Tuesday, March 31, 2009

Global Markets May Recover But India Likely To Linger Here Longer


March proved to be a month where most of the views posted on this blog have turned out to be right. Crude is back to the region of $50/bbl poised to start an upward trend. Steel prices have stabilized. Global markets tested their October lows and bounced back. Indian bonds tanked as yields soared due to heavy borrowing program by the government. Overall, from financial forecasting point of view, the month of March turned out to be exactly as anticipated.

Going forward, we are entering probably the choppiest part of the current market. There are multiple signals that the market is getting from the real economy, some suggesting that the end of the tunnel is in sight, some signaling that we will continue to go down the tube. Nerves tend to be shaky and confidence takes time to build up. Till then, every piece of negative news brings up traumatic memories (and responses). At the same time, there are sharp rallies whenever there is good news as practically everyone is sitting short with a highly bearish sentiment.

Still, some strands are emerging in the global market situation that do indicate that things are changing. One, the short term bottom seems to be in place in the markets as the retest of the October lows is past us and the markets did not go substantially below that level. It indicates that the worst case scenario is not going to take the markets much lower from here. Two, economic data have begun to show mixed trends rather than persistent downward trends. Of course, some economies like Japan are posting consistent downward data but that is more due to their heavy export dependence and trade will take some time to pick up. Three, regardless of the so-called differences among the global leaders, no one believes that the financial system will be allowed to go belly up after throwing many trillions of dollars at it. Of course, there is too much at stake. But there is sunk cost fallacy as well and more money will have to be thrown at the problem simply to safeguard (if nothing else) what has been spent earlier.

We are not out of the woods yet, but the market will keep on looking for signs of an end to the current hopelessness. In this situation, the following assume significance:

  • Global markets continue to be oversold. People who have made money on the bearish side will continue to run shorts. But there is a problem with that stance. To be able to make good money on the bearish side, you need to believe that markets will fall by 10-20% at least from these levels. This is a contention which may not be tenable. As more and more people move away from this contention, a sustainable rally may be likely.
  • Commodity and trade indicators do not support an Armageddon scenario. Crude oil is 40-50% above its recent bottom. Baltic dry index is at three times the bottom. Be it steel, aluminum or any other commodity, prices are higher than their 2005 level. While it may a shock to traders and producers (who went in for highly expensive acquisitions), it is not an indication of an economy going down the tube. Despite all the pessimism, real demand has stayed stubbornly high to keep commodities at these levels.
  • So far, the huge infusions of money into the system have not had an impact simply because of one factor. High pessimism leads to a free run for hoarding instincts. Falling velocity of money and money multiplier would directly offset any cash infusion. But as confidence comes back slowly and activity picks up; a rapid recovery in the money multiplier will expand money supply much faster than anyone can control. Two, this time around, central banks are likely to dither on early signs of inflation. No one would want to kill a nascent recovery and hence, early indications of inflation are likely to be ignored. This means delayed monetary action and a nasty inflationary surprise. In the initial phase, this is positive for the stock and commodity markets.

What Goes Up Stays Up

Contrary to popular conception, it is true for some things. An inflationary overhang that has taken a decade to build up is likely to take a lot more pain to abate, especially when every government around the world is bent upon keeping it alive. This means a boon for commodity producers in the medium term. I have been predicting the resumption of a commodity up-cycle after March for quite some time and have not found any reason to change my views till now.

Stock markets, on the other hand, still need another year or two of consolidation before the build up of the next bull run. This does not preclude a short term rally in the markets that is more than likely.

Indian Markets

India stands in a unique position. On one side, the real economy has shown resilience, especially the consumption led sectors. The headline number, however, will continue to disappoint. But the international interest in India is likely to be shortlived. The current interest in India is due to the fact that India is likely to deliver 5% growth in the middle of no growth. That will change over next 9-12 months and as global markets rally, India is likely to underperform the global equity markets. The single reason behind this underperformance is going to be government. By blowing money on ineffective measures (fuel price cuts beyond warranted, ineffective tax cuts, etc.), it has created a big hole in public finances. To pick one example, the excise duty reductions have all been absorbed by the producers to boost margins. That has led to the familiar specter of the government having to bully and threaten the car producers to pass on excise cuts or else… Demand stimulation? Possible, if the government has the resources to monitor a few thousand large industry units (and a few million SMEs). Complete choke on the industry and crowding out? Quite likely over next few months as the government appropriates all the necessary resources in the economy to plug such massive holes in its finances.

