Hussman's timing may be wrong again!

John Hussman predicts epic stock crash in his recent newsletter. He says:

The financial markets are establishing an extreme that we expect investors will remember for the remainder of history, joining other memorable peers that include 1906, 1929, 1937, 1966, 1972, 2000 and 2007.

He follows up with another gem:

Enlightened members of the FOMC should even question the theoretical basis for their actions. The Phillips Curve is actually a scarcity relationship between unemployment and real wage inflation – basically, labor scarcity raises wages relative to the price of other goods (see Will The Real Phillips Curve Please Stand Up and the instructive chart from former Fed governor Richard Fisher in Eating our Seed Corn). That’s the only variant of the Phillips Curve that actually holds up in the data, and there is no evidence that this or other variants can be reliably manipulated through monetary changes.

Only long-term sustainable, predictable employment creates a turnaround. Till this I agree with him. Now comes the crucial issue of timing. Here he says:

They want to believe that the Federal Reserve has their backs; that as long as the Fed doesn’t explicitly hike interest rates, the market will move higher indefinitely. We saw one question last week that asked “What if the Fed doesn’t raise rates for another 20 years?” Let’s start with an aggressive, optimistic estimate. If we assume that despite conditions warranting two decades of zero interest rates, nominal GDP and corporate revenues will grow at their long-term historical norm of 6% annually over the coming 20 years, we would expect the total return of the S&P 500 to average about 5.5% annually over the next two decades (see Ockham’s Razor and the Market Cycle for the arithmetic behind these estimates). Even in this optimistic scenario, to imagine that this path would be smooth would have no basis in history, requiring the absence of any external shock for the entire period (and I’ve already demonstrated, I hope, that many of the worst market declines in history have been accompanied by Federal Reserve easing).

If Fed hikes, it will interfere with the risk equation causing "a breakdown in market internals" as Hussman calls it causing precipitation. But it is unlikely that Fed will hike. Fed may experiment with a token hike but may quickly reverse. Or, more likely, Fed will signal a prolonged pause (lasting more than a year or two). 

If Fed does not hike, things won't be as simple as 5.5% annual growth. It will be more. The past data behind this calculations comes from low monetary expansion era. When there is a flood of money, prices should inflate commensurately. Thus, if Fed does not hike,  S&P may average annual growth of ~10% or more for few years. 

Hence, S&P may double from here before Hussman's prediction comes true. We, no doubt, are establishing an extreme. We are confounded by its extremity.

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The Boring Banking Industry?

Two of the leading voices in finance Frances Coppola and Yves Smith are in a disagreement - sort of a pseudo-disagreement if you ask me - over whether banking should be boring or not. The question itself is the reason for the confusion. Banking should be boring was endorsed by Elizabeth Warren too.

I think Banking should be my kind of boring. By boring I mean two things - it should not be unnecessarily complex, and it should be capable to meet the complexity inherent in banking. Retail banking is not boring - for wrong reasons. It confounds the public with products that are too complex for their needs. At the same time, the back end that supports these products (read - corresponding asset liability matching mechanism, hedging etc.) is not as sophisticated. Investment banking on the other hand is too boring - meaning it does the complex shit right but it passes that shit to people who have no clue without retaining any skin in the game. 

Banking has multiple facets:

First there is a probability management that allows banks to take deposits for different terms and make loans for different terms and manage the asset-liability gap. This is similar to the insurance industry managing premiums and payouts. A smaller part of this is managing float which is a skill by itself. This is more like extremely short term trading.

The second aspect of banking is your ability to make loans that will pay a decent return without going bust. It is often known as the essence of banking. Borrowers whetting, background checks, credit history check etc. forms part of this aspect of banking.

Third aspect of banking is about sales of a variety of investment products. Here the retail staff of the bank tries to meet its sales targets by selling complex investment products to unsuspecting customers. The customers, most often, are meeting these sales-people to get some transaction done - they are not there to seek investment products.

Fourth aspect is support services which can be totally outsourced. This aspect covers your cheque-book issuances, mailing the account statements, keeping the personal records up to date. Issuing certificates for taxes, etc. On the asset side - it deals with record keeping, and procedural stuff. It is fairly automated and most customers can be empowered to do it themselves as well.

