was the associated oil demand. The price of oil at that time was trading at around $70 a barrel. Oil prices then doubled between August 2007 and June 2008 due largely to speculation and the resultant monetary tightening by several central banks in developing economies arguably contributed to the global recession last year. It is incredible that oil and many other commodity prices are now trading well above the average price that prevailed during the 2003-07 economic boom even though demand is yet to recover. Global spare capacity is currently running at 8% and in the past, oil prices have only risen when spare capacity was below 5%. Indeed, world oil demand is set to contract in 2009 for the first time since 1983.
• A commodity price rally during the initial stages of the economic recovery was not in the script of policymakers. Food and energy prices — the biggest contributors to inflation in many countries — usually remain relatively low so early in an economic upturn. Central banks then do not have to worry about inflation until the recovery is well entrenched.
• During previous expansion phases in the US dating back to 1970, the stock market on an average rose 30% six months after hitting a bottom while commodity prices were more or less flat over that period. This time around, prices of metals and oil have risen by almost the same magnitude as the already outsized 50% jump in the US stock market from its March lows.
• Nearly $35 billion has flown into commodity Exchange Traded Funds or ETFs that are a popular way for investors to gain exposure to commodities. The number of commodity ETFs outstanding has surged to 12 million securities compared to just three million in February this year. Speculative turnover in the commodity markets is also huge. Estimates put the daily trading volume of futures contracts in the energy space at a staggering 15 times underlying demand. The norm, just five years ago, for trading volumes of various commodities was four to five times actual demand.
• It is remarkable to see how emboldened speculators in commodities have become all over again just a year after the rout they faced when the bubble burst. ‘Echo bubbles’ are hardly uncommon in history. In several instances bubbles in the same asset class have resurfaced shortly after the original boom-bust cycle as it takes a long time for an idea to die and easy money conditions created to deal with the slump often end up reflating the same old notion. However, echo bubbles typically tend to be of a lesser magnitude as the original bubble. While both policymakers and market participants are slow to learn lessons from their previous mistakes, they do not completely forget the painful consequences of the previous boom-bust experience, suggesting the current run up in commodity prices will not be anywhere as large as the move seen during the 2003-07 bubble phase. In addition, any surge in commodities has to be self-limiting.
• If the easy money-driven economic recovery rolls on in its present form then oil prices will soon be back at close to $100 a barrel. Such a price shock will be too much for the global economy to handle; oil close to $100 a barrel will have the same debilitating effect on consumer balance sheets as oil at $150 a barrel had last year. Consumer incomes in many economies have shrunk from when oil traded close to $150 a barrel; at $80 a barrel now, oil is already draining away more resources from consumer wallets than at most points in history and offsetting much of benefit from the stimulus plans. Food and energy account for one-third of the consumer basket in developing countries and with prices of various agricultural commodities from vegetables to sugar also joining the commodity party, inflation worries are surfacing rather prematurely in the economic recovery cycle.
• The concerted and vigorous actions of policymakers across the world to revive the global economy are now doing more to reflate asset prices rather than lift economic growth. The realisation that easy money alone cannot create economic growth and the adverse consequences of just pumping liquidity into the system are likely to dawn upon investors and policymakers alike in the months ahead.
Tuesday, November 03, 2009
Mother of all Carry Trades Faces an Inevitable Bust
In a must read article in FT Dr. Nouriel Roubini explains how the combined effect of the Fed policy of a zero Fed funds rate (through carry trade) + quantitative easing + massive purchase of long-term debt instruments is fuelling the current market rally. But when will the bubble burst?
Dr. Roubini explains, “if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments. Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed. This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.”
V. Anantha Nageswaran writes on the same topic in his weekly article in Mint today. Says Nageswaran, “That might become the more pressing objective of the two goals that the US would be pursuing in the coming years: asset price reflation and preserving its hegemonic status in global affairs. Unfortunately, both cannot be pursued simultaneously at all times, although that would be preferable. Now, after a few trillion dollars of last year’s losses have been clawed back in the asset markets in the last seven months, the US can and would likely switch priorities. The persistence of the gold price above $1,000 per ounce and in excess of its high earlier in the year would be unwelcome at the US Federal Reserve board. Hence, some increase in risk aversion, stability to slight recovery in the dollar and reduction in the bond yield might be the Fed’s prescription for the hour. Whether financial markets would deliver on this combination remains to be seen. Well, if the Fed could deliver a 60% rise in US stocks at a time when nearly three million jobs were lost, it could make this happen too—provided, of course, that this is its immediate goal.”
As per Mr. Nageswaran article, Fed should bring in some increase in risk aversion + stability to slight recovery in the dollar + reduction in the bond yield. If this happens then as per Dr. Roubini a stampede could occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts will trigger a co-ordinated collapse of all those risky assets. Macro investors should keenly monitor this issue as this could impact their returns substantially.
However, for all those in the bottoms-up camp, the great guru (Warren Buffett) advice should be of utmost importance during volatile times, “Price is what you pay, value is what you get” + “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” + “We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely.”
Happy Reading!!
Dr. Roubini explains, “if factors lead the dollar to reverse and suddenly appreciate – as was seen in previous reversals, such as the yen-funded carry trade – the leveraged carry trade will have to be suddenly closed as investors cover their dollar shorts. A stampede will occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts triggers a co-ordinated collapse of all those risky assets – equities, commodities, emerging market asset classes and credit instruments. Why will these carry trades unravel? First, the dollar cannot fall to zero and at some point it will stabilise; when that happens the cost of borrowing in dollars will suddenly become zero, rather than highly negative, and the riskiness of a reversal of dollar movements would induce many to cover their shorts. Second, the Fed cannot suppress volatility forever – its $1,800bn purchase plan will be over by next spring. Third, if US growth surprises on the upside in the third and fourth quarters, markets may start to expect a Fed tightening to come sooner, not later. Fourth, there could be a flight from risk prompted by fear of a double dip recession or geopolitical risks, such as a military confrontation between the US/Israel and Iran. As in 2008, when such a rise in risk aversion was associated with a sharp appreciation of the dollar, as investors sought the safety of US Treasuries, this renewed risk aversion would trigger a dollar rally at a time when huge short dollar positions will have to be closed. This unraveling may not occur for a while, as easy money and excessive global liquidity can push asset prices higher for a while. But the longer and bigger the carry trades and the larger the asset bubble, the bigger will be the ensuing asset bubble crash. The Fed and other policymakers seem unaware of the monster bubble they are creating. The longer they remain blind, the harder the markets will fall.”
