Real Estate forecast - I told you so edition

Back in the middle of 2007 it was clear that property markets across the world are overheating. However, ground realities, in terms of property off-take were yet to show visible signs of a slowdown. During a presentation to top management of an Indian public-sector bank, I advocated enhancing the credit standards for lending to real estate developers. I had mentioned that a slowdown in Indian real estate markets is imminent and while timing cannot be correctly ascertained, we (me and my employer) believed that it could be sooner rather than later. My presentation was met with intense skepticism and hostility. The real estate loan portfolio, the bank recently declared, has lost all its capital and not much hope exists of any recovery. In the details I find that almost all the loans since 2007 have gone bad.

Now, apart from a little trumpeting "I told you so", there are important lessons. First, from a credit side, an early warning is a boon. It presents an opportunity for actionable strategy. The bank in question could have easily adjusted its loan portfolio by tightening the credit norms and intensively screening the borrowers. For short term equity investments, the early warning is nearly meaningless.

In the later part of the 2007, I made another forecast about Chinese real estate developers, this time for equity investment. The firms, some mentioned in the Bloomberg report above, were showing robust growth and off-take. Yet, by all measures, a slowdown in Chinese residential market was imminent. The question was of timing. The early warning is difficult to interpret in case of equities. It was generally agreed to reduce exposure to these companies. Yet, the timing of it all remained an issue.

The idea in ST equities is to forecast the trigger. Clearly, for property developers, the trigger is capital availability. For real estate developers, the first step of a slowdown shows constraints in long term capital availability. In the later stages, short term funding becomes difficult to tie-up. Leading to panic selling of sale-able units leading to softening of prices.

The 2007-call turned out ok because of global slowdown of 2008 pulling out capital thus leading to correction in real estate developer stocks. However, recently, S&P Cut China Property Developers to ‘Negative’ - Bloomberg. It means developers may suffer even more in coming months.

---

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Investments in India - building long term advantage

India has always admired the high Chinese domestic investment. Policy makers have also talked of striving for higher investment-led GDP growth in India. Contrast that with a fall in investment numbers and we seem to have a problem. 

In light of huge global over-capacities, particularly in metals etc., is it right for India to invest in similar capacities? I believe this is not a right way of deploying resources at the moment. For a start, it is advisable to invest in things that the world cannot provide, either because it is too local or because the global investment climate does not allow it. In both these cases there is a huge opportunity.

In terms of local investments, infrastructure is paramount. In fact investment can be directed at easily accessing the idle global capacity. Thus transportation infrastructure, namely ports, highways, ware-houses and terminals, railways etc., makes a good case for itself. Such infrastructure will also unleash local supply-chain efficiency reducing cost of goods while maintaining better quality. Agricultural produce, on which 55% of Indian population still depends, will be main beneficiary. Long ago, my colleagues at CRISIL did a study that indicated it was possible to double farm incomes by improving supply chain. I believe we underestimated the impact on incomes and possibly the doubling can be achieved with today's income.

Second dimension that needs impetus is information. For a country that is a leader in IT, we have poor information infrastructure. We can plan for unique products effectively. Small cars, unique food items (like spices, fruits and flowers unique to our climate etc.), IT services etc. can be strengthened. Rather than recreate redundant infrastructure, we must deploy investments to strengthen our advantages.

The impetus, at the moment, must come from the government. Almost all areas where India has advantage, save for IT, we have no policy backing. Organized industry hardly has any presence in such areas. Primarily, that is due to lack of clarity from government and proper strategic direction among private players. Let us hope things change and we make right investment and create sustainable value than create redundant supply that will wither the value away.

---

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

How Low interest rates create mal-investment?

Interest rate identifies the minimum return that the business must generate. In a way, it is a fitness test for the business. It signals to the entrepreneur if he/she is truly adding value to the economy or if they are better off doing something else. Thus in a way, interest rate represents a threshold above which businesses should operate. This is Hayekian view of interest rates. 

Low interest rates and value addition 

When interest rates are too low, they are encouraging entrepreneurs to take risk. This impacts the business models differently. 

At one end are business models, like infrastructure projects, that cannot add threshold value in the initial years of the venture. The low interest rate regime, allows a valuable gestation period for such business models. Often, government artificially lowers interest rates for such projects. 