Understanding banking:

We cannot classify banking into retail and investment banking and expect to gain any new understand. We need to cut banking up into two chunks - transaction management and investment management.

Transaction management should be boring - like telephone exchanges or something. It should simply be WYSIWYG. It is also similar to McDonalds - it is basic and simple but you need to have skills to pull of the quick delivery at low cost. Meaning it is more a function of skill (can be acquired by repetition) than expertise (research, experience and insight are essential)

On the flip side, the investment management side should be complex. Now loans are debt investments and so is float. Selling investment products is as different from transaction management as chalk and cheese. You need experts to sell those products and ensure that they are not mis-sold. This part has been wrongly simplified. This part requires expertise.

What is boring?
Currently what is boring is selling investment products - which shouldn't be. Most people I know - yes most - do not understand the risks with any of the investment products they buy. It can be insurance policies, term deposits, mutual funds, debt funds, real estate or whatever.

Now basic risk management tells us that just because you buy different products does not mitigate your risks - sometimes your risks may go up. This risk compounding is not even understood by the practitioners let alone the customers. The sellers of these products, to use a popular phrase, get a salary to not understand them.

Now credit cards and over-drafts are not simple transaction management products. They are in fact loan products and deserve to be sold professionally. Most of the unnecessary complexity lies here. People who go for credit cards do not understand the terms of loan they are entering - and Warren has highlighted it time and again. Same goes with OD - while it is not as bad as credit card terms - hereto people do not understand what they are getting into.

There is quite a bit of complexity in term deposit side as well. If we really examine, most of the depositors do not make as much from their deposits as they should. The optimisation is never explained and never understood. It is in the interest of banks that depositors do not understand this - CASA (current account - savings account) helps keep the cost of capital low.

These cannot be boring - quite the opposite. These issues need to be explained - some by the banks selling these products, others by general education.

What is not boring?
Conversely, the transaction management is unnecessarily complicated. Real time settlement should have been a norm now - yet banks do enjoy settlement floats on many payment mechanisms. These represent the money the banks use after the debit the account and before they credit the account of the beneficiary.

One source of complications in transaction is authentication and identification. These cannot be eliminated as they exist to keep your bank account safe. However, all other sources of complexity are available for simplification.

Transaction fees are pretty complex, sometimes they are waived other times you get charged for using some facility during a holiday or something like that.


In sum
Banking is simple and complex at the same time - just not in the right places. It is time to rewire banking - simplify it just as much as required and no more.

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Austerity V/s Stimulus, Government Spending and Greece

Sometimes it is worth repeating something that is actually right. Let me say this again:

Stimulus works best when you need to push-start the demand engine. Note that it implies that stimulus won't do the work of engine - it will only push-start it. The engine must be in working condition otherwise. 


Austerity works best when Government borrowing is crowding out private investment. Usually Government is borrowing too much because it is spending too much. New investment is required to put a new engine in place.


In Greece's case - their engine is not working and their Government is spending a bit more than required. A combination is required when economy stalls - i.e. Government must reallocate/realign the spending targeting it into essential things. It also needs to increase spending once the new "engines" are set up. 

In a nutshell - neither Austerity nor stimulus alone will work in Greece's case. A combination of sane reforms and practical stimulus is required. Till such time...

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Why deflationary forces are so unrelenting?

Despite good GDP numbers and PMI data the deflation does seem to give up. Here are the reasons:

1. Incomes have fallen and are not rising again: Since 2009 there has been a fall in incomes resulting from retrenchment and layoffs and consequent oversupply. While employment numbers have improved (unemployment is falling), incomes are not rising. In fact they have settled well below their previous highs.
2. Consumption goods prices continue to fall: The fall came from two sources - improved productivity (from about 1990 to about 2000) and thereafter from combination of productivity gains and exchange rate dynamics. The QE era flooded the world with low-cost  capital leading to reduced interest rates across the world. This low-cost debt is transposing low-capital-cost-but-high-running-cost human employment with high-capital-cost-but-very-low-running-cost robots. Today the US consumption good prices are still at the mercy productivity gains and exchange rate dynamics but the pressures are more aggravated. The new productivity gain mechanisms are putting exceptional pressure on employment and wages. Further the exchange rate dynamics have morphed into all out currency wars.
3. Investment goods prices are deflating too:When you reduce the interest rate, you increase the prices of assets usually by setting the yield or return scale lower thereby pushing risk-averse investors into risky assets thereby inflating asset prices. Secondly, we coupled lower interest rates with ingenious financial engineering leading to improved credit availability which also advances demand from decades ahead and packs it into short timeframes. The converse is that there is prolonged period of lacklustre demand phase. I believe we are in that phase or may be entering that phase.

