Jeremy Grantham knows we were warned!

Years back in 2008, I wrote a post about how Shakespeare's Polonius (from Hamlet) had good advice for us investors. Today, Jeremy Grantham, in his quarterly newsletter, discovers that very advice.

Here is my post from 2008: "How to avoid the credit crunch?"

I was really surprised when I realised that entire credit crunch and related problems were highlighted and we were warned back in 16th century itself.

For Rating Agencies
See thou character. Give thy thoughts no tongue,
Nor any unproportioned thought his act.

For investors - particularly those who misguide people on CNBC
Give every man thy ear, but few thy voice;
Take each man's censure, but reserve thy judgment.

For US / UK and European Consumers
Costly thy habit as thy purse can buy,

For Mortgage dealers (they heeded but CDS borrowers didnt)
Neither a borrower nor a lender be;
For loan oft loses both itself and friend,

For all market operators
This above all: to thine ownself be true,
And it must follow, as the night the day,
Thou canst not then be false to any man

Here is the full advice:
Yet here, Laertes! aboard, aboard, for shame!
The wind sits in the shoulder of your sail,
And you are stay'd for. There; my blessing with thee!
And these few precepts in thy memory

See thou character. Give thy thoughts no tongue,
Nor any unproportioned thought his act.

Be thou familiar, but by no means vulgar.
Those friends thou hast, and their adoption tried,
Grapple them to thy soul with hoops of steel;
But do not dull thy palm with entertainment
Of each new-hatch'd, unfledged comrade. Beware
Of entrance to a quarrel, but being in,
Bear't that the opposed may beware of thee.

Give every man thy ear, but few thy voice;
Take each man's censure, but reserve thy judgment.

Costly thy habit as thy purse can buy,
But not express'd in fancy; rich, not gaudy;
For the apparel oft proclaims the man,
And they in France of the best rank and station
Are of a most select and generous chief in that.

Neither a borrower nor a lender be;
For loan oft loses both itself and friend,
And borrowing dulls the edge of husbandry.

This above all: to thine ownself be true,
And it must follow, as the night the day,
Thou canst not then be false to any man.
Farewell: my blessing season this in thee!

- Shakespeare in Hamlet (Lord Polonius advice to son Lartes)

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

Commodity valuation

A lot of people believe in strength of commodity prices but the boom is fragile for the following reasons.

Substantial part of valuation depends on strong and sustained commodity consumption driving growth in India and China. The growth is unlikely to be either strong or sustained (in near term). This may take the wind out of the boom.

But I believe we have underestimated two other reasons.

Commodities as store of value
A part of boom in commodities can actually be explained as a result of money trying to protect value of developed countries investors. To protect value, you translate your money into equivalent basket of benefits (goods and services) that can be bought with your money. So we can imagine the equation as (money I have in year "t") = (sum of products and services that can be bought in year "t").

Every year this equation must be evaluated from the RHS not LHS. Thus, the true comparison can be achieved when we compare (sum of products and services that can be bought in year "t") vs. (sum of products and services that can be bought in year "t+1"). Ideally, we must be able to buy more products and services in "t+1".

However, in common parlance we do compare LHS. The question we ask ourselves is "do I have more money than last year?" It is a misleading question. People get fooled when the answer is yes. In fact, American middle class thought they had more money in every subsequent year. But in real terms the wages are stagnant for more than 2 decades.

To protect the RHS value, investors try to hoard certain commodities that are irreplaceable. The degree of irreplaceability, knowledge of alternatives, certainty of whether commodities will indeed be part of value-store equation are all unknowns.

The Real Chinese demand
The resource intensity of growth of China will reducing drastically. This is simply because of three main reasons.

Firstly, China has built out infrastructure for next N years, advancing their consumption of commodities. This will revert to mean in the next N-4 years. (The value of N is matter of debate).

Secondly, China has already bought or locked in its commodity requirement for next few years and this has no price implication for commodities hereafter.

Lastly, it has to reduce drastically just to make scientific sense. This will have new winners and losers within different commodities. 