V. Anantha Nageswaran writes on the same topic in his weekly article in Mint today. Says Nageswaran, “That might become the more pressing objective of the two goals that the US would be pursuing in the coming years: asset price reflation and preserving its hegemonic status in global affairs. Unfortunately, both cannot be pursued simultaneously at all times, although that would be preferable. Now, after a few trillion dollars of last year’s losses have been clawed back in the asset markets in the last seven months, the US can and would likely switch priorities. The persistence of the gold price above $1,000 per ounce and in excess of its high earlier in the year would be unwelcome at the US Federal Reserve board. Hence, some increase in risk aversion, stability to slight recovery in the dollar and reduction in the bond yield might be the Fed’s prescription for the hour. Whether financial markets would deliver on this combination remains to be seen. Well, if the Fed could deliver a 60% rise in US stocks at a time when nearly three million jobs were lost, it could make this happen too—provided, of course, that this is its immediate goal.”
As per Mr. Nageswaran article, Fed should bring in some increase in risk aversion + stability to slight recovery in the dollar + reduction in the bond yield. If this happens then as per Dr. Roubini a stampede could occur as closing long leveraged risky asset positions across all asset classes funded by dollar shorts will trigger a co-ordinated collapse of all those risky assets. Macro investors should keenly monitor this issue as this could impact their returns substantially.
However, for all those in the bottoms-up camp, the great guru (Warren Buffett) advice should be of utmost importance during volatile times, “Price is what you pay, value is what you get” + “I will tell you how to become rich. Close the doors. Be fearful when others are greedy. Be greedy when others are fearful.” + “We don't get paid for activity, just for being right. As to how long we'll wait, we'll wait indefinitely.”
Happy Reading!!
Saturday, October 31, 2009
The Echo Bubble
Post the result reason it was refreshing to read some good articles couple of which I will highlight here.
The first article is written by Jerry Guo in Newsweek, titled The Echo Bubble. The article questions the current market rally and calls it an echo bubble, which is defined as “…… the smaller bubbles that follow on the heels of major ones, usually after the authorities helicopter in loads of cash to patch up the first round of damage, setting the stage for a second round of easy-money-driven speculation. The phenomenon has been observed throughout history, from the British railway bubble of 1830 to the Saudi stock bubble of 2005. Edward Chancellor, author of Devil Take the Hindmost: A History of Financial Speculation, says, "Echo bubbles tend to be smaller and fade away faster than the first bubble." On average, they reach about 30 to 40 percent of the size of the original before bursting and sending market values back down to where they should have been all along, wiping out the gains of the echo, but generally not dipping back to the previous low. That implies a Dow falling to 7000 or 8000.”
Jerry quotes Mr. Ruchir Sharma from Morgan Stanley and PIMCO’s CEO Mohamed El-Erian to prove that the story of emerging markets is a dream that dies hard. An example from Behavioural finance is also given to prove the irrationality of the markets, “……….. In one recent experiment done by Smith, participants were asked to trade an imaginary security, of which the underlying real value was understood. The experimental traders started out underbidding the security but slowly bid it up into a bubble, which then burst. They were subsequently asked to trade the same security again, knowing full well what happened last time around. Nothing changed—except the velocity at which the bubble was created; it happened much faster in the second round. Only in the third round did some participants finally learn their lesson. "We think we can beat the crowd," says Smith with a laugh. "But we are the crowd." It's true not only for the little guy, but also for the world's most sophisticated investors.”
Ride the bubble as long as you stay on the right side of them ( only if you can you time the markets!). “This echo bubble, like those past, is fueled by the fact that there is still a lot of money desperately seeking big returns in global markets. The total amount of financial assets worldwide has fallen from its all-time high of $194 trillion in 2007 to $178 trillion today, according to the McKinsey Global Institute. That $16 trillion in losses is larger than the U.S. economy. But the remaining $178 trillion is still a lot of money, and nearly 60 percent more than the 2000 total of $112 trillion. With interest rates so universally low, investors feel pressured to put that money somewhere. In China, the credit boom has resulted in massive speculation in equity and property markets…………………….. No matter: bubbles are inherently illogical, and the timing and scale of their highs and lows are nearly impossible to predict. One thing that history does tell us about echo bubbles is that they always crash and lead to a new cycle of creative destruction, only after which real and sustained growth can once again emerge…………………………………This rally is not driven by giddy investors convinced they are grabbing a piece of the future, but by wary buyers trying to make back their losses, hoping to profit from a government-subsidized gravy train that they know will come to a halt sooner rather than later. "I think the key distinguishing feature between this period and 1999 is memory. Back then, the previous crash was far away. Now you'd have to be an amnesiac not to remember, and that creates a different psychology," says University of Maryland professor Carmen Reinhart. Still, the rally may yet have some legs. Its length will depend on things like the speed with which central bankers start pulling back the stimulus bucks, the possibility of a Chinese banking blow-up, and whether we start to see currency crises resulting from all the new government debt (as some experts, like Harvard professor Kenneth Rogoff and Reinhart, predict). Rogoff and Reinhart, who re-cently published a book titled This Time Is Different: Eight Centuries of Financial Folly, say if that happens, it could well be emerging markets—today's darlings—that will be the victims. If there is any bubble truism to remember, perhaps it's this: the faster they rise, the harder they fall.”
William Bonner & Addison Wiggin, authors of, Empire of Debt - The Rise of an Epic Financial Crisis, interview in DNAINDIA is a must read. Click here. The author says, “We have run out of enemies so we will have to figure out a way to destroy ourselves. We are collapsing under our own weight. Another way of phrasing it is that we are sort of victims of our own success. We have gotten used to getting our way for a long enough period of time. But you know, all things rise and all things fall. And I think that is natural for nations as well. After the Second World War, the dollar became the reserve currency of the world, which took the coalescence of power in Washington and distributed it globally. We are still looking at the end of that era now. The question is, how are we going to wean ourselves off the dollar as the standard currency or the reserve currency of the world because so many countries India, China, South Korea and Japan hold massive amounts of dollars, and pretty much universally? Even Americans agree that it is not a good idea to hold them anymore. But there is no alternative (TINA) yet. The rise of the empire has been an interesting story, but like all empires, we have outlived our utility to most of the people that we do business with………… Every dollar that is printed cheapens the ones before it. Even in normal times, the Fed's target is 2% inflation rate, which means that the dollar loses value by 2% per year. But with all the printing that is going on, you can expect inflation down the road to be much more aggressive. The interesting tension is that they are fighting against the deflationary cycle, a credit bust, which requires all this cash to be poured in. So we don't see inflation on the horizon just yet, but that will be the interesting story to be done.”