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What happens when passion for transformation meets attachment to bureaucracy?

It often so happens that your passion to transform the organisation meets with the organisation's love for its status quo. The meeting is like "unstoppable force meets an immovable object". So then how do we transform organisations.

Well, to start the resistance comes from systems - but more from people who love certainty of those systems. These people, called bureaucrats in the book, haven't bought into the reason for change. The selling of change / transformation needs to be increased. The other reason why people resist change is because they see uncertainty beyond the change curtain. Bureaucrats hate uncertainty. 

There are four types of personalities in the organisation - Scouts, Commandos, Bureaucrats, and Leaders. Leaders are those who can flip between the working styles and deploy respective talents properly.

Change makers are usually commandos or scouts - both hate process driven approach. It is the nature of their make-up. These people often operate in uncharted waters therefore they are tuned to working without maps and processes. The resistance they pose comes from premise that they believe the change will not work or that it is ill-conceived. These people are more or less in agreement with need for change but have doubts as to the directions.

When processes seem to be fairly visible you can bring in the bureaucrats. Till such time, bureaucrats are better assigned to working the established lines of business creating window for change.

Some times mistakes happen when we are not looking. 

For example, during the change process if the finance department is fairly tightly controlled by bureaucrats then change is doomed. Expect tough fight for budget sanction and deviation to be questioned seriously. To avoid this, it is better to sandbox the venture.

OR

Another mistake occurs when scouts are left in charge of process formulation. Scouts are absolute worst with this job. They lose interest pretty quickly and resulting process are a mess - a bureaucrat's nightmare. The venture with successful proof of concept goes down the drain as bureaucrats are unable to replicate the success of the commandos.

OR

When change-makers make the change they leave the process formulation to other commandos who may not have bought into the concept of change. It is important that process formulation is done by commando team which has completely bought into the concept of change and/or feels confident enough to make necessary changes in the course of action.

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2015: Images from the Crystal Ball!

We are at the threshold of 2015 with US posting one of the record quarterly earnings, FED talking of tightening, Russia and China on the brink of their own respective crises and some rather tricky security flashpoints - information security breaches and physical security breaches by ISIS, Boko Haram and the usual Al Qaeda and Taliban.

From the markets perspective, we have rather exhilarating ride. Oil prices have hit $60 from $100+ just a year back. Gold prices have softened, US markets are touching all time highs. EU is on the thresholds of a QE for itself. Japan has voted Abe back. Seems like good times are here!

Well they are! The recovery is thanks to the US Fed and so long as Fed does not tighten or initiates another form of QE, we can enjoy the benefits. It is time to make money and build up a solid rainy-day reserve. 

The cycles and volatility are our friends

The year promises to be as cyclical and volatile as previous if not more. This year though I am expecting at least 3 full equity market cycles - as compared to 2.5 (3 peak-2trough or vice versa) I expected last year. Unlike last year though, there will not be a secular up-trend. Thus last year if we missed a peak it was easy to recoup the lost gains by simply waiting. This time we may see some losses in such scenario.

US and developed markets
In general I agree with the Jeremy Grantham's forecast that US markets may move till 2300 -2500 before any correction. His analysis is worth a read. Secondly there is nothing that can shake up the US markets in present circumstances. The shock, if it must come, must be substantial. I think the Fed must continue to be on a pause till the employment outlook improves. This will allow for the growth to get traction. In the early '30s US withdrew the stimulus too soon with disasterous effects. Therefore I presume they will err on side of caution this time around.

The EU on the other hand still sustains itself on internal trade and consumption. EU stimulus, when it comes will be of great benefit. Let us hope to get the mechanics of this stimulus right as EU is more vulnerable to a currency run than USD. 

