It's the deleveraging process stupid

I read an impressive article on Bridgewater Associates (the world's biggest hedge fund) and its CEO Ray Dalio, in the Fortune magazine. His flagship fund has clocked an annual return of 15% over the last 18 years – a very impressive performance indeed. The fund never imploded during the many crises the financial markets have seen over the last two decades. Also, when 70% of the hedge funds lost money last year and the average hedge fund was down 18%, Dalio's fund returned an impressive 14%.

The article claims that over the last two years, the hedge fund industry in aggregate terms has been closely correlated to the S&P 500 and had even reached a 75% correlation. I am not able to digest the fact that hedge funds had such a big bias towards growth even though signs of strain in the economy had begun to surface 2 years ago.

I liked the way Dalio put the current economic woes in perspective:
“Most people think that a depression is simply a really, really bad recession. But in reality, the two are distinct, naturally occurring events. A recession is a contraction in real GDP brought on by a central bank tightening monetary policy, usually to control inflation, and ends when the central bank eases. But a D-process (deleveraging process) occurs when an economy has an unsustainably high debt burden and monetary policy ceases to be effective, usually because interest rates are close to zero, and the central bank has no way to stimulate the economy. To compensate, the value of debt must be written down (risking deflation) or the central bank must print money (a trigger of inflation), or some combination of both.” In recent years the level of debt as a percentage of GDP in the U.S. has skyrocketed past previous highs last seen in the early 1930s. And the Federal Reserve's benchmark rate is now hovering just above zero. "It seems very likely that stocks will get materially cheaper," he says. "We have to go through an important debt restructuring process, and a lot of assets are going to be for sale, huge numbers of assets. And there's going to be a shortage of buyers."

If Dalio’s predictions come true, the expectation that the markets have bottomed out could be short-lived.

Jon Stewart vs Jim Cramer

Jon Stewart, host of The Daily Show, recently interviewed Jim Cramer, the host of CNBC's Mad Money. Jon takes a dig at the business news channels that failed to educate viewers on what was happening in the financial markets and Cramer is defenseless.

The interview has had a huge fan faollowing in the US. The Washington Post reports White House Press Secretary Robert Gibbs saying "I Enjoyed It Thoroughly", when asked about the show.

When the equity markets were in a bullish phase, CNBC's Indian unit - CNBC TV18, made the mistake of celebrating (literally) every additional 1000 points on the Bombay Stock Exchange, knowing very well that the market was frothy. The reporters wore colorful dresses, cut cakes and decorated the studio with balloons! Why did they do all that? The TV channel has a stake in the market going up all the time and small investors feeling gung-ho about it. So it was just an act of playing to the gallery. One wondered whether CNBC TV18 is a business news channel or an entertainment channel.....

Watch Jon Stewart's interview here:

I hope shows like this highlight and encourage debate on the important issue of an inherent conflict of interest that the news media faces these days - the quest for profit versus the duty of quality reporting and investigative journalism. If the issue of conflict of interest is not resolved, news media risks failing in its role as a pillar of democracy.

Black Swan Fund gains 236% amidst capitulation in financial markets

Bloomberg reports that 36 South Investment Managers, a New Zealand based hedge fund, gained 236% in the last 12 months. This is a terrific record in a year where hedge funds lost 19% on an average.

How did 36 South manage to put up such an impressive performance? It has to do with the trading strategy. 36 South buys long-dated options it considers cheap - in currency, bond, equity and commodity markets, betting that rare and unforeseen events would generate unusually large profits. The premium it pays on those options are relatively small - but when the direction of the bet is right, the pay-off is huge.

36 South had profited from bets on interest-rate cuts in Australia and New Zealand, and the purchase of put options on major stocks around the world, including BRIC nations. The fund had also bought put options on commodities.

The risk premium on most of the financial instruments has risen significantly over the last few months, making such a trade not so lucrative these days. Volatility indices have risen substantially and consequently the options premia have shot up. So, a trade similar to what 36 South entered into last year, is unlikely to be lucrative this year.