Three points from Jeremy Grantham third quarter newsletter that I would once again highlight are, (1) “Notwithstanding this concern, I believe we are well on the way to my “emerging emerging bubble” described 18 months ago (1Q 2008 Quarterly Letter). I would recommend to institutional investors, including my colleagues, to give emerging equities the benefit of value doubts when you can. For once in my miserable life, I would like to participate in a bubble if only for a little piece of it instead of getting out two years too soon. Riding a bubble up is a guilty pleasure totally denied to value managers who typically pay a high price to the God of Investment Discipline (Thor?) for being so painfully early. I think the first 15 percentage points over fair value would satisfy me.” (2) “The lessons, if any, are that low rates and generous liquidity are, if anything, a little more powerful than we thought, which is a high hurdle because we have respected their power for years.” And what we thought were powerful and painful investment lessons on the dangers of taking risk too casually turned out to be less memorable than we expected. Risk-taking has come roaring back” and, (3) “Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment”
RBI latest monetary policy review gave a clear indication that the monetary policy reversal is beginning. It also highlights the policy dilemma that most central bankers are currently facing. RBI noted, "the challenge for the Reserve Bank is to support the recovery process without compromising on price stability. This calls for a careful management of trade-offs. Growth drivers warrant a delayed exit, while inflation concerns call for an early exit. Premature exit will derail the fragile growth, but a delayed exit can potentially engender inflation expectations." It is widely expected that RBI will lift policy rates by 25bp in January 2010. Hopefully by then, the RBI should have had adequate comfort in the pace of recovery. Also, at present the money markets are expecting the federal funds rate to rise by 100bps by the end of next year and the Bank of England to raise rates by 150bps by the end of 2010. Greed and fear in his latest note highlights, “…But if the S&P500 does turn around and “melts up” to the 1,200 level into year end, it can be confidently assumed that these rate hike expectations will increase further, an assumption which macro traders should be prepared to bet aggressively against. GREED & fear remains of the view that neither the Fed nor the Bank of England will raise rates at all next year. GREED & fear also remains of the view that neither will abandon completely so-called unorthodox policies in 2010.” This is one important thing to watch out for and any premature tightening (or aggressive) vs. current expectation could spook the markets and vice versa.
Other good articles worth reading are (click on the link):
· Akash Prakash: The capital inflow conundrum
· The Gold Standard
· Morgan Stanley GEF
· Hussman Funds
Happy Reading!!
The first article is written by Jerry Guo in Newsweek, titled The Echo Bubble. The article questions the current market rally and calls it an echo bubble, which is defined as “…… the smaller bubbles that follow on the heels of major ones, usually after the authorities helicopter in loads of cash to patch up the first round of damage, setting the stage for a second round of easy-money-driven speculation. The phenomenon has been observed throughout history, from the British railway bubble of 1830 to the Saudi stock bubble of 2005. Edward Chancellor, author of Devil Take the Hindmost: A History of Financial Speculation, says, "Echo bubbles tend to be smaller and fade away faster than the first bubble." On average, they reach about 30 to 40 percent of the size of the original before bursting and sending market values back down to where they should have been all along, wiping out the gains of the echo, but generally not dipping back to the previous low. That implies a Dow falling to 7000 or 8000.”
Jerry quotes Mr. Ruchir Sharma from Morgan Stanley and PIMCO’s CEO Mohamed El-Erian to prove that the story of emerging markets is a dream that dies hard. An example from Behavioural finance is also given to prove the irrationality of the markets, “……….. In one recent experiment done by Smith, participants were asked to trade an imaginary security, of which the underlying real value was understood. The experimental traders started out underbidding the security but slowly bid it up into a bubble, which then burst. They were subsequently asked to trade the same security again, knowing full well what happened last time around. Nothing changed—except the velocity at which the bubble was created; it happened much faster in the second round. Only in the third round did some participants finally learn their lesson. "We think we can beat the crowd," says Smith with a laugh. "But we are the crowd." It's true not only for the little guy, but also for the world's most sophisticated investors.”
Ride the bubble as long as you stay on the right side of them ( only if you can you time the markets!). “This echo bubble, like those past, is fueled by the fact that there is still a lot of money desperately seeking big returns in global markets. The total amount of financial assets worldwide has fallen from its all-time high of $194 trillion in 2007 to $178 trillion today, according to the McKinsey Global Institute. That $16 trillion in losses is larger than the U.S. economy. But the remaining $178 trillion is still a lot of money, and nearly 60 percent more than the 2000 total of $112 trillion. With interest rates so universally low, investors feel pressured to put that money somewhere. In China, the credit boom has resulted in massive speculation in equity and property markets…………………….. No matter: bubbles are inherently illogical, and the timing and scale of their highs and lows are nearly impossible to predict. One thing that history does tell us about echo bubbles is that they always crash and lead to a new cycle of creative destruction, only after which real and sustained growth can once again emerge…………………………………This rally is not driven by giddy investors convinced they are grabbing a piece of the future, but by wary buyers trying to make back their losses, hoping to profit from a government-subsidized gravy train that they know will come to a halt sooner rather than later. "I think the key distinguishing feature between this period and 1999 is memory. Back then, the previous crash was far away. Now you'd have to be an amnesiac not to remember, and that creates a different psychology," says University of Maryland professor Carmen Reinhart. Still, the rally may yet have some legs. Its length will depend on things like the speed with which central bankers start pulling back the stimulus bucks, the possibility of a Chinese banking blow-up, and whether we start to see currency crises resulting from all the new government debt (as some experts, like Harvard professor Kenneth Rogoff and Reinhart, predict). Rogoff and Reinhart, who re-cently published a book titled This Time Is Different: Eight Centuries of Financial Folly, say if that happens, it could well be emerging markets—today's darlings—that will be the victims. If there is any bubble truism to remember, perhaps it's this: the faster they rise, the harder they fall.”
William Bonner & Addison Wiggin, authors of, Empire of Debt - The Rise of an Epic Financial Crisis, interview in DNAINDIA is a must read. Click here. The author says, “We have run out of enemies so we will have to figure out a way to destroy ourselves. We are collapsing under our own weight. Another way of phrasing it is that we are sort of victims of our own success. We have gotten used to getting our way for a long enough period of time. But you know, all things rise and all things fall. And I think that is natural for nations as well. After the Second World War, the dollar became the reserve currency of the world, which took the coalescence of power in Washington and distributed it globally. We are still looking at the end of that era now. The question is, how are we going to wean ourselves off the dollar as the standard currency or the reserve currency of the world because so many countries India, China, South Korea and Japan hold massive amounts of dollars, and pretty much universally? Even Americans agree that it is not a good idea to hold them anymore. But there is no alternative (TINA) yet. The rise of the empire has been an interesting story, but like all empires, we have outlived our utility to most of the people that we do business with………… Every dollar that is printed cheapens the ones before it. Even in normal times, the Fed's target is 2% inflation rate, which means that the dollar loses value by 2% per year. But with all the printing that is going on, you can expect inflation down the road to be much more aggressive. The interesting tension is that they are fighting against the deflationary cycle, a credit bust, which requires all this cash to be poured in. So we don't see inflation on the horizon just yet, but that will be the interesting story to be done.”
