Wednesday, December 10, 2008

Rally comes, rally goes? Hold on, I think there is some money in there…

The view as well as the systems call on the Nifty stays intact. 2900 was a tough resistance as per the GANNs that have been following the market and its break does augur quite well. There is every likelihood that the market will break above 3000 during this week and head for 3250 as the next solid barrier.

But once the 3250 level is met, there is a good chance that India specific factors will start weighing in on the market. A congestion pattern should emerge post January 15 and the market will need to stay above 3150 to keep the GANN based patterns intact. I am still convinced that global stock markets are headed higher from these levels, notwithstanding the naysayers. At the same time, I am also convinced that Indian participation in the global rally is likely to be sporadic and may keep fizzling out time and again. Hence, exercising caution is completely necessary and taking profits frequently is quite in order.

I will begin posting GANN related ideas and fundamentals of setting up a network in case there is an interest. Anyone who wants to participate in this can leave a message to my latest post and I will check it out.

Tuesday, December 9, 2008

Of Bad Policy, Muddled Thinking and Half-baked Solutions Part-1

Policy prescriptions to pull the Indian economy from the muddle continue to be muddled and there seems to be almost no thought given to the real effects of the prescriptions. Today's Economic Times contains one such debate where three policy honchos have outlined the course of action for reviving the economy.

One of the key recommendations (accompanied by a comment of course) is that since the problems of the economy are due to bad monetary policy followed over last one year, the government should cut the CRR. Furthermore, it should cut the SLR also to release more funds.

I will address the comment on bad monetary policy separately. Here, is this advice likely to work? Chances are that it is not. Here is why.

Dwindling Forex Reserves will Suck Out Liquidity

Each percentage point cut in CRR releases roughly Rs. 40,000 crores in the system. Each $10 billion reduction in reserves sucks out Rs. 50,000 crores at current exchange rate. The current period of tight liquidity began in September, hence it is appropriate to check the movement of reserves from then.

Total forex reserves as on August 29 were US$ 295.3 billion (RBI weekly statistical supplement). Reserves fell to US$ 247.7 billion as on November 28 (you can check here). This reduction of close to 50 billion dollars in reserves has sucked out staggering amounts of liquidity, equivalent to close to 6% point cut in the CRR. Clearly, there is a price to be paid in supporting the currency.

This is where we are getting our priorities wrong. The original argument for defending the currency was that it was likely to help in our fight with inflation. With inflation no longer a concern, should RBI continue to defend the currency so aggressively and starve the local market of much needed liquidity?

Strong Rupee DOES Hurt Exports

When will we wake up to this reality? The fact is that Indian export sector has been severely hit by strong rupee. During past 5 years, the only item that has registered a strong rise is Petroleum items. It does come as a surprise to most of the people as we are big crude importers. But all along, India has been one of the only few countries in the world with massive spare refining capacity. Nothing wrong with that. Except the fact that petroleum item export has masked the critical condition of many other sectors, notably textiles. It is worth noting that textiles and readymade garments is a high employment sector unlike refining.

Now that the rising crude price cycle has been broken and lower world demand is reducing refining margins, we are suffering the outcome of slowing exports. But nobody has woken up to the fact that we have done extensive harm to ourselves.

Industry commentators, on the other hand, continue to make asinine demands. Textile industry is fighting for a 2% duty drawback handout. How much help will that be? Why do they not ask for a rupee which is 10% weaker than the current levels? Not only will it mean higher margins for them, it will in fact improve liquidity in the system because RBI will not be reducing reserves to protect the rupee at current levels.

SLR Cut?

What will the SLR cut do for industry? The answer is NOTHING. The main culprit in such times is the massive size of the government borrowing program that crowds out commercial loans. What an SLR cut does is that it allows banks to buy less of government bonds. But somebody has to buy them afterall. And that means that an SLR cut is totally ineffective.

Put another way, if a bank is holding Rs. 25 in bonds and SLR cut allows them to hold Rs. 24 instead. The assumption is that they will sell Re. 1 of bonds to raise money and will in turn lend to industry. But who will buy the bond? It is fine if government buys it back. But the government is already selling more due to a massive rise in its borrowing needs. It will just mean that an investor will hold a government bond instead of keeping money in the bank (probably). So by asking banks to sell the bonds, you are just taking money out of one pocket to put in another.