At the other extreme, there are weak business models, those that are viable only in low return scenario. In a low-interest rate regime, even such business models get funded. These business models, however, die out once the interest rates start rising. In between, there are experimental and innovative business models. Some of these use the low interest rate period to forge better, more robust models. Such businesses thrive later. Others, however, end up going bust. 

The role of banks is to identify each of these business models and fund them while appropriately mitigating the risks.

 

How low interest rate leads to mal-investment 

A bank takes risk by investing in a venture. Interest rate is also a reward bankers get, for taking the risk. This is another way of framing the value addition threshold principle. Yet, the difference in the two has implications for the economy. 

Banks are conditioned to finance lowest risk assets that are available to them. Debt simply happens to be a low risk asset. So if banks have the opportunity to invest in assets more liquid and less risky, banks will move away from debt. Even in lower interest rate scenario, those projects with best risk-return trade-off should get financed. However, anecdotally, lower interests rates actually lead to mal-investment, to borrow Hayek’s term. This is other aspect of the reputation problem we discussed earlier. 

Lower yielding large borrowings backed by reputed corporates get access to financing more easily than new ventures. This means, irrational mega-projects or mal-investments of large corporates get financed at the cost of genuine investments of new ventures. Typically, irrational mega-projects consume a lot of credit requiring load syndication. This has twin benefits for bankers. First, there is a higher degree of comfort in being with the herd. Secondly, bankers do not have to go through credit appraisal of many small entities of questionable risk profile. This makes them assign a lower risk to these projects than appropriate. Despite the low interest rates, the risk with new ventures is always higher. Further, debt is not a very liquid asset at the lender-borrower level. 

The second blow to new ventures comes from crowding out. It implies that even in a low interest rate environment, small businesses and entrepreneurs may not have access to lower cost capital. Therefore this impacts the long-term strength of the economy. In high interest rate scenario, the irrational mega-projects seem less promising. Hence, contrary to popular belief, it may be easier for smaller businesses to compete in high interest rate scenarios.

This post is excerpted from my book "subverting Capitalism & Democracy.

---

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Greece and the labors of Hercules

Greek government is considered to be down and out. But may not be though a rescue is certainly a herculean task. The difficulty of Greek situation is not the economics, but the intersection of problems of different dimensions, primarily political and economic.

Problems with economics

Political parties need to understand that the first task is to get the greek economy moving. It means unemployment must reduce, demand, preferably localized demand and supply needs to get moving. Usually, housing and construction are good bets to create localized demand-supply dynamics going. However, in the recent crisis, this very sector was at the center of the recession. Hence the onus of recovery should lie with some other sector. Probable alternatives could be tourism (outside demand, localized supply), infrastructure (hopefully localized) etc.

However, even with full employment and reasonably stable demand Greek government may not be able to pay back the debt. That means some hair-cuts are required. This is also aligned correctly with incentives. Lack of due-diligence from borrowers is no excuse and they must take a hair-cut.

Problem with politics

The problem of politics is vastly bigger than the economic problem. The greeks do not trust their government. This fact is manifested in their tax-evasive behavior. A population that does not trust a body they themselves elected, implies that something is broken in the greek political system. That needs to be fixed.

Once the political system starts fixing itself, tax reforms need to be undertaken. It is my guess that most of tax evasion stems from tax confusion and subsequent concessions (wrongfully targeted). A simplification of taxes will improve the collection.

The problems with political system may also indicate problems with legal system (including law and order). Usually that translates as "corrupt people are set free in the courts". This needs to change. The people who have defrauded the nation should be brought to justice. As we start seeing these changes, the political climate will improve and system may begin to correct itself.

In sum

The political problem is worse of the lot. Fixing it may be more complicated - indeed a Herculean task. The whole, financing elections and bargaining power of those financiers may be threatened. Such problems are present in almost all democracies of the world. If a greek revolution takes place it will change the political future of the world. Greece, that once gave us democracy, may give us the next solution.

---

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Mechanics of Asset Bubbles

This is my 250th post on this blog. Thank you for being kind and patient readers.

Barry Ritholtz has a post titled Checklist: How to Spot a Bubble in Real Time | The Big Picture. He puts across a list of conditions that we can watch to spot bubbles. While I agree with the post as a whole I would like to make some modifications to it from investor's thinking point of view. Barry himself is an investor so the end objective of the post is same as mine, to find opportunity to make money.