Evaluating commodity boom is difficult
Thus, the factors affecting commodity prices and demand are different than normally discussed. I am yet to see a reasonable assessment of the two main changes above. Hence, I advise to be really, really careful with commodities. At least do not build any position you cannot liquidate quickly. 

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

The Value of Indian Rupee

The Economist recently published the Big Mac Index that shows Indian Rupee as most undervalued currency contrary to the popular perception of its value. The Big Mac is priced at $1.62 in India vs. $4.2 in the US thereby giving undervaluation of 2.6x.

It raises some hard questions:

1. Has Indian Government absorbed substantial part of costs? Indian government subsidizes diesel and that could show up as mark down. This bloats the government balance sheet but keeps inflation from showing up in consumer goods prices. This has double effects, when high oil prices are absorbed by the government, Indian prices languish. Further, when the global prices start correcting, Indian prices tend to remain firm.
2. INR is undervalued because Indian government finances are not in good shape. India's government finances look more like developed countries than developing countries. To compound the problems, Indian export basket is quite price sensitive while import basket is not. So then does it mean Indian inflation has substantial way to go? 
3. Does it mean that Big Mac Index works better when government budget is nearly balanced?
4. Another important thing is that the price of entry-level burger at McDonalds has been coming down since McDonalds came to India. Part of the reason is product development, but significant part is because of raw material efficiency. This latent competitiveness has not yet been harnessed, but if done so, will make India more resilient to global factors. It may even make Indian exports more competitive.

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

Sticky Wages, Prices and effects of pouring money

Scott Sumner has a post about pouring of money - i.e. effects of expanding money supply. He disagrees with the metaphor that money pours into certain asset classes. While I agree with the principles behind Scott Sumner's post, I find most of times the metaphors send better signals for interpretation. But my main point is about prices and wages.

Prices and wages are embodiment of information - historical, present and future. If they change too quickly then the historical aspect is lost. For better or worse, our scale of value are anchored to the past. It does get influenced by present and to a less degree by expectations of future. But if we lose our anchor point or the reference scale then our mental models collapse and we lose our sense of reality. Thus, if we get paid $30,000 in year 1, $3,000 in year 2 and $3million in the next year, we will develop a sense of confusion.

Then comes the question of pouring. What pouring refers to is change in the relative value of asset classes. Imagine a spread of assets along a value spectrum, sort of a hierarchy (with sometimes assets jointly occupying a hierarchal position). 

If money increase does not modify the hierarchy then it does not impact much. If it does then it creates gainers and losers just because money is created. For example, if a really thirsty person would rather be just under the tap than away where water will eventually get to him. 

The argument therefore is whether the government or central bankers be allowed to create such distortion that has no grounding of productivity or real value creation.

One can argue that over long term the asset hierarchy goes back to a certain mean. But during the time a distortion is set in motion and the time we get back to time-tested mean we can extract advantage. Finance is prepping to do just that.

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

United States of Europe

In principle, there is not much difference between United States of America (as it was intended) and United States of Europe (as it is perceived as of date). 

1. USA was a federal structure in a true sense. Barring money, national security and foreign policy, not much role was envisaged for the central government. However, just like in the case of USA, USE must be wary of tendency of the central government to start hijacking things to itself. Sometimes there are legitimate reasons for doing so, for example:
1. Inter-state issues of national security and policy. For example, establishing of FBI, DEA etc.
2. Creating economic efficiency. For example, inconsistent laws between states creates problems and there is good argument for center to create a unifying law.
2. Other times, central agency takes up power at times of crisis when collaborated and concurrent action is required by all the states together. Naomi Klein in Shock Doctrine, highlights some of the instances where disaster was used to by-pass checks and balances of the system.

Implication

So I don't see any problem when there exists a possibility of politically uniting Europe. If handled properly, it could be successful. However, odds are always stacked against it. Pursuing it at this moment will be a mistake. I am reminded of the quote, friendship always exists among equals. In today's Europe, there is no equality and hence no friendship.

Aside

If you have enough decentralization, then any aggregation at the top level has little or no effect. It is the centralization that starts creating the problem. It belittles the citizen and magnifies the government. 