Indian Markets
In general, emerging markets will follow US markets. India should be special, and in general flight to quality to US should affect Indian markets to a lesser degree. Indian markets should have similar pattern like that of US - about 3 cycles over a secular uptrend. It seems 35K on Sensex does not seem out of reach. Within the broad Indian market uptrend we should see some sector rotation. Infra stocks should be back in favour along with asset intensive industries. Expect to see higher volatility in the markets thereby allowing for higher gains than the 27K-35K interval suggests. However, buy and hold will be a risky bet given sector rotation and global risks.

The nature of risks from shocks

The year while positive is fraught with risks:

1. End of ZIRP?: Yellen's comments in the last Fed meeting have prompted analysts to pencil in a Fed rate hike in calendar 2015. I find that hard to believe. In the very least we should see a prolonged ZIRP pause. We should expect a shock only around June if at all Fed decides to hike.
2. Draghi - Will he won't he?: What Draghi does and when he does it will naturally have a lot of bearing on the nature of cycles. I suspect EU will ease before US tightens. The qantum of QE is likely to be lesser and more directed than US.
3. Japan - Abe it is!: Japan has done quite a bit quite quickly. I think they will have to continue with it and make the stimulus, QE more directed using policy interventions. Japan will be more aggressive on investments across the world.
4. Chinese growth: Analyst expect the Chinese growth to surprise on the downside. I am not sure about China but most likely the numbers may be better than analyst estimation. Lower Chinese growth implies easier commodity prices - sort of a QE by itself.  

My Strategy for 2015
The buy-and-hold era ended in 2008. These days the best buy-and-hold stocks never reach the broader markets when there is still money to be made. They sit tight with PE or angel investments. The stock markets are being used by promoters as a sort of exit option. So indeed we must sort and sift through the stocks and keep churning as soon as they fall out of our valuation metrics.

Infra stocks: Infra stocks seem well set to make a comeback. I have been investing in them since 2011 hoping for Indian infra turnaround. The situation is more conducive than 2011 but I have been wrong before.

Commodity stocks: The China crisis seems to have sent some commodities in a tail-spin. Therefore I am not inclined to interfere with metals and non-perishable commodities. Other commodities - like sugar are weathering the oil price shock resulting in lower alcohol demand coupled with excess supply. Sugar should turn around soon. I have been investing in sugar since early part of this year. I will continue to add to my positions.

Banks and Commercial Vehicles: These stocks are leading indicator stocks and I have liquidated my positions in banks and will soon do so in Commercial Vehicles space as well. These two sectors are in for period of good growth and repairing of their balance-sheets. In that sense if there is any correction I will take substantial positions in these. They should turn around pretty quickly once the shock wears off.

Gold: Gold is the only buy and hold thing I can think of currently. Only if you are in a currency that has potential for appreciation vs the USD then you can ignore gold for short term. The current USD strength is good for buying gold. The currencies of economies where the private sector and consumer is not leveraged and public sector is reasonably benign will ultimately appreciate in relation to USD.


In Sum
The year promises to be exciting year, a rare patch in a lifetime where we can ride multiple cycles within a year itself. The experience of recent past tells us to be nimble with a healthy respect for cash. Let us see how we can capitalize on this coming year.

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To RBI: A Case against Rate Cut

The Reserve Bank of India (RBI) is under considerable pressure to reduce its benchmark interest rates in its upcoming monetary policy meeting. However, prudent monetary policy needs to keep rates at the current level rather than a premature easing for various reasons.

First, the present high inflation problem was caused by supply-side constraints combined with demand-side factors induced by rural wage growth. Over the past few months, rural wage growth has moderated and the government is also prudent and is not increasing MSPs. This has eased demand-side pressures and hence the recent inflation strength can be attributed primarily to supply side factors. 

Our strategy to counter supply-side inflation has been to boost supply through increased infrastructure investment coupled with measures to improve ease of doing business. To make it work, we must let supply overtake the latent demand by such a margin that any easing thereafter should unleash a positive demand catch-up spiral. The risk with a premature rate cut is that it creates demand even before supply-side catches up, in turn pushing the inflation trajectory higher. Therefore it is better to err on the side of caution and reduce rates later rather than risk another inflation spurt.