In other words, during tight liquidity, banks cannot sell much of their bonds anyway. If they do, it will in fact mean higher interest rates for everyone and nothing else. The real problem in this situation is a massive borrowing need of the government who anyway does not have an option to stop spending.

Crowding Out Certainly A Real Possibility

Given the current fiscal situation, it is likely that fiscal deficits will continue to rise. It means a much higher government borrowing level for many years to come. While it helps the economy in the short run, it is highly negative for the real economy in the longer run.

Indian economy has suffered high interest rates historically due to this factor. The reason is quite simple. Governments tend to be highly inefficient in their spending programs. Most of the times, return on investments is poor which throttles future growth. At the same time, private sector is kept out of the game by high cost of money. It is a cycle that India had broken only a few years back. It will be highly unfortunate if we get back into the same trap.

Internationally, there is enough evidence that crowding out is a real phenomenon. Japan is a case in point. During the '90s and early 2000s, the government borrowed heavily to keep the economy going. The following graph shows what it did to the private sector borrowers.

JGBs and Loans as percentage of total assets of Japanese Banks; 1993-2008, Bank of Japan.

The above chart shows that during the 10-year period between 1995 to 2005, Japanese banks raise their JGB holdings by 10%, mirrored by an equivalent fall in commercial loans. They bought safer bonds by reducing lending to private sector even when they were not mandated to. (If you want to download this data, here is the Bank of Japan link).

Given the current situation, banks in India are also likely to increase their government bond holdings and not reduce it. There is already evidence to that effect. While RBI has reduced the SLR by one percentage point, banks' holding of bonds has gone up by TWO percentage points from 26.5% to 28.5%.

To summarise, SLR cut or no SLR cut, we are heading for a tighter liquidity situation and higher interest rates for commercial borrowers. One real variable that can alter this in the short run is reduction in CRR coupled with no further reduction in forex reserves.

Will It Change?

This is one risk that I am particularly afraid of. All the "experts" at present are indulging in a highly dangerous thing. They are presenting half-baked solutions. This is not going to help the economy because some of the recommendations are useless, some are counterproductive. We are not only in a bind, we do not even know what we are doing and whether it will actually help us get out of the bind.

We will continue this discussion before we get down to the real task of building GANNs that help us invest profitably in this muddled environment.

Happy Trading!

Time to Short?

Tax cut in India

Recently, I came across a policy prescription for India that went on these lines (by a commentator in former economic policy advisory position). That India needs to give strong stimulus to the economy (agreed); that the plan to spend on infrastructure is likely to take too long (agreed); that we do not have the necessary execution mechanisms to implement infra projects (what? What were we doing till now?); so on and so forth. Therefore, we need a tax cut as that is the fastest way of putting money into people's pockets.

This is absurd. This is the logic used by Bush and his men to fool the US masses and put some more money into the pockets of the filthy rich. Since the suggestion by this commentator (in a reputed economic daily) sounded so much like Bush, he probably felt compelled to modify the suggestion. A cut in indirect taxes is more "equitable", hence that is recommended.

There is a good reason why this is not going to work at least for India.

The Keynesian Logic

The original prescription by Lord Keynes (undoubtedly one of the brightest minds who ever tried to illuminate some dark economic corners) was raising taxes and NOT reducing them. The Keynesian prescription went on these lines.

  • Individuals in particular and private players in general are never inclined to spend everything they have got. They are inclined to save something and in a downturn; a higher inclination to save actually slows down the economy. This tendency is all across and Chanda Kochhar of ICICI enunciated it on CNBC yesterday, when she said that banks have to carry MORE spare cash due to the downturn as cash flow may slow down unexpectedly. This spells trouble in a slowdown.
  • Government, on the other hand, is inclined to spend more than it gets from taxes.
  • The best approach is to raise taxes, get money from people who are likely to save it anyway and spend on projects that stimulate the economy.

Common sense supports this theory. If you are likely to lose your job tomorrow, are you likely to buy the new LCD TV you have been coveting because the government is lowering the taxes? Will you buy it even if you are only likely to lose your job? Will you buy it even if you are not losing your job but everyone around you is losing theirs?