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

Types of Investment and India's low-hanging fruit

I think India is much better placed at the moment primarily because there is lot of low hanging fruit. I attempt to list a few. When it comes to investment we have two kinds of investment. 

1. The first represents fairly well understood investments where there is ample evidence of cost and benefit and technology is available from the experience of the first world countries. The road-map for development of such infrastructure, its costs, pay-off timelines etc. is well known.
• Agricultural productivity
• Basic Infrastructure - roads, power
• Second-level infrastructure like cold chains, transportation hubs etc.
2. The second is complicated and more like venture capital where risks are higher. Here the objective is to invest in areas that will value-drivers of the future. Here we are breaking new ground and the pay-offs are not clear. US and first world countries are required to invest in such type of infrastructure.
• Alternate energy
• New types of infrastructure including 4G telecom and other related such as NFC payments
• High-end infrastructure e.g. intelligent Highways etc.

  

For India, substantial opportunities exists in the first part. This is what makes India an attractive destination. Starting around 1995, a lot of attempts have been made in estimating this demand. Most have been unsuccessful, but a substantial body of knowledge has emerged in this process. Today is the best time of all for companies to undertake massive infrastructure building projects. The question really is, will government facilitate the process balancing protection of citizen's rights and goals of developments.

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

2012: Images from the Crystal ball

At the doorstep of 2012, I am here again looking at the crystal ball. There are signs

Reworking the Macro 

1. The Eurozone faces tremendous challenges at the moment. 2012 will see the aftermath of the crisis. I imagine the Euro leaders will be able to patch things back, but substantial political sovereignty will have to be ceded. One hopes the sovereignty will be returned post the resolution of the crisis. In any case, Eurozone will spend the next year in hibernation.
2. As I mentioned in previous post, there are currently two systems - Eurozone system and US-China system. 2012 will see stresses in the US-China system rise dramatically. I think as if rhyming with 2011, we will see stress in US-China system next year same time.
3. We may see Chinese economy under stress. I am not sure how much will happen next year but China is unusually fast. I think we will see slowing of China - about 5-6% growth level.
4. The Arab world will experience post-purchase dissonance with respect to new-found political setup. In worst case it means some new dictators will come up and uprising may start all over again or there may be bigger political discussions.

Financial markets

1. I see increased synchronization - both globally amongst markets and within markets among stocks. Thus, old places to hide may not actually work. 
2. From the investor standpoint, we will be forced to be more in cash or cash equivalents.  Correspondingly, even when invested, we must look to highly liquid names. I was hoping to see derivative markets in their full splendor at such times, but MF Global and lack of counter-party settlement systems keeps check on the system. 
3. The other fall-out of this is steeper moves - on upside and downside. It means we can make or lose money super-quick. Markets may rise 20% in a month, fall 20% in the next. We should see more talk about Vix.
4. Funds with specific low-cash rules should find it difficult. I think in general, the strict rule-based fund management should take a beating. Fund managers with broader mandate are likely to deploy the capital better. 

All in all an interesting year ahead. My best wishes to you all and I will see you next year. Merry Christmas, Happy new Year and happy holidays. Cheers

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

Comparing Euro with US-China - MMT

Edward Harrison points to a Randall Wray post about MMT, sovereign debt crisis in Eurozone.

Randall refers to difference in location of monetary policy, within the sovereign in case of UK and outside the sovereign in case of France (with ECB), leading to reduced risk of default. Randall refers to this as one main source of problems of the Eurozone.

However, Euro area is not the only problem. When it comes to difference between where monetary policy is located and where fiscal policy is located, we have two examples of this model operating currently- Euro model and US-China model. Both are at risk, different risk, but definitely at risk.

In principle, US-China model has a similar monetary-fiscal policy situation to Euro area. US sets the monetary policy and that policy trickles down to set of countries that peg their currencies to US Dollar. I have only used China as representative, in reality many more countries peg their currencies to USD and this group is bigger than the Euro-group.[1]

The issues is if you have given up monetary sovereignty, you are eventually forced to give up broad level fiscal sovereignty as well. So a system where monetary policy is regional, you must have a regional fiscal policy at least at a broad level. It all boils down to congruence between fiscal and monetary policy.