While economic activity will continue to recover on the ground, I think the runaway growth phase is far away. Instead of improving, things will continue to worsen on the credit front as money keeps getting sucked out of the system. There is no credit available for risky two-wheeler financing today, SMEs are not getting enough money, banks are threatening to refer perfectly good borrowers to CBI and CVC (in a bid to avoid "diversion" of working capital); these are not signs of credit delivery improving.

More pain for those who hope to make a bundle in India over next six months. But there is a silver lining to the clouds. India typically takes years to recover when there is apparently nothing wrong (three years post the dot com bust, when there was NOTHING wrong). It means a great opportunity for slow accumulation of stocks. Go for SIPs, gradual acquisition, accumulate a good portfolio at leisure. And reap the reward half a decade later… If the government does not melt it down completely in the meantime.


Thursday, March 26, 2009

Bond Market Check


This post comes after a long lag, and for a good reason. For past one month or so, there was time to just sit back and enjoy, watching things pan out as one had anticipated. Along came the "bewildered" protests by friends and fellow colleagues wondering "why" things were going the way they were. Anyway, enough gloating.

Bond market is exhibiting the beginning of a long government borrowing overhang, something that is going to last for at least one full financial year. This is visible in the benchmark yields, now touching 7%. This goes contrary to the earlier expectations of bond yields falling below 5%. As I pointed out in January, that may not happen in a hurry.

The critical factor to watch out for is whether and when RBI decides to go for QE in a substantial way. My call since January has been that QE is likely to become substantial only after April. That causes a lot of heartburn to people who have built up massive positions hoping for a bonds rally. They point out the fall in WPI, an economy in crisis and so on, hoping for more rate cuts and QE. But they are clearly swimming against the current. The current happens to be quite strong and is built up by double digit consumer price inflation, food price inflation of 8%. If the commodity rally begins globally (my call was post March and we are already hearing the rumblings of something beginning to stir, more on that later), there goes "zero inflation", "deflation", cries. In this environment, any QE action is going to be tempered and cautious and very unlikely to compensate fully for the massive government borrowing.

So the yields will continue to tick higher from here, though the 2% jump seen in the last quarter is not likely to be repeated. At some time, RBI may step up the QE efforts and go beyond the current muted operation through secondary market purchases. But expect yields to stay up, corporate rates to stay up as well and housing loan rates to start ticking up again post elections.

Good to be back. Cheers.

Sunday, March 1, 2009

Buying “Undervalued” Stocks Part-4: Base Rate Fallacy and Mean Reversion


Buying "Undervalued" Stocks Part-3: Completing Sectoral Analysis

Buying "Undervalued" Stocks Part-2: Do Other Sectors Follow the Same Pattern?

Buying "Undervalued" Stocks Part 1: Does it Work?

We have seen in the previous posts in the series how "street wisdom" of buying hammered sectors and stocks can backfire. More often than not, once a stock or sector starts outperforming, the outperformance continues till the market conditions change. Similarly, an underperforming sector usually does not turn around till the market conditions themselves change.

The belief in this kind of heuristics still persists because of a cognitive bias known as Base Rate Neglect or Base Rate Fallacy. Put simply, base rate neglect describes how human reasoners tend to ignore background frequencies while calculating probabilities. The following example from wisegeek.com would make it clear:

Another example of base rate neglect in an experimental context would be the presentation to a group of test subjects of a list of ten students and descriptions of their habits and personalities. The presentation is followed by a question as to what grade point average any given student is likely to have. This information is presented together with base rate information on students' academic performance, which should guide test subjects in their guesses, but regularly does not. Given ten poor descriptions of students, test subjects will assign GPA estimates substantially out of line with base rates. Given ten positive descriptions, the bias occurs in the opposite direction.

In financial market context, the neglect is created by considering the prices at which a stock has traded historically. Looking at it objectively, the past price of a stock does not matter when you are valuing it based on future cash flows. To use a simple formula, value of a stock is equal to known future cash flows plus present value of growth opportunities (PVGO). What price a stock has traded in the past at has no significance in this valuation. If the future prospects look really bleak, stock has to be valued low and vice versa.