Indirect taxes are even more obscure. A cut will lower the prices somewhat. In a low inflation scenario, is it likely to work? Anyway, we are seeing government subsidies lowering prices everywhere, administered fuel prices that result in a huge deficit, administered fertilizer prices and so on. It is equivalent of price reduction. It does not matter whether you cut a tax or increase a subsidy. The net impact is the same, lower price to end consumer and lower revenue to the government. Has it stimulated the economy?

Again, the same question arises. Are you likely to buy the new LCD TV if the price has fallen from 80000 to 78000 due to a tax cut? Not if you fear losing your job three months later.

Not Deficits Alone

A lot of people misinterpret Keynes. Perception is that he was about creating massive deficits and unfettered spending. His advice, on the contrary, was quite specific. In a downturn, he argued, your top priority is reviving the economy. When a faltering economy is your primary concern, increasing fiscal deficits should be last of your concerns. He was too keenly aware of unlimited deficits given the hyperinflationary experience of post World War I period. His advice was that the government should spend: raise taxes and spend, create deficits and spend. In other words, during a slowdown, do whatever you can to stimulate. This does not mean uncontrolled deficits. They are more likely to do harm than good.

Majority of the policy makers globally have essentially taken this course of action. But the best interpretation has probably come from the UK (and rightly so). Quick decisive action to stabilize the markets. They have lowered taxes though, but with the express acknowledgement that it is purely symbolic gesture, adopted because they could not find spending avenues and anyway, it does not do any harm.

India

We are, of course, in a totally different situation. We are in a fiscal muddle, with very few alternatives before us (see my previous post). What's worse, the ideas coming from policy makers are so stale, and action is so slow, there is not much hope of a quick revival. It is part of the reason behind my conviction that India will participate only sporadically in the coming global stock rally.

Trade?

Muddled thinking on part of policy makers is not necessarily bullish for stock markets. If the current rally does not break 2900 (a strong resistance as per my GANN) on the Nifty, there is a temptation to short the market and collect some good money over next one week. If you do trade on the short side, quick trades, early profit taking is called for because there will be upside pressure due to international cues. But on the whole, bulls will keep fizzling out. Given the muddle at the policy level, there is no hope in the medium term for investors and as Keynes pointed out, we are all dead in the long term, so that doesn't count.

If you are trading on the long side, caution is necessary. It makes sense to take profits frequently because they may not last. It is too early to look at January targets, but a decisive break of 3150 towards January end on Nifty is strongly indicated. We will continue to refine this over coming two weeks.

Cheers and happy trading!

BTW, if anyone is interested in joining the blog as an author, please do leave a message.

Too Little Too Late?

There is enough buzz (and commentary) around the fiscal stimulus package announced by Dr. Singh. The majority opinion is that the package is too small and is not likely to do much for the economy other than bail out a few specific sectors (e.g., real estate). But we all know that the current government is painted in such a bad fiscal corner that their ability to do anything is limited at best.

But there is some reason to cheer. Elections are coming and governments tend to be populist around elections. While I do not want to comment upon the effectiveness of populist schemes, the money spent does amount to providing a stimulus in effect. Thus, the sixth pay commission handouts as well as other populist doles in effect are likely to provide some sort of stimulus to the economy. Afterall, money is money and what is the difference whether I get extra cash in my hands through a tax refund check or a salary arrear check?

But there are already significant problems that are showing on the horizon and the government has no answer against those problems.

Money troubles

Though primary policy action in India has been on monetary side, all is not well (still) as far as liquidity is concerned. There are "air pockets" and liquidity is likely to be hit with sudden shocks as the economy adjusts to a totally different pace of expansion and a complete sectoral shift in economic activity.

With the continued slowdown in exports and reduction in capital flows, the dollar reserves of the country will keep on coming down (add to it the impact of external borrowings where refinancing at maturity does not materialize). The net result is that the RBI will continue to supply dollars to the market and it will keep on mopping up whatever liquidity RBI supplies. Fortunately, there is enough room for RBI to keep on pumping liquidity in the market for some time due to some wise policy action by ex-Governor YV Reddy. But there are limits to that particularly because of the borrowing program of the government.