Three points from Jeremy Grantham third quarter newsletter that I would once again highlight are, (1) “Notwithstanding this concern, I believe we are well on the way to my “emerging emerging bubble” described 18 months ago (1Q 2008 Quarterly Letter). I would recommend to institutional investors, including my colleagues, to give emerging equities the benefit of value doubts when you can. For once in my miserable life, I would like to participate in a bubble if only for a little piece of it instead of getting out two years too soon. Riding a bubble up is a guilty pleasure totally denied to value managers who typically pay a high price to the God of Investment Discipline (Thor?) for being so painfully early. I think the first 15 percentage points over fair value would satisfy me.” (2) “The lessons, if any, are that low rates and generous liquidity are, if anything, a little more powerful than we thought, which is a high hurdle because we have respected their power for years.” And what we thought were powerful and painful investment lessons on the dangers of taking risk too casually turned out to be less memorable than we expected. Risk-taking has come roaring back” and, (3) “Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment”
RBI latest monetary policy review gave a clear indication that the monetary policy reversal is beginning. It also highlights the policy dilemma that most central bankers are currently facing. RBI noted, "the challenge for the Reserve Bank is to support the recovery process without compromising on price stability. This calls for a careful management of trade-offs. Growth drivers warrant a delayed exit, while inflation concerns call for an early exit. Premature exit will derail the fragile growth, but a delayed exit can potentially engender inflation expectations." It is widely expected that RBI will lift policy rates by 25bp in January 2010. Hopefully by then, the RBI should have had adequate comfort in the pace of recovery. Also, at present the money markets are expecting the federal funds rate to rise by 100bps by the end of next year and the Bank of England to raise rates by 150bps by the end of 2010. Greed and fear in his latest note highlights, “…But if the S&P500 does turn around and “melts up” to the 1,200 level into year end, it can be confidently assumed that these rate hike expectations will increase further, an assumption which macro traders should be prepared to bet aggressively against. GREED & fear remains of the view that neither the Fed nor the Bank of England will raise rates at all next year. GREED & fear also remains of the view that neither will abandon completely so-called unorthodox policies in 2010.” This is one important thing to watch out for and any premature tightening (or aggressive) vs. current expectation could spook the markets and vice versa.
Other good articles worth reading are (click on the link):
· Akash Prakash: The capital inflow conundrum
· The Gold Standard
· Morgan Stanley GEF
· Hussman Funds
Happy Reading!!
Wednesday, October 28, 2009
Jeremy Grantham--Just Deserts and Markets Being Silly Again
Jeremy Grantham third quarter newsletter can be read from here. Key learnings from the newsletter are:
The Last Hurrah and Markets Being Silly Again: “The idea behind my forecast six months ago was that regardless of the fundamentals, there would be a sharp rally.1 After a very large decline and a period of somewhat blind panic, it is simply the nature of the beast..……... After the sharp decline in the fall of 1929, the S&P 500 rallied 46% from its low in November to the rally high of April 12, 1930. It then, of course, fell by over 80%. But on April 12 it was once again overpriced; it was down only 18% from its peak and was back to the level of June 1929. But what a difference there was in the outlook between June 1929 and April 1930! In June, the economic outlook was a candidate for the brightest in history with effectively no unemployment, 5% productivity, and over 16% year-over-year gain in industrial output. By April 1930, unemployment had doubled and industrial production had dropped from +16% to -9% in 5 months, which may be the world record in economic deterioration. Worse, in 1930 there was no extra liquidity flowing around and absolutely no moral hazard. “Liquidate the labor, liquidate the stocks, liquidate the farmers” was their version. Yet the market rose 46%. How could it do this in the face of a world going to hell?
My theory is that the market always displayed a belief in a type of primitive market efficiency decades before the academics took it up. It is a belief that if the market once sold much higher, it must mean something. And in the case of 1930, hadn’t Irving Fisher, arguably the greatest American economist of the century, said that the 1929 highs were completely justified and that it was the decline that was hysterical pessimism? Hadn’t E.L. Smith also explained in his Common Stocks as Long Term Investments (1924) – a startling precursor to Jeremy Siegel’s dangerous book Stocks for the Long Run (1994) – that stocks would always beat bonds by divine right? And there is always someone of the “Dow 36,000” persuasion to reinforce our need to believe that as markets decline, higher prices in previous peaks must surely have meant something, and not merely have been unjustified bubbly bursts of enthusiasm and momentum. Today there has been so much more varied encouragement for a rally than existed in 1930. The higher prices preceding this crash (that were far above both trend and fair value) had lasted for many years; from 1996 through 2001 and from 2003 through mid-2008. This time, we also saw history’s greatest stimulus program, desperate bailouts, and clear promises of years of low rates.
As mentioned six months ago, in the third year of the Presidential Cycle, a tiny fraction of the current level of moral hazard and easy money has done its typically great
job of driving equity markets and speculation higher. In total, therefore, it should be no surprise to historians that this rally has handsomely beaten 46%, and would probably have done so whether the actual economic recovery was deemed a pleasant surprise or not. Looking at previous “last hurrahs,” it should also have been expected that any rally this time would be tilted toward risk-taking and, the more stimulus and moral hazard, the bigger the tilt. I must say, though, that I never expected such an extreme tilt to risk-taking: it’s practically a cliff! Never mess with the Fed, I guess. Although, looking at the record, these dramatic short-term resuscitations do seem to breed severe problems down the road. So, probably, we will continue to live in exciting times, which is not all bad in our business.”
Economic and Financial Fundamentals and the Stock Market Outlook: “The good news is that we have not fallen off into another Great Depression. With the degree of stimulus there seemed little chance of that, and we have consistently expected a global economic recovery by late this year or early next year. The operating ratio for industrial production reached its lowest level in decades. It should bounce back and, if it moves up from 68 to 80 over three to five years, will provide a good kicker to that part of the economy. Inventories, I believe, will also recover.
In short, the normal tendency of an economy to recover is nearly irresistible and needs coordinated incompetence to offset it – like the 1930 Smoot-Hawley Tariff Act, which helped to precipitate a global trade war. But this does not mean that everything is fine longer term. It still seems a safe bet that seven lean years await us. Corporate ex-financials profit margins remain above average and, if I am right about the coming seven lean years, we will soon enough look back nostalgically at such high profits. Price/earnings ratios, adjusted for even normal margins, are also significantly above fair value after the rally. Fair value on the S&P is now about 860 (fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smoldering embers). This places today’s market (October 19) at almost 25% overpriced, and on a seven-year horizon would move our normal forecast of 5.7% real down by more than 3% a year. Doesn’t it seem odd that we would be measurably overpriced once again, given that we face a seven-year future that almost everyone agrees will be tougher than normal?