Let us delve into the mechanics of asset bubbles. All bubbles eventually burst. To understand nature of bubble burst however we must understand bubbles. The nomenclature "bubbles" is misleading when compared to their bursting behavior. Asset bubbles are more like balloons rather than bubbles. Some deflate gradually, some burst open when pricked by risks, others inflate to the point of no return. It is important for investors to identify the bubble and understand when it may burst.

Asset bubbles have three central elements. First being spotting inflating asset prices. The second refers to spotting risks that may cause bubble to burst. The third refers to spotting the timing of bubble bursts. Barry's post deals with all three however, I believe, they are mixed up in his list. 

Spotting possibilities of bubbles

To know if there is a possibility of a bubble we need to consider a few indicators:

1. Standard deviation of valuations: As standard deviations increase beyond 2, we should start considering a possibility of bubbles.
2. Elevated returns: The returns in the markets are high and, more importantly, consistently high. The consistency bit is a flag.
3. Unusually low volatility: The low volatility is another, albeit important, side of consistency in high returns. Volatility is an indicator of doubt. It indicates how much the market believes in higher asset prices. Higher volatility indicates that markets are testing the reasonableness of prices. It may be possible to have reasonably consistent annual returns but  still have high volatility throughout the year. 
4. Robust trading volume: It is difficult to imagine a healthy increasing volumes accompanied by low volatility but such conditions do exists during bubble period. The number of houses bought, number of people who trade in equity markets, etc.
5. Increase in employment: Driven by the bullish forecasts the bubble-prone sector goes into a hiring overdrive.
6. Increase in credit growth: Credit is a measure of low-risk-seeking capital. When all investors think the sector is low-risk quantum of credit flows to the sector increases seeds future bubbles.

Risks to bubbles

While above indicators reveal the possibility of a bubble, they do not specifically indicate the risks that may cause the bubble to burst. The risks emerge from causes of bubbles to their effects.

1. Perverse Incentives: These are difficult to track down before the burst but is eventually obvious. A diligent investor needs to understand the "why" behind the behavior of participants in that sector.
2. Unintended consequences: The frontiers of regulations (or de-regulations) often harbor seeds of bubbles. The problem with regulations in particular is that it can be reversed in a spur-of-the-moment decision by relevant authorities leaving investors in the lurch.
3. Excess Leverage: As the popular opinion of low-risk permeates through the financial world, firms are encouraged to take on more debt increasing their leverage. Increasing equity prices also puts pressure on management to deliver high returns. Managers rejig the capital structure to increase return on equity for the same return on capital. The easiest way to achieve this is by increasing leverage.
4. New products: Barry refers to only financial products however any product that teases regulatory acceptability can create risks. Financial products are more potent because they tend to affect multiple sectors and economy as a whole. Naturally, financial products have been at the forefront of biggest bubbles in history.

Understanding timing of bubble bursts

A few behaviors are prominently visible during the late stage of bubble formations. Typically,

1. Declining credit spreads: While I am using Barry's headings, the central idea he points to is bigger than credit spreads. During late-bubble phase, the price or yield or return distribution and risk distribution do not match. In normal times, higher risk implies lower prices and higher-but-volatile returns expectations while lower risks implies higher prices and lower but more stable return expectations. In other words risk-return equations become asymmetrical.
2. Declining credit standards: This is another face of risk-return asymmetry we discussed above. Firms with strained balance sheets get easy access to credit. It also indicates lower default rates on credit side and further acceleration in credit growth in the sector. The latest credit investments may be difficult to recover and hence are as good as write-offs.
3. Tortured Rationalizations: Almost all bubbles have advocates who have strong beliefs that they validate using unverifiable, anecdotal but mismatched data or new metrics that have no history. Be it eye-balls, estimating number of millionaires as proxy for premium housing demand, etc.
4. Trading volume spike: We note that high and steadily increasing volumes are marks of bubbles but accelerating volumes - spikes - indicate that end is near.
5. Interest rate changes: A credit-driven bubble is sensitive to interest rate changes. However, the sector may not react at the turn of interest rate policy. So when the central bank raises rates after a long cycle of declining rates, there seems to be no effect on the bubble sector. It is after two or three rate hikes that suddenly things start to fall apart.

While spotting bubbles is difficult, the difficulty can be reduced. Bubble-spotting is iterative process and takes a while to establish the conditions for bursting of bubble.