Government borrowing

The borrowing program of the government creates a significant problem. GoI is going to exceed its borrowing targets in a big way this year. There is no information on the state governments' side, but they are also likely to face a slowdown in tax revenues (both their own as well as allocation from taxes collected by the center). They are also likely to face pressure to match Sixth Pay Commission recommendations at the state level. Combined, the total government borrowing is likely to mop up a large amount of liquidity supplied by the RBI.

There is an effect from the older times (when we were not used to 7%+ growth rates) referred to as crowding out when GoI was the primary borrower in the money markets and others had to wait for their turn. The result was very high interest rates for the corporate and other borrowers. If the deficit continues to balloon and borrowing continues to increase, the interest rates may not stay at a low level, something essential for sparking a revival in the broader economy.

It is important to note that a reduction in SLR by RBI does NOT create new liquidity. Only a cut in CRR does that. The reason is that SLR requires banks to buy government bonds. If banks want to release this cash, someone else must be willing to buy and hold these bonds. When there is a glut of government bonds in the market, an attempt by banks to sell SLR bonds will actually add to the supply and consequently RAISE interest rates. The entire logic of the exercise will run COUNTER to the objective of lowering interest rates.

Triple challenge for the RBI

In the current situation, the RBI has to dynamically balance the following three conflicting goals:

  • Manage the borrowing program of the government which is way ahead of the target. This creates problems because of the likely crowding out effect. It is also likely to suck out a large chunk of liquidity injected in the system through CRR cut.
  • Keep interest rates at reasonable levels to revive growth. Government borrowing will likely keep rates higher, so will an attempt by banks to sell SLR bonds (if they choose to do so). While the current situation is comfortable, there is a danger that we can slip into far higher effective interest rates of 15-20%+ for the private sector, something that has been common till about a decade back.
  • Keep inflation under check. While inflation is slowing down now and may hit 1% levels by March, it is too early to declare victory. Commodity prices have suddenly softened internationally but the cycle is likely to resume latest by Q3 of calendar 2009. Moreover, the anticipated 1% inflation in March is a result of a higher base effect as inflation was quite high in March/April 2008 (and rising). Once the base effect is over and commodity prices start looking up, too much of easing on monetary side is likely to revive inflation. I know the priority now is revival in the economy but long term inflation is the biggest danger to growth.

The pressure on monetary policy is only likely to intensify in the coming months. Combined with the fiscal constraints, it spells fairly deep chill in the coming winter.

The prognosis for the stock market is not very good. Global markets are likely to revive and I am seeing a good, sustained rally building up. But the Indian market will participate only in fits and starts. The reality is that the economy has been so poorly managed that only a few months of external shock have broken the growth momentum. The biggest fear is that we may not be able to regain it. I certainly hope that we are able to avoid that fate, but at least till March, 09; India is likely to underperform global equities.

Trade with caution with upside bias. Take profits relatively early instead of hanging on for double digit percentage gains. Buying opportunities will continue to present themselves. There is no need to fear that one may have missed the bus in buying the stocks as market will keep on testing lower levels periodically.

Happy Trading!

Thursday, December 4, 2008

Rally in January?

We have been trading in a bear market for quite some time. The favourite refrain of the bear market "valuation is very attractive" has been heard fairly often now and a few commentators are also now acknowledging the possibilities that we may have a rally of sorts relatively early. But there are a few strong indicators that put the probability at a relatively high level.

Real Economy

Stock market generally leads the real economy instead of lagging it. There is enough evidence that for the US economy, the stock market typically bottoms out three to six months prior to end of recession. In case of the current bear market in the US, it started in August/September last year which preceeds the beginning of the current recession by about 3 months.

The current recession in the US is likely to end by middle of 2009, give or take a couple of months at the most. Most of the market commentators foresee a global recovery beginning around that period and Compleat Trader has the same assessment. It means that the US stock market is likely to begin a medium term sustained uptrend somewhere between January and March. Compleat Trader's call, though, is that the rally will begin in January itself.