What is 36 South going to do next? It will start a fund that will bet on inflation around the world going up significantly. With governments around the world planning to tackle recession by printing money and pumping it into their economies, 36 South is likely to make a killing once again.

The funny side of capitalism

I came across two very interesting pieces of work that take potshots at the way capitalism works:

The first one is an article by Jonathan Weil, a Bloomberg columnist.
Weil talks about GM's 2033 bonds, whose prices indicate that the market is betting GM will go down under in the next 2 years, even with a government subsidy. The article argues that in the current market, knowing government's plans is the only way to make money. If one doesn't then there is a very good possibility of losing money, irrespective of whether you are long or short.

This does not come as a surprise to people who follow the Indian markets. The Indian finance minister has many times reversed market sentiment just by calling a press conference!



The other is a post on a blog, in which one of the commenters had combined the news on Somali pirates with the news of Citigroup shares tumbling 46% in two days, to come up with this masterpiece:

The Somali pirates, renegade Somalis known for hijacking ships for ransom in the Gulf of Aden, are negotiating a purchase of Citigroup. The pirates would buy Citigroup with new debt and their existing cash stockpiles, earned most recently from hijacking numerous ships, including most recently a $200 million Saudi Arabian oil tanker. The Somali pirates are offering up to $0.10 per share for Citigroup, pirate spokesman Sugule Ali said earlier today. The negotiations have entered the final stage, Ali said. ``You may not like our price, but we are not in the business of paying for things. Be happy we are in the mood to offer the shareholders anything," said Ali.

The pirates will finance part of the purchase by selling new Pirate Ransom Backed Securities. The PRBS's are backed by the cash flows from future ransom payments from hijackings in the Gulf of Aden. Moody's and S&P have already issued their top investment grade ratings for the PRBS's. Head pirate, Ubu Kalid Shandu, said "we need a bank so that we have a place to keep all of our ransom money. Thankfully, the dislocations in the capital markets has allowed us to purchase Citigroup at an attractive valuation and to take advantage of TARP capital to grow the business even faster."

Shandu added, "We don't call ourselves pirates. We are coastguards and this will just allow us to guard our coasts better."

Funny metaphors

The following are some funny metaphors that people use to describe the beaten down markets and the never-ending volatility

1. This is a dead cat bounce
2. The stock markets took of like a rocket and then nosedived like a failed rocket
3. We all learnt in school what goes up must come down

This is my favorite: “The train has left the station. There is no point in getting off now”

Emerging market OR Submerging market? Ask FIIs

There is a tendency among Indian investors to portray FIIs as villains. There is a general belief that FIIs benefited when Indian stock markets scaled new peaks last year and when the markets started falling, FIIs made a timely exit - leaving the Indian retail investors high and dry. I have been wondering how true it is and now I have the answer.

The Economic Times, the most widely read Indian business daily, carried an interesting article:

“Foreign institutional investors (FIIs) have played a major role in pushing up the index and pulling it down, hurting themselves in the process.

During the ride of the sensex from 10,082 points on February 7, 2006 to 20,582 points on January 10, 2008, FIIs had made a net purchase worth Rs 1,00,951 crore (close to 22 billion USD). During this period, the FIIs provided the required liquidity and the cues for others to follow.

FIIs' net off-loading was to the tune of Rs 47,299 crore (close to 11 billion USD), dragging down the sensex from 20,582 points to 9,975 points”

This clearly shows that FIIs could not make a clean and complete exit and have, along with Indian investors, burnt their fingers getting carried away by the euphoria caused by the Fed’s slashing of benchmark rate in September 2007.

Where is the global economy headed?

Where is the global economy headed? People will kill to get a definitive answer to that question.

There is so much panic, skepticism, and fear among not just investors but also laymen who are wondering whether they will get to keep their jobs, be able to feed their families and pay their mortgage. The scenario is so anti to how it has been over the last few years when words like optimism, confidence and euphoria defined the mood.