Major imbalances are unlikely to be quick or easy to work through. For example, we must eventually consume less, pay down debt, and realign our lives to being less capital-rich. Global trade imbalances must also readjust. To repeat my earlier forecast, I expect developed markets to grow moderately less fast – about 2.25% – for the next chunk of time, and to look pretty anemic compared to emerging countries growing at twice that rate. We are nervous about the possibility of a major shock to Chinese growth. (My personal view of a major China stumble in the next three years or so is that it is maybe only a one in three chance, but is still the most likely important unpleasant surprise of the fundamental economic variety.)
Notwithstanding this concern, I believe we are well on the way to my “emerging emerging bubble” described 18 months ago (1Q 2008 Quarterly Letter). I would recommend to institutional investors, including my colleagues, to give emerging equities the benefit of value doubts when you can. For once in my miserable life, I would like to participate in a bubble if only for a little piece of it instead of getting out two years too soon. Riding a bubble up is a guilty pleasure totally denied to value managers who typically pay a high price to the God of Investment Discipline (Thor?) for being so painfully early. I think the first 15 percentage points over fair value would satisfy me. If I’m right, the first 15% will be a small fraction of the eventual bubble premium. So in a sense, we would be early once again. We believed from the start that this market rally and any outperformance of risk would have very little to do with any dividend discount model concept of value, so it is pointless to “ooh and ah” too much at how far and how fast it has traveled. The lessons, if any, are that low rates and generous liquidity are, if anything, a little more powerful than we thought, which is a high hurdle because we have respected their power for years. And what we thought were powerful and painful investment lessons on the dangers of taking risk too casually turned out to be less memorable than we expected. Risk-taking has come roaring back.
Value, it must be admitted, is seldom a powerful force in the short term. The Fed’s weapons of low rates, plenty of money, and the promise of future help if necessary seem stronger than value over a few quarters. And the forces of herding and momentum are also helping to push prices up, with the market apparently quite unrepentant of recent crimes and willing to be silly once again. We said in July that we would sit and wait for the market to be silly again. This has been a very quick response although, as real silliness goes, I suppose it is not really trying yet. In soccer terminology, for the last six months it is Voting Machine 10, Weighing Machine nil!
Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment………………………”
So, back to timing. “It is hard for me to see what will stop the charge to risk-taking this year. With the near universality of the feeling of being left behind in reinvesting, it is nerve-wracking for us prudent investors to contemplate the odds of the market rushing past my earlier prediction of 1100. It can certainly happen. Conversely, I have some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again. I would still guess (a well-informed guess, I hope) that before next year is out, the market will drop painfully from current levels. “Painfully” is arbitrarily deemed by me to start at -15%. My guess, though, is that the U.S. market will drop below fair value, which is a 22% decline (from the S&P 500 level of 1098 on October 19).
Unlike the really tough bears, though, I see no need for a new low. I think the history books will be happy enough with the 666 of last February. Of course, they would probably be slightly happier with, say, 550. The point is that this is not a situation like 2005, 2006, and 2007 when for the first time a great bubble – 2000 – had not yet broken back through its trend. I described that reversal as a near certainty. I love historical consistency, and with 32 bubbles completely broken, the single one outstanding – the S&P 500 – was a source of nagging pain. But that was all comfortably resolved by a substantial new low for the S&P 500 last year. This cycle, in contrast, has already established a perfectly respectable S&P low at 666, well below trend, and can officially please itself from here. A new low (or not) will look compatible with history, which makes the prediction business less easy.”
The Last Hurrah and Markets Being Silly Again: “The idea behind my forecast six months ago was that regardless of the fundamentals, there would be a sharp rally.1 After a very large decline and a period of somewhat blind panic, it is simply the nature of the beast..……... After the sharp decline in the fall of 1929, the S&P 500 rallied 46% from its low in November to the rally high of April 12, 1930. It then, of course, fell by over 80%. But on April 12 it was once again overpriced; it was down only 18% from its peak and was back to the level of June 1929. But what a difference there was in the outlook between June 1929 and April 1930! In June, the economic outlook was a candidate for the brightest in history with effectively no unemployment, 5% productivity, and over 16% year-over-year gain in industrial output. By April 1930, unemployment had doubled and industrial production had dropped from +16% to -9% in 5 months, which may be the world record in economic deterioration. Worse, in 1930 there was no extra liquidity flowing around and absolutely no moral hazard. “Liquidate the labor, liquidate the stocks, liquidate the farmers” was their version. Yet the market rose 46%. How could it do this in the face of a world going to hell?
My theory is that the market always displayed a belief in a type of primitive market efficiency decades before the academics took it up. It is a belief that if the market once sold much higher, it must mean something. And in the case of 1930, hadn’t Irving Fisher, arguably the greatest American economist of the century, said that the 1929 highs were completely justified and that it was the decline that was hysterical pessimism? Hadn’t E.L. Smith also explained in his Common Stocks as Long Term Investments (1924) – a startling precursor to Jeremy Siegel’s dangerous book Stocks for the Long Run (1994) – that stocks would always beat bonds by divine right? And there is always someone of the “Dow 36,000” persuasion to reinforce our need to believe that as markets decline, higher prices in previous peaks must surely have meant something, and not merely have been unjustified bubbly bursts of enthusiasm and momentum. Today there has been so much more varied encouragement for a rally than existed in 1930. The higher prices preceding this crash (that were far above both trend and fair value) had lasted for many years; from 1996 through 2001 and from 2003 through mid-2008. This time, we also saw history’s greatest stimulus program, desperate bailouts, and clear promises of years of low rates.
As mentioned six months ago, in the third year of the Presidential Cycle, a tiny fraction of the current level of moral hazard and easy money has done its typically great
job of driving equity markets and speculation higher. In total, therefore, it should be no surprise to historians that this rally has handsomely beaten 46%, and would probably have done so whether the actual economic recovery was deemed a pleasant surprise or not. Looking at previous “last hurrahs,” it should also have been expected that any rally this time would be tilted toward risk-taking and, the more stimulus and moral hazard, the bigger the tilt. I must say, though, that I never expected such an extreme tilt to risk-taking: it’s practically a cliff! Never mess with the Fed, I guess. Although, looking at the record, these dramatic short-term resuscitations do seem to breed severe problems down the road. So, probably, we will continue to live in exciting times, which is not all bad in our business.”