Government Action

This crisis is unprecedented also due to the fact that we had a credit crisis exactly at a time when there was a lame duck president in the US. Though it did not hinder the rescue packages, etc., it certainly created uncertainty on a number of counts:

  1. It put a limit on what kind of fiscal stimulus would be given to the market, when it could be given and what was the size and extent of that.
  2. There has been relatively little clarity on Mr. Obama's stance on key issues like global trade, outsourcing, etc. While he has spoken a number of times in terms that are strongly negative on these counts, his recent actions contradict his earlier statements. Particularly, by appointing a pro-trade person (Governor Richardson of New Mexico) in a key position in his administration, he has signaled that his actions may go otherwise.
  3. Henry Paulson has not helped things by frequently changing his mind on using the bailout package, the timing, etc. The outcome of the presidential election might have had some bearing on his decision on whether to use the bailout money right now or to leave it to the next president.

All this is likely to change in mid-January. This way or that, the market will know exactly where things stand and that is a positive for the markets.

Neural Model Output

Our long term GANN (800 cells, trained on 20 year data of long term indicators) also indicates a revival in early January. The same model had shown a massive dip in the US markets around September 2007 and using the same indicators, we see a strong possibility of a sustained rally beginning in January 2009. Since I do not trade the US markets and did not trade Indian markets in 2007, I cannot comment on actual performance based on these signals.

January is the Likely Turning Point

There is a clear indication that we are heading into a period where global equity markets are facing more upside pressure than downside pressures. China in particular has already started what looks like a secular uptrend. Other markets also, particularly the US and the ones with commodity exposure (other than oil) should also see a strong rally from January onwards. Oil, though, is in a different trading realm at the moment and may not rally with the stock markets. We will explore that in a separate post.

Indian Markets

This makes things a little bit complicated for Indian Markets. Indian Markets are not likely to bottom out so early due to factors specific to India. Hence, working out a proper strategy for the Indian market is going to be a bit more difficult at this time. I think we need more data before we can stick our collective neck out in either direction. Though I think the situation will clear up by end of January and India should participate in the global rally with a little bit of delay. But there are numerous roadblocks in India including poor fiscal situation, rapidly worsening external account, corporates sitting on bad currency/loan hedges and political uncertainty brought in by a lame duck government. Recent terror strikes have not helped. Hence, the probability of rallies fizzling out early is high.

How Do We Trade?

At this moment, this is a question mark. I do want to set up a test system that can successfully trade over next two months. Any testable ideas on setting up the system are welcome. On my part, whatever results are generated that can be used will be posted on the blog.

Happy trading!

Panic Over? Recession takes over...

The panic from the credit crisis is more or less over, especially after the bailout of Citibank. CT does not believe that the market is going to worry at all in the future about the possibility of the banks going under. The regulators have shown enough resolve and thrown enough resources at the problem and it is likely to be over for good.

That means recession is the main driving force behind the markets. Even during past one month, when credit worries have subsided, it is the depth and the extent of the recession that has driven market price action. From this point on, outlook on the recession is something that will drive the markets for next few months.

The main worry at the moment is that the world will go down in a lockstep downturn and emerging markets are at a major risk. Some commentators (particularly Stephen Jen) are predicting a major "moment" for emerging market currencies, particularly Indian Rupee. But the risks are diminishing by the day because emerging markets have not suffered a major systemic shock. Most of the EMs have robust currency reserves, banking systems remain relatively well capitalized and the corporate sector (barring South Korea and India) is not flirting with currency related disaster.

The recession also seems to have panned out pretty wide and deep. But at the same time, the good news is that the US Fed has been well ahead of the curve (albeit for credit crisis related reasons) and has been cutting interest rates well ahead of the recession. While the credit crunch has created a lot of problems for businesses, the problems will ease as soon as the flow of money resumes.

The economic newsflow, which has stayed very negative over past few weeks, is also likely to improve going forward. Most of the commentators anticipate the recession to last well into 2009 and the recovery is likely to happen only in the 2nd half of the year. This assessment seems to be pretty fair as the flow of credit will take some time to resume and confidence will take some time to recover. This sets things up for a global recovery post June, 2009. It, however, means that we will have a recession/slowdown spanning more than six quarters which makes is fairly long and deep recession.

The implications for India are very clear. On the economy side, exports will continue to flounder well into 2009. We are already suffering a negative growth in exports which is likely to continue for the forseeable future. One, high growth in global trade (from which we have benefited during the past few years, though we have underperformed on high value items) is not likely to resume before 2010. Trade growth will take some time to resume after the recession is over. Then, there is anti-trade stance of the Obama administration to consider and we do not know how it is going to impact US imports. Two, Indian Rupee continues to be overvalued in relative terms to key trade rivals like China and other Asian countries on a 15-year trade weighted basis.