But investors frequently place undue reliance on past information, particularly prices at which a stock has traded. This creates a base rate neglect as investors pay insufficient attention to relevant information like future prospects for the stock. Hence, if a real estate stock is valued at Rs. 500 and conditions now warrant it to be valued at Rs. 100, a lot of investors will continue to value the stock at more than Rs. 100. They will continue to see "value" in stock at various price points above Rs. 100 based purely on the historical high of Rs. 500.

This bias works both on the upside as well as the downside. This is the reason why an outperformer is seldom picked up by retail investors early on. Since investors pay unduly high attention to past prices, they will continue to ignore the outperformer till the price stabilizes a bit and then get in. Clearly enough, a large chunk of the move is over by then and many times, retail investors get into a stock close to its peak.

"Fading the Fool" Theory

This is precisely why the Wall Street theory of Fading the Fool has some ring of truth to it. Do exactly the opposite of the "average retail investor" and you will make money. Whether you make money by doing it or not, the fact that majority of retail investors lose money when the market turns is due to the fact that insufficient attention is paid to relevant price information while irrelevant historical information is given undue credence.

That is the reason why retail investors seldom cut their losses short. Most of them keep holding on to poor performers believing they will regain past highs. Add on to it the reluctance to take a certain loss and keeping potential profits open (more on that in another article) and you have a portfolio busting combination. To that, we will add something that even seasoned investors are not immune to: the belief in mean-reversion.

The Giant Killer: Mean-Reversion

Investopedia defines mean reversion as:

What Does Mean Reversion Mean?

A theory suggesting that prices and returns eventually move back towards the mean or average. This mean or average can be the historical average of the price or return or another relevant average such as the growth in the economy or the average return of an industry.

The concept of mean reversion has come from natural sciences and the principle was discovered by Sir Francis Galton in 19th century. Along came various tools of statistical analysis and the famous bell curve of normal distributions.

Most of the complicated mathematical modeling that underlies sophisticated risk analysis models like VaR relies on the bell curve and its underlying assumptions of mean reversion. These models were at the heart of trading strategies deployed at Long Term Capital Management (LTCM) and led to one of the most famous investment debacles in recent financial history.

But the belief in mean reversion is not limited to the sophisticated investor alone. Everyone believes that there is some "mean" or "trend" value or return or price to which every security would return. This is at the heart of even sophisticated advice offered. This belief is at the core of the concept of "value buying".

Does Mean Reversion Happen?

The answer to this is yes and no. There may be evidence of growth at the economy level returning to "trend" level from time to time though the variations in between are huge. From time to time, we keep on hearing about long term growth trend of the world economy, the US economy, etc.

But this does not mean that investments based on this "trend" are going to be profitable. For one, there is no way to ascertain what this "trend" growth is going to be. In absence of more concrete tools, economists generally rely on different mathematical averages from the past, none of which may be relevant in fundamentally changed circumstances. Even if you get a good handle on the "trend", actual economic performance may vary from the trend for multiple economic cycles. That means, you need to hold on to your stocks for 10, 20 or 30 years to make money.

Survival of the Fittest

Of course, when we say that a sector or economy will average out to the "trend" over 20 years, we are talking about the economy as a whole. We do not mean that each and every company listed on the exchange will also conform to that.

That is where value investing becomes especially tough. What if your chosen sector does revert to trend over next 20 years but the company you have bought goes bankrupt in the meantime? This is a real risk because the average listed corporation does not survive beyond a few decades. You can almost take it as a rule that stocks that fuel one boom will not be the ones fueling the next boom. So what good is mean reversion if the individual components of the move back to the mean are different from the ones that you are relying upon?


We have seen that the standard advice offered to buy "undervalued" stuff seldom works in the short run. It might seldom work in the long term also (unless you are Warren Buffett and hold stocks "forever"). Still, it is frequently offered and accepted as a trading strategy by individual investors in particular. It leads to quite strong biases and warped behavior to the extent that you might even make some money by "fading the fool".

How do we avoid getting into this trap and escape relatively unharmed? Does this bias create trading opportunities if you are actively on the lookout for them? These are some of the questions we will seek to answer in the final and concluding part of this series.