Economic and Financial Fundamentals and the Stock Market Outlook: “The good news is that we have not fallen off into another Great Depression. With the degree of stimulus there seemed little chance of that, and we have consistently expected a global economic recovery by late this year or early next year. The operating ratio for industrial production reached its lowest level in decades. It should bounce back and, if it moves up from 68 to 80 over three to five years, will provide a good kicker to that part of the economy. Inventories, I believe, will also recover.
In short, the normal tendency of an economy to recover is nearly irresistible and needs coordinated incompetence to offset it – like the 1930 Smoot-Hawley Tariff Act, which helped to precipitate a global trade war. But this does not mean that everything is fine longer term. It still seems a safe bet that seven lean years await us. Corporate ex-financials profit margins remain above average and, if I am right about the coming seven lean years, we will soon enough look back nostalgically at such high profits. Price/earnings ratios, adjusted for even normal margins, are also significantly above fair value after the rally. Fair value on the S&P is now about 860 (fair value has declined steadily as the accounting smoke clears from the wreckage and there are still, perhaps, some smoldering embers). This places today’s market (October 19) at almost 25% overpriced, and on a seven-year horizon would move our normal forecast of 5.7% real down by more than 3% a year. Doesn’t it seem odd that we would be measurably overpriced once again, given that we face a seven-year future that almost everyone agrees will be tougher than normal?
Major imbalances are unlikely to be quick or easy to work through. For example, we must eventually consume less, pay down debt, and realign our lives to being less capital-rich. Global trade imbalances must also readjust. To repeat my earlier forecast, I expect developed markets to grow moderately less fast – about 2.25% – for the next chunk of time, and to look pretty anemic compared to emerging countries growing at twice that rate. We are nervous about the possibility of a major shock to Chinese growth. (My personal view of a major China stumble in the next three years or so is that it is maybe only a one in three chance, but is still the most likely important unpleasant surprise of the fundamental economic variety.)
Notwithstanding this concern, I believe we are well on the way to my “emerging emerging bubble” described 18 months ago (1Q 2008 Quarterly Letter). I would recommend to institutional investors, including my colleagues, to give emerging equities the benefit of value doubts when you can. For once in my miserable life, I would like to participate in a bubble if only for a little piece of it instead of getting out two years too soon. Riding a bubble up is a guilty pleasure totally denied to value managers who typically pay a high price to the God of Investment Discipline (Thor?) for being so painfully early. I think the first 15 percentage points over fair value would satisfy me. If I’m right, the first 15% will be a small fraction of the eventual bubble premium. So in a sense, we would be early once again. We believed from the start that this market rally and any outperformance of risk would have very little to do with any dividend discount model concept of value, so it is pointless to “ooh and ah” too much at how far and how fast it has traveled. The lessons, if any, are that low rates and generous liquidity are, if anything, a little more powerful than we thought, which is a high hurdle because we have respected their power for years. And what we thought were powerful and painful investment lessons on the dangers of taking risk too casually turned out to be less memorable than we expected. Risk-taking has come roaring back.
Value, it must be admitted, is seldom a powerful force in the short term. The Fed’s weapons of low rates, plenty of money, and the promise of future help if necessary seem stronger than value over a few quarters. And the forces of herding and momentum are also helping to push prices up, with the market apparently quite unrepentant of recent crimes and willing to be silly once again. We said in July that we would sit and wait for the market to be silly again. This has been a very quick response although, as real silliness goes, I suppose it is not really trying yet. In soccer terminology, for the last six months it is Voting Machine 10, Weighing Machine nil!
Price, however, does matter eventually, and what will stop this market (my blind guess is in the first few months of next year) is a combination of two factors. First, the disappointing economic and financial data that will begin to show the intractably long-term nature of some of our problems, particularly pressure on profit margins as the quick fix of short-term labor cuts fades away. Second, the slow gravitational pull of value as U.S. stocks reach +30-35% overpricing in the face of an extended difficult environment………………………”
So, back to timing. “It is hard for me to see what will stop the charge to risk-taking this year. With the near universality of the feeling of being left behind in reinvesting, it is nerve-wracking for us prudent investors to contemplate the odds of the market rushing past my earlier prediction of 1100. It can certainly happen. Conversely, I have some modest hopes for a collective sensible resistance to the current Fed plot to have us all borrow and speculate again. I would still guess (a well-informed guess, I hope) that before next year is out, the market will drop painfully from current levels. “Painfully” is arbitrarily deemed by me to start at -15%. My guess, though, is that the U.S. market will drop below fair value, which is a 22% decline (from the S&P 500 level of 1098 on October 19).
Unlike the really tough bears, though, I see no need for a new low. I think the history books will be happy enough with the 666 of last February. Of course, they would probably be slightly happier with, say, 550. The point is that this is not a situation like 2005, 2006, and 2007 when for the first time a great bubble – 2000 – had not yet broken back through its trend. I described that reversal as a near certainty. I love historical consistency, and with 32 bubbles completely broken, the single one outstanding – the S&P 500 – was a source of nagging pain. But that was all comfortably resolved by a substantial new low for the S&P 500 last year. This cycle, in contrast, has already established a perfectly respectable S&P low at 666, well below trend, and can officially please itself from here. A new low (or not) will look compatible with history, which makes the prediction business less easy.”
Wednesday, October 21, 2009
Micheal Mauboussin's new book-Think Twice, Mohnish Pabrai interview in Dnaindia and Economics!!
I follow Micheal Mauboussin from Legg Mason very closely and his new book “Think Twice” is now on stands. You can buy his book in India from here. Mr. Mauboussin is a thought leader and his books will help improve on our latticework of mental models- a though process framework which will help in our investment & day-to-day endeavours. I will try and highlight some of the key points from his book in a later post.
Mohnish Pabrai interview in Dnaindia is a must read for all Value investors (although I believe that growth investors too can have value bias thereby blurring the line between value and growth). You can read the full interview here. He has also written a book on investing, The Dhandho Investor: The Low-Risk Value Method to High Returns.
Pabrai was at his best in the interview when he said, “An investor should think of himself as a gentleman of leisure. Don’t think that you are in some profession. You just think that you are a person who is focused on enjoying and living life well. If you focus on yourself as a gentleman of leisure what is going to happen is that you do not feel any compelling reason to act. It has been several months since I have bought any new stock. And that is not a problem because we went through a period in December when we bought ten stocks. The first thing is that we are in a profession were you don’t pay for activity, you get paid for being right. So there should be no compelling reason to act. Basically, the thing you do is you take out the reason to act…..The second thing you do is you focus on acquiring worldly wisdom. I read an enormous amount of stuff and relate to what different investment managers who I respect are saying. So, at times, things become no brainers………...…………………………………………………………………………………..I would say that we will never see another Warren Buffett. Just like we will never see any Albert Einstein or another Mahatma Gandhi. Buffett is a very unique individual. His skillsets outside of investment are phenomenal but they get dwarfed by his investing skills. The main thing that makes Warren Buffett Warren Buffett is that he is a learning machine who has worked really hard for, let’s us say seventy years, and is continuously learning every day. So the thing is if you want to be like Buffett, there is no short cut. First of all, you have to be deeply interested in investing and you have to be very willing spending tens of hours, hundreds of hours, reading the minutiae. There is a very famous value investor called Seth Klarman. He is into horse racing. And his famous horse is called Read the Footnotes.”