Second, higher interest rates combined with lower inflation augur well for positive real savings return. This has twin benefits. On one hand it redirects household incomes away from consumption into savings; and on the other hand it will creates a corpus of domestic saving that can be re-invested into the economy making Indian investments less dependent and more resilient to external / global shocks. 

Third, high asset prices, particularly real estate prices, are a more substantive burden on economic growth than interest rates. A premature cut can re-invigorate the real estate cycle, adding to the countries financial vulnerability. As the BIS has stated, central banks should focus not just on the business cycle, but also the financial cycle. Higher real interest rate will maintain a pressure on asset prices thereby creating beneficial conditions for sustainable economic growth.

Fourth, higher interest rates (more capital inflows) coupled with exchange rate sterilization measures are helping the RBI create a war chest to counter any external currency shocks. This was indeed the learning from the South East Asian crisis of 1990s – make hay while the sun shines. The RBI, rightly so, expects the near future to be tumultuous in light of US Fed tightening and changes in divergent monetary policies in developed countries. Higher rates will ensure that the RBI has enough dry powder in case of a global economic shock.

In sum, calling for the RBI to cut interest rates – just when the inflation battle is being won- is premature, short-sighted and tantamount to declaring a victory even before the enemy has been defeated. In a world where global central banks are creating conditions for future instability, the RBI should remain a beacon of stability.

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What we need to estimate effects of multi-country QE?

I was thinking about ways to estimate impact of QE on potential offered by different equity markets in general or asset markets in general.

Currently we do not have money inflow metrics (i.e. indexed price and volume data) for all asset classes. Nor do we have an exhaustive asset class database (types of asset classes e.g. art). Without these metrics it is difficult to construct a true impact of QE on global markets in general and specific markets in particular. Maybe someone can construct some sort of blended index.

I suspect when we do construct some quasi-indicators we will find that M3 has grown disproportionately with GDP and the difference can be explained by blended asset class inflation.

Once the global effect is understood, the specific country level effect can be understood using a parametrized gravity model. Such model will tell us how the excess liquidity will move. 

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Employee Costs of firms Firms, Free Agents and Talent Market Exchange that could be LinkedIn

Thomas Piketty's book "Capital in twenty-first century" talks about increasing income polarisation. One of the reasons for this has been the dumbing down of jobs available in the market. There is also a lot of debate about whether robots will take over our jobs. These debates deal with two forces acting on the firm. First is constant need to reduce employee costs and their need to engage with highly skilled talent. The confluence of these two forces can be extrapolated into robots taking over our jobs, polarised incomes or in a utopian view an era of free-agents. But that era has not yet arrived. So what keeps us away from realising an era of free agents? Well let us look at it from our firm model view.

Over the past 250 years we have moved from fairly simple, independent value chains to highly interconnected complex value chains. This means that expertise developed in one value chain has diverse applicability and therefore higher value across multiple value chains. However, from the view point of the firm, their value is limited. Consequently the employee groups developing these capabilities feel underpaid and switch jobs frequently. While there is a marked rise in their pay, I think this is miniscule compared to the value they can potentially create. I believe it makes sense to organise these individual clusters of competencies into tradable units - either as mini suppliers to various value chains or as free agents' agglomeration. 

The agglomerations will need efficient markets wherein you can know, hire and enter into contracts with these entities. In LinkedIn I see a potential market quite similar to equity markets where the buyers are firms and sellers are these micro-agglomerations or even individuals. 

A market where each person is like a listed entity seems ominous. Yet, it is not one market. Specific skills by themselves are a market. So LinkedIn needs to create multiple markets within their entire database. The parallels with equity markets and supplier discovery engines are ever more relevant. The amount of energy LinkedIn spends in validating their "listed entities" is nowhere close to the energy spent in the equity markets and supplier discovery engines. LinkedIn will have to create algorithm based bots to do that effort so that these bots can make the markets relevant to the buyers and sellers.

The responsibility of creating such a market is not simply that of LinkedIn or some such other job site. But it is responsibility of every individual, teams and also of HR departments wanting to leverage their human resources to maximum extent.