---

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Austerity not a medicine for all occasions

One of the key lessons of the great depression is that austerity is not a medicine for all occasions. However, over the subsequent excesses we seem to have lost out on this learning.

Austerity is not a solution for US

There is hardly any doubt about ability of US to compete. In fact, if the fat corporate balance sheets are to go by, US companies are in their best shape among past 5 years. Yet, the unemployment numbers are languishing which makes US a pump needing priming. Such priming will be achieved through a jobs program to create next-gen infrastructure that will allow US manpower to compete in knowledge era. Austerity, in this case, will impair future competitiveness. However, the kind of priming as envisioned in the Fed's quantitative easing program is nothing but wasteful. These programs do not have well established working channels to reach fruition. 

Greece and wasting water priming the pump

We don't waste water priming the pump so long as the pump works and there is water at the end of the well. In case of Greece, both parts seem to be a problem. In such case, austerity is a better alternative till the economic engine is repaired. Further, Greek government must set in place tax reforms allowing fair and easy collection of taxes. Once such necessary conditions are in place, then Greece will need a spending program to kick start growth in a sustainable manner.

Implications for markets and democracy

The problem with misunderstanding related to austerity is two-fold. The problem with austerity is that it will wreck havoc with asset prices in general impairing genuine investment leading to future problems. The second problem is the people's confidence in the system is shaken leading to anarchy and threat to general system of law and order. In short, the cost of misunderstanding austerity will be massive.

---

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Geoffrey West on corporation and cities onEdge.org

My day was made when I read the edge piece today. Geoffrey West, professor, talks about interesting aspects of Why Cities Keep Growing, Corporations And People Always Die, And Life Gets Faster.

As an investor, company life-cycle represents a lesser-debated frontier. Analysts tend to rely on the accounting view of going-concern. Yet, the permanence we take for granted is a mirage. However, understanding when the decline of the firm comes about is easier said than done. 

Dr. Geoffrey West points to yet unpublished (and still being verified) work that says firms scale sub-linearly. In other words as firms get bigger, they become less profitable and they eventually perish. Compare this with cities (which he discusses before firms) that grow super-linearly. In other words as cities get bigger, they become more beneficial for its inhabitants. So then, should investors stop companies from growing? And how should one view the increase in scale. 

I think as investors it highlights a very important and much neglected area.

---

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Wary of QE2 withdrawal effects!

At a time when Indian markets were nearing valuation comfort, they surged again. Usually, it would be a positive reinforcement and time to get in. However, I am not sure today. The risks arising out of end of QE2 pose significant threat to markets.

On its own, the end of QE2 alone would be a perceptible trigger. But more important is the situation of world economies at this point. With EU on the brink of another crisis, waning strength of US recovery and still-to-gain-traction Japan, we are at the most unstable point in recent years. At such a time a withdrawal of QE from US may not auger well for the markets. 

I guess we must hold on tight and keep powder dry for there may be interesting times to invest in very near future. 

---

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Krugman & Delong and Weak Dollar

Brad Delong links to the Krugman post titled A Weaker Dollar Is in America's Interest. I have always maintained that weaker dollar is essential for US economy to recover. Weaker dollar has come about using a different mechanism that investors anticipated.

The value of any currency refers to or is derived in relation to a basket of goods. The basket has significant number of commodities. So as investors moved the commodity prices up, the value of the US dollar automatically depreciated. In other words, investors created this devaluation and not the central bank.

The process, however, is fraught with risks. In a world of pegged currencies, we now have devalued the entire currency universe. This, to my mind, is not correct. The purchasing power of other currencies, particularly the Yuan, should be higher. The discrepancy has crept in because of central bank action. Developing countries are worried about export competitiveness declining with even small appreciation in currency. As a result they have to tolerate higher inflation and no amount of domestic slowdown may correct it. Only those countries that have strong economic transmission mechanisms can tolerate inflation. However, this is only short term relief. As transmission mechanism takes effect, it translates into higher wages and thus lower competitiveness.

With the Chinese reserves topping USD3 trillion, I guess we have some more time. I had mentioned in an earlier posts that it will take doubling of Chinese reserves till we have decisive action. At the time Chinese reserves were close to USD 2 trillion. So I am expecting this process to continue for some more time in accordance with the phases I mentioned back in video (relinked below) in 2009.