The persistence with this monetary-fiscal distortion polarizes the participants creating a production pole and consumption pole. In case of Euro area, we have Germany and Greece as representative poles. In case of US-China model the respective poles are China and US.

Now the difference is Germany, the production pole, has larger influence over monetary policy[2] in Eurozone while its corresponding pole China, has no say in policy of US. 

In the US-China case, US does not seem to have a problem. But actually it does. The model requires the China-group to keep buying US treasuries. This allows US more monetary policy room but forces these countries to absorb, either through government or overseas investment, this impact. It masks the problems of US till one fine day US suffers a heart attack. Further imagine the policy environment if Greece ran the policy in Eurozone. I won't go into more detail here but suffice to say this model is equally broken.

Notes:

1. Euro as a group, single entity, also has a similar arrangement. Here Euro-group occupies the position of US and few countries peg their currencies to Euro. In addition, Euro is also influenced by its value with respect to USD. It is sort of a complex fractal. We will leave aside these complications for the moment.
2. Apologies to those who believe monetary policy is truly independent. And, of course - there is no Santa Claus - it was your parents all along.

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

Uncomplicate the Taxes

High sovereign debt implies increase in taxes in the near future. However, Barack Obama, who wanted to raise taxes, is facing stiff resistance from the Republicans. So also

There are specific problems with our tax system 

First, it is very difficult to calculate the best tax rate or the lowest tax one can pay through the system. Second, taxes have unintended consequences. They sometimes promote or prevent marriages, home purchases, bigger cars, etc. Government has no business interfering with the lives of taxpayers in such a way. Third, taxes are unfair. The rich often pay lower taxes than the poor. Fourth, there is no way to measure return on taxes just as we measure return on capital. Finally taxes are high because they are paying for over-regulation by government or they are paying for large governments.

Better simplify the tax system

It might be better if tax was simplified into just one tax, either on income or consumption. Incomes should not be classified according to their sources. All incoming cash flow should be treated as income. There should be no part exemption what so ever. Government can define a level of income below which tax rate is nil. Above that income, taxes should be at one single rate. The only flexibility in policy will be to determine what rate should be.

The common argument is about the beneficial taxes on cigarettes. Those are not taxes. Those are penalties imposed on cigarette manufacturers for damaging lives of people. Those should be recovered as penalties and directed towards treatment of heart and lung diseases.

Tax filing has been made easy. What is difficult is to figure how much tax we have to pay. That has to be easier. We need to protect individuals from complexity in taxes. Just like the Consumer Financial Protection Agency (CFPA) is trying to simplify credit card agreements, it should also simplify tax calculations.

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

The Rakoff manifesto

Judge Rakoff's principle based on Contract rights and duties vs. legal rights and duties

Two types of rights (and/or duties)

First are rights created out of mutual agreement, called contractual rights. These exists separately outside the law. Only when there is dispute, the law intervenes. Even then, law only intervenes to clarify what is the real agreement between the parties and has it been honored. Contractual rights exist within the boundaries of law - sort of like a playground where you are free to do what you want so long as you don't hurt anyone. Second are rights created by law. These are typically like the classrooms of strict schools - ordered and disciplined, everything is straitjacketed here. Punishment is imposed by the law to those who transgress the rights of others or duties imposed on them. 

Important consideration is that contractual rights cannot infringe legal rights. Thus contracts to commit illegal acts are void.

Settlement agreement with SEC

Settlement agreements, though contractual in nature, affect rights created by law when settlement is about illegal activity. Hence I agree with Judge Rakoff, one cannot have a settlement and also be considered not guilty. 

Yves Smith has a post on JP Morgan being impacted by Rakoff decisions (read down to comments too) speaks of this debate. (The post itself speaks about not allowing insurance for fraud etc).

I think Judge Rakoff is on the right track. 