Moving on from Value investing to Economics. Another article in Dnaindia provides data of how China can’t get enough of US treasuries. As highlighted in an earlier post, the dollar debasement trade will most likely drive the final down leg in the 2000-14 equity bear market, as per Russell Napier. However, some economist suggests “China's total holdings of US securities were $1.44 trillion at the end of August, or about $34 billion more than suggested by monthly TICS data. In fact, during the July-September quarter of 2009, China's reserves increased by $141 billion, compared to a gain of $177.9 billion in the second quarter….. Significantly, China's purchase of US securities continues to show a bias towards longer-dated Treasuries for the third straight month. The average yield differential between the 10-year Treasuries and 3-month bills was 3.42% in August, compared to 3.38% in July.” This is an important data to watch out for if one is a macro investor and is interested in making money on dollar debasement trade.
Happy reading!!
Mohnish Pabrai interview in Dnaindia is a must read for all Value investors (although I believe that growth investors too can have value bias thereby blurring the line between value and growth). You can read the full interview here. He has also written a book on investing, The Dhandho Investor: The Low-Risk Value Method to High Returns.
Pabrai was at his best in the interview when he said, “An investor should think of himself as a gentleman of leisure. Don’t think that you are in some profession. You just think that you are a person who is focused on enjoying and living life well. If you focus on yourself as a gentleman of leisure what is going to happen is that you do not feel any compelling reason to act. It has been several months since I have bought any new stock. And that is not a problem because we went through a period in December when we bought ten stocks. The first thing is that we are in a profession were you don’t pay for activity, you get paid for being right. So there should be no compelling reason to act. Basically, the thing you do is you take out the reason to act…..The second thing you do is you focus on acquiring worldly wisdom. I read an enormous amount of stuff and relate to what different investment managers who I respect are saying. So, at times, things become no brainers………...…………………………………………………………………………………..I would say that we will never see another Warren Buffett. Just like we will never see any Albert Einstein or another Mahatma Gandhi. Buffett is a very unique individual. His skillsets outside of investment are phenomenal but they get dwarfed by his investing skills. The main thing that makes Warren Buffett Warren Buffett is that he is a learning machine who has worked really hard for, let’s us say seventy years, and is continuously learning every day. So the thing is if you want to be like Buffett, there is no short cut. First of all, you have to be deeply interested in investing and you have to be very willing spending tens of hours, hundreds of hours, reading the minutiae. There is a very famous value investor called Seth Klarman. He is into horse racing. And his famous horse is called Read the Footnotes.”
Moving on from Value investing to Economics. Another article in Dnaindia provides data of how China can’t get enough of US treasuries. As highlighted in an earlier post, the dollar debasement trade will most likely drive the final down leg in the 2000-14 equity bear market, as per Russell Napier. However, some economist suggests “China's total holdings of US securities were $1.44 trillion at the end of August, or about $34 billion more than suggested by monthly TICS data. In fact, during the July-September quarter of 2009, China's reserves increased by $141 billion, compared to a gain of $177.9 billion in the second quarter….. Significantly, China's purchase of US securities continues to show a bias towards longer-dated Treasuries for the third straight month. The average yield differential between the 10-year Treasuries and 3-month bills was 3.42% in August, compared to 3.38% in July.” This is an important data to watch out for if one is a macro investor and is interested in making money on dollar debasement trade.
Happy reading!!
Friday, October 09, 2009
Markets needs “Goldilocks scenario” to maintain the momentum
The debate on “to tighten, or not to tighten” is gaining thrust. Australian central bank (CB) was the first to tighten rates thereby eliminating the “moral hazard” of other CBs who did not want to be seen as the first to start the tightening process (since the risks of policy mistakes are high). As the world cleans up after the U.S. housing debacle, central bankers are already fretting over how to tackle the next bubble, which may not be too far off as super-easy monetary policies worldwide leave financial markets flush with cash.
With CBs in a flux, markets are caught in a Catch-22 situation. Akash Prakash writes in his recent article, “If economic growth does bounce back with a vengeance, as some of the bulls think, it will force the hands of policy-makers to quickly pull back the emergency measures, which will ultimately be a strong negative for equity returns. It is unlikely that equity markets can continue their manic rise in the face of tightening liquidity conditions. Markets will probably do better if growth is slow enough to not force tightening. Yet, given the market reaction to the recent weak economic data, equities do not seem to be able to digest sub-par economic numbers, implying that an element of growth is already priced in. Markets seem to need incoming data to continue surprising positively to sustain the uptrend….Equities are only cheap if you believe in a strong earnings recovery. However, to get a strong earnings recovery, you need robust economic growth. As it is unlikely that corporate houses can do much more cost cutting, we now need top line growth. If we get a robust economic recovery (as earnings estimates imply), policy-makers will reverse the emergency fiscal and monetary measures, which will tend to be a drag on price-to-earnings (PE) multiples………… Thus, unless we get a perfect “Goldilocks scenario”, where growth is strong enough to deliver earnings, but slow enough to not force policy-makers’ hands, equities are going to have a choppy few months as the countervailing forces of economic acceleration and liquidity withdrawal fight each other. It is not clear who will triumph.”
Mr. Prakash continues, “Even in the Indian context, we need to worry about RBI beginning a new tightening cycle and rising interest rates. This tightening cycle will be a negative as RBI is not raising rates because the economy is overheating. The central bank is doing so because of inflation concerns in the face of spiking agricultural prices. G-sec yields are rising, hence, ultimately, interest rates will rise system-wide because of a huge government borrowing programme. In fact, bankers talk of a lack of credit demand from good quality borrowers. If interest rates were rising because of strong economic growth and an overheating economy, very strong corporate earnings would have compensated for the impact of rising rates on valuation multiples. However, rising rates will only damage multiples now, with no earnings offset. A strengthening rupee will further tighten financial conditions and damage profitability. We are also yet to see any credible plan from the government to put the fiscal in order. We all seem to be betting on growth to bail out government finances. Unless we find a path to bring the fiscal under control, at the first signs of strong credit demand from corporate India, rates will spike further and we will be hugely dependent on global capital flows to sustain growth………………………………………….….. Thus, while we may have a bit of a hiccup, if we can hold on and live through some short-term volatility and price declines, gains are likely. A correction is quite a possibility, which may even be severe but nothing like 2008.”