The outcome of such developments can unleash substantial benefits in rising pays and lead to healthy development of free-agent marketplace. The ancillary benefits could be substantial development in ideas that these free-agents focus on which may receive a boost because of focussed effort. Lastly, it will lead us to enriched lives of people.

Note: I have used value chain as it is generic word, but readers of the book "Understanding Firms" can appreciate this concept better with Resource Transformation Chains which is explained in the book.

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Welfare v/s Austerity - India's issue

Many people including some experts, attribute Indian growth of about 5% to the welfare schemes of the UPA government. Their honest belief is that UPA government's welfare schemes helped alleviate some of the harshness of the global economic slowdown. They also point to Chinese stimulus as something to emulate. Thereby they believe Modi's promised subsidy rationalisation (euphemism for reducing welfare) is not a good idea. I disagree. 

First, there is a difference between global issues and Indian condition. Global economic engines have stalled, while India's remain switched off for want of fuel (investment and clarity in policy making). 

Second, fixing the engines requires fuel which is currently diverted to subsidies. Thus, if there were an ideal subsidy level, current burden is most likely higher than this level. Therefore, naturally, to bring sanity back this will have to be rolled back. 

Finally, what is required is to push-start the engines is additional effort which will eat away more subsidy than generally required. Thus, push-starting this engine will cause subsidy to dip below this ideal levels. The blame for this does not lie with present government but with UPA which killed the engine long time ago.

Fix the engines and Indian engines can hum along for quite a while creating economic growth and surplus necessary to smoothen the income disparity in later years. Acche din aane wale hain!

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Reducing Importance of the budget

The first budget of the new Indian government is scheduled to be announced in a few hours. However, I believe budget announcement has outlived its excitement value.

I would rather see the past expenditure analysis session and a strategic planning session replace what is currently made into a single event. 

There is absolutely no discussion about effectiveness of past expenditure as against their objectives. I don't want to see how welfare expenditures have contributed to the economy as it would be too premature to so such analysis making the budget useless. I would rather see how effectively were the cash transfers were made, what was the loss, what was the cost required to transfer that cash, etc. I also want to know that how fiscal deficit target was achieved using cash accounting jugglery by simply delaying payments. 

Similarly, we do not have a strategic planning session. The presidential address to both houses intends to do that but is hardly ever used that way. The election manifesto is the strategic plan we look to. I think that is inadequate. However given the level of understanding in the houses of the strategic issues, one wonders if it is better to not let the parliament do strategic planning. Most of the MPs are "knowledge proof" as the popular adjective goes. 

In sum in a few hours you will see much hula boo about a non event. Let us hope Arun Jaitley breaks another norm. 

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Make or break elections in India

As the election nears, the political discourse has become shrill, divisive, rhetorical but seldom, if at all, insightful. From the economy and markets perspective, there was never a turning point as pronounced as this. 

The market favours Narendra Modi, BJP’s prime ministerial candidate. However, the electoral numbers present a challenge. The BJP is strong in North and West, marginal in East and almost absent in the South. As per recent opinion polls, North and West are firmly backing BJP. The East will be crucial test for BJP’s party machinery while South will depend upon alliances. 

At the same time, opponents are getting their act together. Aam Admi Party despite its ludicrous politics, enjoys continued support amongst its followers. If not anything AAP may limit BJP’s seat share below the 180 mark. Congress may gain from its many populist gifts to rural India in the past decade. Congress is a shrewd tactician at election games and can still ratchet up 150+ seats simply because of it truly national presence. The third front is realigning itself to increase the bargaining power at the time of government formation. The lack of coherent leadership within third front makes it a target for alliances and partnerships, legitimate or otherwise. 

A rational result hints at BJP winning 190-200 seats. This number was adequate to run stable coalitions in the past. However, Modi’s polarized image may present a problem and a lot will depend on tally of other parties. If Congress wins 150+ seats, there is a reasonable possibility that BJP may be sitting in opposition even after winning 180 seats. BJP needs at least 230-240 seats to decisively win the mandate.

From market’s perspective, there are three likely outcomes of this national election – a coalition led by strong BJP, a coalition led by weak BJP and a indecisive-mandate.