Not everyone has realized yet that the turmoil in credit markets will affect the real economy. The freeze in credit markets is bound to have a ripple effect on economic activity. People must be naïve if they think the credit crisis would affect only the financial markets. The crisis would push CEOs make preserving cash the objective, rather than chasing growth. Jeffrey Immelt, the Chairman & CEO of GE recently commented (not quoting him verbatim here) "for every dollar of economic activity, there is 10 dollars of financing involved in the entire supply chain. So if credit market freezes, economic output is bound to be affected."

Now back to the question - Where is the global economy headed?
A recent Reuters poll of economists showed that “the global economy will likely shudder to recessionary levels in 2009 as developed nations' woes damage emerging countries' economic prospects”. The IMF has also projected sharply lower growth for 2009. My take is that we should consider ourselves lucky if we can escape a deep and prolonged recession.

One bright spot in the economy right now is the fall in commodity prices. Oil prices have fallen 50% from the peak and prices of industrial commodities have crashed as well. Oil prices are likely to remain soft if OPEC does not become too greedy. Lower commodity prices will ease the pain many economies are facing.

Manic Markets

I stumbled on a very good cartoon image that captures what is happening in the markets right now.




source: unknown

The demise of Bear Stearns

Bear Stearns has been absorbed by JP Morgan for just $2 per share – reportedly valuing the company at $236 million. It has been a dramatic collapse of a Wall Street Firm that was the darling of employees and stock markets. The employees seem to own nearly 30% of the company (though a significant chunk is likely to be owned by the top few executives) and it has been a terrible loss of personal wealth for them.

I feel sorry for Bear Stearns employees and investors. But I think such incidents tend to make the market healthier by weeding out excesses.

It is apt to be a little philosophical at times like these. Incidents like these reinforce our belief in the laws of Systems Thinking and Behavioral Economics

a) In my post of 30th March 2007, I had discussed how the ballooning asset bubble was threatening to push the financial markets off a cliff and the events that are unfolding now were not so hard to predict even a year earlier.
b) Students of Game Theory know about “Prisoner’s Dilemma”. To cut a long story short, it says that every individual acts in his own interest, thereby causing systemic failures. This failure ends up harming the individuals’ interest which they thought they could protect by acting in a “selfish” manner. Run on banks follows the same principle. When everyone is in a hurry to withdraw their assets from a bank (to protect their own savings, and in hurry to withdraw the asset before the neighbor next door does so), the bank collapses. It does not require erosion in the value of assets of the bank to trigger a crisis like this – it requires just erosion in confidence in the bank.
c) “The law of unintended consequences” is playing catch up: The last few moves of the Fed have had quite a few undesirable effects. Excessive rate cuts by the US Fed have always created asset bubbles – Nasdaq, Subprime, and now a short lived bubble in emerging market equities. Despite the rate cuts, the mortgage crisis is only gathering pace and the economy does not seem to stop sinking into a recession.

The US Fed is blamed by many for taking no action to prvent the crisis. It is interesting to read the comments of Alan Greenspan, the former Fed Chairman, as gathered by Paul Krugman, a columnist with the New York Times

What Greenspan said: “The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.
Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal.”

What Keynes said: In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

Debunk the Decoupling Theory Atleast Now

My comments on January 20th (read post on this link) have all come true !!!

Just a day after I posted the comment, the Indian stock market fell 10% on an intraday basis. The next day it fell another 14% on an intraday basis. Though stock markets recovered a bit, they have been on a down-trend ever since.

It takes a brave man to voice opinion against the wisdom of the crowds and the events over the last few weeks make me feel vindicated.