In another article Ruchir Sharma lucidly points out that the current synchronous global recovery has reached its mature stage and the extremely “high correlations are a symptom of a global boom-bust environment. Hopefully, after the tech and credit boom-bust cycles, it will be a while before the same mistakes are repeated and a relatively dull environment should prevail for the next few quarters. In such a scenario, it will be key to focus more on secular themes and less on cyclical movements…………..At the sectoral level, fortunes of sectors such as materials and energy will remain tied to global macro variables, but consumer stocks (both discretionary and staples) with exposure to emerging markets should show steady growth through cycles given the relatively low leverage of the consumer in many developing countries…….. Of course, the risk persists of the global economy suffering a major double-dip or conversely of a policy-induced synchronous melt-up in growth rates after the meltdown of last year. Either event will make the world continue to behave as just one market. However, the odds do not favour another extreme outcome and the markets are therefore likely to go horizontal after being vertical and highly correlated in the recent past. The time for taking aggressive oneway directional bets is probably behind us and the case for differentiation based on local influences is strong. The nature of markets is, in fact, to let new factors take on the reins just when everyone is convinced about the prevalence of a particular regime”
John Hussman writes in his column, “Probably my clearest drawback as an investment manager is that I have too often assumed that investors should recognize what seemed to me to be patently obvious dangers (the predictable collapse of the dot-com bubble, the tech bubble, the housing bubble, the oil and commodities bubble, etc) with a longer lead-time. Unfortunately, we inevitably experience a period of frustration – at least temporarily – for assuming such foresight…….the most important lesson I keep having to re-learn is how utterly myopic investors can be when there’s an uptrend to be played….…. Since I have no plans to risk the financial security of our shareholders on securities that are not worth their price, or premises that I believe are dangerously false or irrational, I can’t say that learning this lesson will make us strikingly more responsive to speculative runs in the future. But there may be some middle ground that we can exploit.”
Finally, Macroman writes thus, “Markets might be screaming “you suck!” to Macro Man, but trust him: the feeling is mutual.”
Happy reading!!
With CBs in a flux, markets are caught in a Catch-22 situation. Akash Prakash writes in his recent article, “If economic growth does bounce back with a vengeance, as some of the bulls think, it will force the hands of policy-makers to quickly pull back the emergency measures, which will ultimately be a strong negative for equity returns. It is unlikely that equity markets can continue their manic rise in the face of tightening liquidity conditions. Markets will probably do better if growth is slow enough to not force tightening. Yet, given the market reaction to the recent weak economic data, equities do not seem to be able to digest sub-par economic numbers, implying that an element of growth is already priced in. Markets seem to need incoming data to continue surprising positively to sustain the uptrend….Equities are only cheap if you believe in a strong earnings recovery. However, to get a strong earnings recovery, you need robust economic growth. As it is unlikely that corporate houses can do much more cost cutting, we now need top line growth. If we get a robust economic recovery (as earnings estimates imply), policy-makers will reverse the emergency fiscal and monetary measures, which will tend to be a drag on price-to-earnings (PE) multiples………… Thus, unless we get a perfect “Goldilocks scenario”, where growth is strong enough to deliver earnings, but slow enough to not force policy-makers’ hands, equities are going to have a choppy few months as the countervailing forces of economic acceleration and liquidity withdrawal fight each other. It is not clear who will triumph.”
Mr. Prakash continues, “Even in the Indian context, we need to worry about RBI beginning a new tightening cycle and rising interest rates. This tightening cycle will be a negative as RBI is not raising rates because the economy is overheating. The central bank is doing so because of inflation concerns in the face of spiking agricultural prices. G-sec yields are rising, hence, ultimately, interest rates will rise system-wide because of a huge government borrowing programme. In fact, bankers talk of a lack of credit demand from good quality borrowers. If interest rates were rising because of strong economic growth and an overheating economy, very strong corporate earnings would have compensated for the impact of rising rates on valuation multiples. However, rising rates will only damage multiples now, with no earnings offset. A strengthening rupee will further tighten financial conditions and damage profitability. We are also yet to see any credible plan from the government to put the fiscal in order. We all seem to be betting on growth to bail out government finances. Unless we find a path to bring the fiscal under control, at the first signs of strong credit demand from corporate India, rates will spike further and we will be hugely dependent on global capital flows to sustain growth………………………………………….….. Thus, while we may have a bit of a hiccup, if we can hold on and live through some short-term volatility and price declines, gains are likely. A correction is quite a possibility, which may even be severe but nothing like 2008.”
In another article Ruchir Sharma lucidly points out that the current synchronous global recovery has reached its mature stage and the extremely “high correlations are a symptom of a global boom-bust environment. Hopefully, after the tech and credit boom-bust cycles, it will be a while before the same mistakes are repeated and a relatively dull environment should prevail for the next few quarters. In such a scenario, it will be key to focus more on secular themes and less on cyclical movements…………..At the sectoral level, fortunes of sectors such as materials and energy will remain tied to global macro variables, but consumer stocks (both discretionary and staples) with exposure to emerging markets should show steady growth through cycles given the relatively low leverage of the consumer in many developing countries…….. Of course, the risk persists of the global economy suffering a major double-dip or conversely of a policy-induced synchronous melt-up in growth rates after the meltdown of last year. Either event will make the world continue to behave as just one market. However, the odds do not favour another extreme outcome and the markets are therefore likely to go horizontal after being vertical and highly correlated in the recent past. The time for taking aggressive oneway directional bets is probably behind us and the case for differentiation based on local influences is strong. The nature of markets is, in fact, to let new factors take on the reins just when everyone is convinced about the prevalence of a particular regime”
John Hussman writes in his column, “Probably my clearest drawback as an investment manager is that I have too often assumed that investors should recognize what seemed to me to be patently obvious dangers (the predictable collapse of the dot-com bubble, the tech bubble, the housing bubble, the oil and commodities bubble, etc) with a longer lead-time. Unfortunately, we inevitably experience a period of frustration – at least temporarily – for assuming such foresight…….the most important lesson I keep having to re-learn is how utterly myopic investors can be when there’s an uptrend to be played….…. Since I have no plans to risk the financial security of our shareholders on securities that are not worth their price, or premises that I believe are dangerously false or irrational, I can’t say that learning this lesson will make us strikingly more responsive to speculative runs in the future. But there may be some middle ground that we can exploit.”
Finally, Macroman writes thus, “Markets might be screaming “you suck!” to Macro Man, but trust him: the feeling is mutual.”
Happy reading!!
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