India Q3 GDP: No Surprises But More Pain Ahead


India's Q3 GDP numbers came out on Friday. The number that has come out is way below the consensus forecast (read financial press expectations), government forecast, etc. But the market did not react too violently to the information.

All key market participants have known for some time what the GDP number is likely to settle at. Most of the international fund managers have maintained for quite some time that India will grow at sub-5% levels during next one year and 4.5% is a good estimate for next year's GDP number.

Why Market Analysts Miss the Bus?

Contrary to expectations, Q4 of FY09 is not going to see a better GDP number and the slowdown is gong to continue for next few quarters. But why have the Indian analysts continued to be overly optimistic about the GDP when the writing has been on the wall?

The main reason behind the optimism of financial press has been the faulty way in which they sum up GDP forecasts. The key to getting a good handle on economic forecasts is to focus on the demand side and not on the supply side. This works exactly like a business, you do not make a budget based on what you can manufacture (of course, it represents an upper limit if you are operating at full capacity) but what the demand is going to be and how much you can sell. Likewise, unless an economy overheats and is suffering high inflation, it is likely to be operating at less than 90% capacity utilization. Under such circumstances, supply side simply tells you about potential growth, not exactly how much is going to happen. Hence, focusing on demand side aggregates is critical.

Due to this particular anomaly, you come across market analysts saying, "I don't think manufacturing will contribute less than X". What manufacturing is going to do is a function of demand, and if demand slows down, there is nothing the manufacturing sector can do about it.

Q4 – Blues to Continue

Looking at the demand side, things do not look very well. One of the key components on the demand side, exports, continues to suffer. Even though exports are just 13% of the GDP, a 20% hit on exports translates to 2.5% penalty on growth side. This is significant because during the current quarter, exports are going to witness a similar hit.

While it did seem that global trade came to a standstill in Q3 FY09, the key segments in export sector did not completely shut down during the quarter. What happened in Q3 was that orders spilling over into Q4 got cancelled and new orders did not come. All the key industries we spoke to actually said that they still had some orders to service in Q3, it is Q4 that is likely to go completely empty.

Taking into account this one quarter lag between order receipt and actual servicing, the current quarter is likely to be very bad for the sector even if demand recovers.

Disaggregation of other key demand side sectors reveals further trouble. Urban consumers, particularly upper middle class, are badly hit and demand for key consumption items, housing, consumer durables, etc.; is not likely to recover soon. Rural demand has been buoyant, but a dip in agricultural output (2.2% in Q3) might see demand dipping as rural incomes plunge.

Is It a Surprise?

To a large extent, no. That is the reason why the market did not react too violently to the number, though the initial reaction was negative. Hence, in terms of expectations, we may already have hit the bottom.

But getting the bottom in sight is not enough to spark a recovery in the markets. To see a recovery in the market, we need to get an economic recovery in sight. Without that, the markets can drag on aimlessly in a tight trading range.


Is far away at the moment. Previous posts on the blog have recounted the reasons numerous times, but the latest fiscal adventures of the government have postponed the painful consolidation phase also to after the elections.

First, a bit on why these measures will delay recovery rather than aiding it. One, the government is running a huge deficit on the oil account which it does not even include in its deficit numbers. What is the rationale for continuous fuel price cuts? Just because the government wants to see an artificially depressed inflation number before the elections. Does it help the economy in any way? No. the real inflation number is the CPI, which is not going to be affected by this cut. It is foolish to assume that cheaper diesel or petrol or cooking gas will stimulate demand in the economy. The economy was much better off had the prices been kept at a reasonable level and money was spent on stimulating demand.

Two, the value of tax cuts in stimulating demand is quite dubious. I have written enough on it in the past and will not revisit the issue. But you cannot avoid the nagging suspicion that the government is resorting to tax cuts instead of spending because it doubts its own ability to spend anything in an efficient manner.

Fiscal Drags

All these things create a drag of their own. The bigger hole in finances due to these populist measures needs to be plugged at some stage. We sincerely hope that it happens immediately after the elections, the best time to effect a consolidation. That will mean about a year of pain followed by a good economic recovery.

If, on the other hand, the new government also chooses to be populist and refuses to reverse these "measures", we might see a prolonged slowdown that can even threaten the Indian growth story.

In any case, next one year is going to see a lot more pain and no early respite.

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