What were those predictions and how have they markets shaped up against these predictions ?

a) During a downturn, money flows into the home market
There have been huge outflows from emerging markets. Indian and Chinese stock markets have been the worst performers this year.

b) If there is a recession in the US, no country can fully decouple itself and maintain its growth rate

There are signs of sluggishness in the Indian economy. Reports indicate that India’s Industrial Production grew by only 5.3% in January. Bank of China estimates Chinese GDP growth to slow down. Decoupling theory has now given way to Recoupling theory !!!

c) Reckless rate cuts will only stoke inflation rather providing a real impetus to growth (China is currently witnessing inflation of over 6% and the authorities have committed themselves to fight it through a tight monetary policy). Despite the heavy fall in short term interest rates in the US, the long term interest rates have refused to budge, indicating bullishness on inflation trends.

Just look at Gold and Oil. Gold has reached $1000 and oil has crossed $110 – close to a 100% gain in the last 12 months.

How do you position yourself ?

a) Act like a hedge fund; have a long-and short strategy. Immediately switch out of stocks that are dependent on discretionary consumer spending in the US. You can buy into emerging market equities on dips, but buy into those stocks which have lower export component and are fairly valued. Don’t buy stocks whose valuations are can be justified only by a great growth story.
The Indian and Chinese markets have fallen 25% from the peak and people who bought into “growth stocks” have burnt their fingers very badly.

b) If you play commodities, play agri-commodities – the switch from food to fuel is unlikely reverse in a hurry and will help maintain an upward bias on prices.
Soybean, Corn, and Wheat futures have gained around 25 percent from the time I posted the message two months back.

c) If you are currency trader, short the dollar and the pound and go long on the Chinese Yuan. The Chinese government is not answerable to its people and will not mind paying the cost of holding a huge forex reserve (the reserve is already worth about $1.6 trillion – over 50% of its GDP). The government is in NO mood to let the currency seek its natural level and China's trade surplus is not going to disappear in a hurry
Dollar is at an all time low versus a basket of currencies and the Yuan has gained further ground against the dollar. A short position on the dollar and long position on the yuan would have given handsome rewards.

We are in recession and what to do now ?

Recently, I posted an answer to the question of a blogger:


QUESTION

We are in recession and what to do now ?

The subprime wipeout alone, says history's best paid fund manager John Paulson, will last the next two and a half years. Even Merrill Lynch says Wall Street is "in denial" about a U.S. recession -- because recession has already arrived. "According to our analysis," one of the firm's most recent reports says, "this isn't even a forecast any more but is a present day reality."

Goldman Sachs agrees. And other big-time analysts are lining up to say the same. We're 'undoubtedly in a recession," says famous investor Jim Rogers. And Nouriel Roubini, the economist who called the housing bust, calls today the "tipping point" for U.S. consumers.

"The effects will be ugly," Roubini just told CBS Marketwatch "Expect the great recession of 2007 to be much nastier, deeper and more protracted than the 2001 recession." Even AT&T says they've had to cut record numbers of phone and broadband accounts because customers can't meet their bills.

What will be the impact on Indian / Chinese stock markets will more funds drive them up ?


ANSWER

As with most other downturns, this one has been induced by people buying “stories” ignoring caution and commonsense.

Let’s looks at some of the bubbles to get a perspective:

In March 2000, the NASDAQ hit 5,049, followed by a sell-off. The market plunged downward, reaching its bottom of 1,114 on October 9, 2002. People bought stocks with a belief that a “new economy” had emerged in which technology ensured that recessions were a thing of the past and productivity gains would continue at levels that formerly had seemed unattainable.

In 1989, the Nikkei hit its all time high of 38,916, and then slid downward for more than a decade, reaching its bottom of 12,698 in 2001. After a decade of deflation and banking reform, the Nikkei hit a five-year high in January 2006, about 33 percent of its peak value.