Even though policy makers continue to emphasize that exports do not matter for India much, exports do matter on the margin. At 13% of GDP, a 10% negative growth in exports deals a blow of 1% cut in GDP growth. Even if the domestic economy grows by 7%, negative export growth is going to pull down the overall GDP to sub-6% levels. So from 20%+ growth and 2.5%+ contribution to the GDP growth, export sector is going to be a drag for a few months to come.

The need for export sector reform and a drastic change in the currency management policies form a completely separate topic. For now, what we can see is that the slowdown in India is likely to last a little bit longer than the US and the rest of the world. Anyway, India got into the slowdown cycle a bit late and the excesses of the past 5 years will take a little bit longer to clear out.

The set up does indicate that investors and traders need to be cautious for at least next one month. Sustained rallies may not be possible and selling into rallies in December seems to be the right thing to do.

Cheers.

Tuesday, December 2, 2008

Right tools for trading the current market...

During past two and a half months, the panic created by massive failures in the financial market has dominated all trading and market actions. Usefulness of trading and analysis tools has been quite suspect during such a time.
  1. Volatility has skyrocketed. This makes it very hard for a shorter term trader to put on any kind of trades. No matter which side you are trading, chances are you will get stopped out by daily swings in the market which have routinely exceeded 5% on intra-day basis.
  2. There is a realization that panic is creating a strong impact on the market. Hence, whenever the bears relent, the bullish spike is so violent that it is hard to pin down where it will end. At the same time, panic keeps returning to the market and we never know when a rally will die a premature death.
The result has been sharp rallies at times when noone expected them, rallies that have surprized by their speed and many times, intra day swings that have been complete shockers.

All these have been signs that normal tools of technical analysis, mechanical trading system, etc. have not been of much help. Practically every support or resistance or congestion indicated by technical tools has been taken out routinely,

But as the panic is abating and market is returning to normal behaviour, it does allow use of the tools from this point on. From this point on, what we are witnessing is a more "traditional" recession worldwide and a slowdown in India that is gripping the markets. It should make things more manageable for traders and investors alike.

Till the time of next market turn, technical analysis should be the right tool to trade this market along with a few simple algorithmic models. Since the current bear market began in January in India, use of a simple 10-cell network trained on Jan to Sept data should also give useful signals.

Technical analysis and networks with a short training are, however, not very useful in predicting significant market turns any more. Though, traditionally technical analysis has given reversal patterns like head and shoulders, these patterns have not been seen at big market turns since the early '90s. There is a good reason for that. Technical analysis became highly fashionable in the early '90s. Since everyone watches technicals now, it is no longer a very reliable tool; particularly in predicting big turns.

For trading the market, two things seem appropriate. One, technicals can be used for short term trading but longer term call needs to be taken based on less popular systems. Two, at least we are getting back to a market where normal assumptions work. Hence, a trader whose system was successful prior to September but who has been suffering a total breakdown of the system during past two months can go back to the originally successful system. There is no reason why that system should fail from this point onwards.

Cheers.

The GANN Project

As explained in the title of the blog, this blog is a project that is designed to test viability of simple GAs and ANNs in aiding trading and investment decisions. This is a departure from algorithmic trading that is more quantitatively oriented.

Algorithmic trading requires fairly strong support in terms of resources, something that an individual investor or a trader cannot replicate so easily. This denies the average trader, currency risk manager and investor access to a tool that is highly useful. It is not our purpose to neutralize this disadvantage completely. Rather, it is an attempt explore ways to achieve more favorable results in an uncertain environment.

This project, therefore, is more of an outlet for ideas and how they can be used for better investing and trading. The posts to the blog are open, anyone can share anything. The ideas shared on the blog will be tested out by GANN, wherever a robust quantitative testing and backup are required. That gives a strong advantage to the originator of the idea because then they do not have to go through the trouble of building a strong quantitative model to test and modify it.

The primary focus of the project is the Indian market and the Indian investor. Over a period of time, we may expand the focus of enquiry into other areas. But at the moment, we begin with both BSE and NSE, as well as Indian Rupee as matter of discussion.

Wish you happy and profitable trading ahead!

Cheers.
 
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