USD Dollar Views from 2009(links to old post)

---

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Commodity markets and synchronized investment

John Kemp has a piece on the financial post titled Analysis: Commodity markets wobble | Investing | Financial Post. He argues that prices have diverged from fundamentals and talking heads are merely retrofitting explanation to reality.

Broadly, I want to add that such trend build-up is seen in many asset classes. The bubble-like behavior needs a sustained up move and as the move loses momentum, downward forces take effect. The downward action, in most cases, is swift leaving many (occasionally including yours truly) in the lurch.

I believe this is as much a result of group think as speculation. Algorithm-based trading, herding aided by technology (mass-emails) and lack of diversity of ideas probably causes synchronized money flows resulting in self-reinforcing behavior. Some fund managers interested in exploiting this behavior often talk about leading such trends or buying stocks not companies.

A typical trend comprises of four phases accumulation, discovery, bull-run and realization. Accumulation happens when prices are low for sustained period of time. At such times a section of population accumulates the assets leading to firming of its price. The group is led by fundamental investors and many others follow suit. Discovery happens as more and more people realize the downside resilience of the prices of that asset. Technical charts start suggesting potential for up-moves. Early speculators jump on the bandwagon and soon this phase moves into a bull-run. In bull-run the prices start accelerating, crossing the targets investors have in mind, but the move shows no signs of abating. The prices soon reach the bubble territory and often confidently march on prompting investors to re-look at fundamentals to see if they are missing something. As prices cross the bounds of incredulity, realization dawns about weak fundamentals and all the hell breaks loose. The synchronized move out of the asset creates more distress to prices that warranted by fundamentals.

While I am critical of this issue, the issue itself is not new. Such behavior is a reality of the market. It is merely exposed more during volatile times. In periods of stability the trends hide this behavior from public scrutiny.

Volatility and investments

As the markets are getting more volatile by the day, we turn our focus to impact of this volatility. In general, volatility is enemy of long term investment. It is a friend of aggressive trader when luck is favourable. It promotes, a sort of, alignment towards short term.

Current macro climate in India is sensitive to such short-term focus. India needs long term investments that should boost supply to accommodate the growing demand. Such investments are are difficult to conceive during times of high volatility. The attempt of policy-makers should be to create pockets of certainty in areas that can be controlled. Particularly, monetary policy, fiscal policy and government regulation need to demonstrate continuity and stability thus not contribute to the already existing volatility.

China has successfully shown policy continuity and stability that promotes such investment. India needs to learn from China in this regard.

---

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Super Boom - 500% increase in stock prices

Barry Ritholtz comments on plausibility of Jeff Hirsch's Super Boom: Why the Dow Jones Will Hit 38,820 and How You Can Profit From It | The Big Picture. As Barry mentions, it is plausible. However, timing the bottom still remains a challenge.

I believe there were trends ready to take over during episodes Jeff points to. There was the automobile boom, suburban boom and consumer products boom, the internet and computing boom etc. The problem is, as of now, I do not see any sector ready to create the growth momentum required for 500% increase in stock prices. I was looking at alternative energy among other things, but it doesn't seem to be a big contender as yet.

For a sector to be an able contender to create (not simply augment or drive) growth momentum it needs a few qualities. It needs to be a mass employer at a value-chain level. It needs to create productivity gains in existing economic engine while creating ancillary products and services that are growth engines in their own right. The first past will help finance investments in the technology while the second will create exponential gains in the sector both in terms of adoption and profitability.

Alternative energy cannot, as yet, be a mass employer. Though it can create energy independence and help the economic engine. To be specific, I think the sector has the potential to become a top trend creator in 10 years time. Another sector in its infancy could be water management and treatment. In my view, healthcare services or healthcare delivery services as industry fellows call it, may be a reasonable bet. I do not have much conviction in the idea as yet, but it ticks off some important boxes. It can be a mass employer, it will help improve productivity of economic engine (by keeping labour employable), it is a critical need so funding should not be an issue. The missing link is the exponential take-off. Unless people come up with innovation, I do not see exponential take-off materializing easily.

In all probability, the identification of trend should take at least couple of years. Till such time I do not see the beginning of the 500% trend. However, I am convinced that once such a trend is in place, we will see a period of sustained growth as the trend propagates through the global economy and benefits begin to stabilize. I am not sure if the percentage 500% is relevant but a sustained growth is always welcome. So let us hope for a quick revival!

---

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.