However, asset bubbles are not a recent phenomenon, nor are they limited to stock markets. The Dutch Tulip bubble of the 17th century was one of the most dramatic examples. As the price of tulip bulbs increased, speculators began buying the bulbs from sailors and selling them to the wealthy. It is estimated that a bulb at the peak of the bubble sold for $34,584 in today’s dollars. Eventually, some investors began to liquidate their interests in tulips, supply increased dramatically, and during a six week period in 1636, tulip prices fell by 90 percent. To limit the chaos that followed, the government nullified all tulip contracts and declared tulip speculation a form of gambling. Tulip prices never recovered after the bubble burst, and today rare tulip bulbs sell for $0.30 to $0.40 apiece

Recent bubbles have been induced by “reckless” action from the US Fed. This is called the “Fed Put” - the Fed trying to rescue careless investors and traders by cutting interest rates. This action has created one bubble after the other – Nasdaq, Sub Prime, and the next could be emerging market equities and industrial commodities.

People have definitely bought into the “decoupling theory” and the “TINA – There is no alternative” theory, pumping money into India, China, Gold, Oil – you name it !!! US Dollar has been reaching new lows, creating problems for exporters (into the US), but providing better gains for investors in assets denominated in currencies other than the USD.

What will happen in future ? There are a few golden rules which probably will not be violated this time too
a) During a downturn, money flows into the home market
b) If there is a recession in the US, no country can fully decouple itself and maintain its growth rate
c) Reckless rate cuts will only stoke inflation rather providing a real impetus to growth (China is currently witnessing inflation of over 6% and the authorities have committed themselves to fight it through a tight monetary policy). Despite the heavy fall in short term interest rates in the US, the long term interest rates have refused to budge, indicating bullishness on inflation trends.

How do you position yourself ?

a) Act like a hedge fund; have a long-and short strategy. Immediately switch out of stocks that are dependent on discretionary consumer spending in the US. You can buy into emerging market equities on dips, but buy into those stocks which have lower export component and are fairly valued. Don’t buy stocks whose valuations are can be justified only by a great growth story.
b) If you play commodities, play agri-commodities – the switch from food to fuel is unlikely reverse in a hurry and will help maintain an upward bias on prices.
c) If you are currency trader, short the dollar and the pound and go long on the Chinese Yuan. The Chinese government is not answerable to its people and will not mind paying the cost of holding a huge forex reserve (the reserve is already worth about $1.6 trillion – over 50% of its GDP). The government is in NO mood to let the currency seek its natural level and China's trade surplus is not going to disappear in a hurry.

If the inter-connectedness of the global economy and the consequent complexity creates anxiety in you, Welcome to the Club !!!

Buffett's Annual Letter to Shareholders

Every year Warren Buffett, the world’s most legendary (and richest) investor, makes his annual letter to shareholders public. As always, the 2007 letter is a good read (its labeled “2006″ because its a report about last year).

As always, this year, his thoughts range quite widely. A few parts caught my attention:
His company increased in value by $ 16.9 billion in 2006 - the biggest single year value gain in corporate history (or so they think). Berkshire-Hathaway owns more than 60 companies, including insurance, clothing, furniture, jewelry and candy companies, restaurants, natural gas and corporate jet firms .

He has announced his retirement, but still don’t have a successor for him. But he is not handing over to children, nor ducking the decision. That would be to risk, in his own words, “decay… accompanied by my delusional thinking that I am reaching new heights of managerial brilliance”.
“Our most important business, insurance, benefited from a large dose of luck: Mother Nature, bless her heart, went on vacation. After hammering us with hurricanes in 2004 and 2005 — storms that caused us to lose a bundle on super-cat insurance — she just vanished. Last year, the red ink from this activity turned black, very black.”

Buffett expresses regret at the passing of traditional climate patterns, and had similar sentiments for the glory days of the newspaper industry (another big industry for Berkshire-Hathaway), where he thinks that “eroding fundamentals will overwhelm managerial brilliance”. Even if “non-economic buyers” emerge for newspapers “the ‘psychic’ value of possessing one will wane”.

Buffett does not expect that upcoming disclosure rules will put a stop to “astronomical” executive compensation, often unrelated to performance. That will “only occur if the largest institutional shareholders - it would only take a few - demand a fresh look at the whole system”.