1. You cannot settle away an illegal act. And more so when the parties to settlement are not the only ones who are affected. The problem occurs when the other parties are kept in the dark and have no clue they have suffered from illegal acts. The SEC is duty-bound to expose such acts not merely settle them out. Hence the para "But the S.E.C., of all agencies, has a duty, inherent in its statutory mission, to see that the truth emerges; and if it fails to do so, this Court must not, in the name of deference or convenience, grant judicial enforcement to the agency’s contrivances."
2. Courts are not house of power that can be called at the whim of parties. In the particular case, SEC wanted the courts to apply injunctive relief to which the counter-party, Citi Group had agreed. The role of the Court was that of an umpire. 

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

Basics: General Investment strategy

A very basic view of investment strategy is given below. I will need to explain a few terms below, but do spend time with this chart. In a nut-shell, that is all there is to investment.

Here are some basics you need to keep in mind before using that chart:

1. We first need to do research to understand what is a good company and a bad company. I prefer to meet the management before conclusively tipping myself into either category. Companies with hints of fraud (refer to John Hempton's treatise on Chinese companies and some other fraudsters).
2. Unclear company refers to company which cannot be classified as either. 
• It does mean that you have conclusively eliminated the possibility of apparent fraud. Yet, something about such companies do not feel right. (yes, feel!). 
• Alternatively, you are not convinced about the business models of such companies, though the companies may be upright and well governed.
3. I presume we will know about bear and bull markets. Unclear markets are typically directionless markets or range bound markets.
4. Uncertain investment strategy means, you cannot invest without substantial research. I must repeat SUBSTANTIAL research. It means unless you have a full scale financial model with sensitivities to various scenarios, macro and industry forecasts, appreciation of changing minor trends, met customers, suppliers, industry experts etc, you cannot take a call. It is like a minefield, you are taking a risk and analytical advantage can alleviate some of the risk.
5. Going Long for uncertain companies in bull market has one disclaimer that such companies must not have fraud-flags, even feeling types. Ideal strategy for that box is "uncertain".
6. Companies move in an out of categories. But if a company goes bad, it rarely turns good. I know people will dispute this, but that is my experience. Better stay away or go short.
7. Ideal chart is 3-D where another axis, industry, needs to be included. This parameters takes into account business cycles. One can logically interpolate my strategy from this chart and apply it to business cycle. If someone can make me a 3D chart please email me or leave a comment.

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

Fraud and illegality in the Crisis

Till recently, that is about a year ago, I believed that substantial part of causes of the crisis were a result of mistakes, incompetence and lack of understanding. However, stark evidence is emerging as to substantial fraud and illegal dealings.  

• First was the Robo-signing scandal (which still thrives) where banks first signed thousands of mortgage applications without any background checks. When a lender behaves in such a manner, he has clearly acquiesced to default.
• Then there was a random credit card fees scandal that Elizabeth Warren talked about. To be sure this was known before but the scale, I realised later, was huge!
• There were some hints, particularly how Eliot Spitzer was sidelined when pursing the money trail. Eliot Spitzer was also to blame, in my opinion, he should have kept his pants zipped.
• Next came Madoff which was more accounting scandal in the family of Enron. One might have thought we had learnt our lessons but that was clearly naive thinking.
• Then came Bloomberg expose about secret Fed facilities to big banks. The problem here is the way Fed is structured as against normal central banks. In many ways Fed looks like a club of bankers rather than a government sponsored, independent controller of monetary policy. Fed reform is critical and I find both Senate and the House, i.e. the Congress lacking in will and expertise. 
• Further, we get the news that Treasury secretary Hank Paulson had a closed door meeting about possible liquidation of Freddie and Fannie while claiming they were healthy to the public.
• The ultimate was expose about Congress being allowed to trade on inside information. This is becoming tragic. This is US we are talking about not some banana republic. 
• Then, the way MF Global was handled, the way client money was dealt with.

One important common ingredient has been how effectively democracy has been subverted by these forces. MF Global showcases how financial institutions are able to subvert the right to property, a fundamental right at the core of democracy, by allowing financial institution to use personal money to further their cause. Janet Tavakoli's recent article is right - this is class 1 fraud. 

Finally, I am surprised at my naivete. I also wonder why no one has yet gone to jail.

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