The first case will allow Modi to implement a model of economic reform he has articulated. It is a big challenge as there is little time to address the breadth of issues facing the economy. In case of a weak BJP-led coalition, things will become uncertain. We must realize that the national mood is pro-Modi and not exactly pro-BJP, and BJP continues to be riddled with its old problems even today. In a weak coalition Modi-detractors may not allow a broad-based economic reform. This situation will test the political ability of Modi to maintain stability, something Vajpayee achieved with help of Brijesh Mishra.

However, in case the electorate throws up an indecivisive-mandate, we are positively doomed. Our present predicament leaves less room for experimentation or populist adventurism. It will result in a lost decade and some of the damage caused may leave deep scars. A lack of coherent policy may make low growth endemic and entrench our structural problems.

There is hardly any margin of error this time but then Indian voter has demonstrated surprising political maturity in the past. So let us hope for sanity.

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Banking and the Post Office

Yves Smith blogged about post office providing banking services. Here is my take on it.

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Double whammy of withdrawal of funds from emerging markets

In the past few trading sessions, there has been a considerable withdrawal of funds from the emerging markets. We can attribute this to two basic reasons.

Firstly, we have seen reduction of QE from $85 billion to $65 billion in the last four months. Secondly, we have seen an upward pressure on interest rates in the developed world. These two factors have combined to create A double whammy. At the time when funds are scarce, we have a reverse potential difference that is pulling money towards developed markets. This perverse situation will lead to substantial abatement of money flows from emerging markets to the developed markets.

In addition, there is already in place, an incentive to emerging markets sovereigns to invest in developed market treasuries for mercantilistic reasons.

I believe, these three forces will lead to substantial correction in equity markets in developing countries. Hence, we will see drastic correction in Indian equity markets. I also think, the same logic will hold for other developing countries.

I will be trying to close my open positions as soon as I can. Let us hope that we are able to ride out this turbulent phase. However, I do not think that this turbulence will last more than three months. Therefore, it is essential to get into the market say around end-April.

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Money Supply and GDP growth

Here is a chart I made showing money supply v/s GDP growth of top 4 developed economies. Tell me what do you think about this.

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The globalization puzzle

Dani Rodrick has an interesting post about globalization here : http://blogs.lse.ac.uk/politicsandpolicy/archives/38743

The essential argument is institutional in nature. The institutional development Prof. Roddick argues depends on democratic choice expressed by various countries. He therefore concludes that full globalisation is almost impossible. I beg to differ slightly. 

I agree at this point in time it is difficult to achieve full globalization. However, it is neither impossible nor unlikely in the future. Prof. Roddick allows for such situation in extreme long term so I may have gotten it wrong. 

I think two main forces are working towards that goal. 

First internet and technology is making us realize how similar we are as peoples of the world. In older times we were skeptical of other people - they spoke different language, worshipped different gods, had different skin colour, ate different things, etc. There has been even starker change in people's perception of other counties from pre-1960s where non-western was exotic and a global traveller was a privileged person. Well, no longer is that true. We now have people interacting globally with each other across time zones and across cultures. This is a potent unifying force. We see often than this urge to communicate, trade, intermingle often crashes with the political borders and norms developed to keep peoples separate. No longer are we threatened by those of other culture. 

Second the world human and environmental rights movement is creating a template for global legal alignment. The UN human rights movement is creating a lowest common denominator set of rights that countries and their people are eagerly adopting. This methodology gives us a template that can be used for developing set of common rights which can expand gradually. 

Of course there needs to be a certain convergence between economic development of various countries to make it easier. But this convergence is not as strict a requirement as it was before the internet era. Today the world is  truly and rightly coming closer into a global village. And I sure hope this happens in my lifetime. 

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NIFTY in 2013 chart

The Nifty over in 2013 did something expected - it did three peak- two troughs ~ 2.5 cycles in one year as shown in the chart below.

NIFTY over 2013 calendar (Bloomberg.com)

Following are the interesting points to note:

Firstly, the amplitude of the first cycle is smaller than second cycle. I see this increasing over the next year. Thus, in 2014, Nifty will have at least 2.5 cycles each with amplitude at least as much as the second cycle of 2013. It means a lot of volatility which is positive or negative depending on how you look at it.

Secondly, the time between the two cycles is quite small and there was a muted volatility (bearish lull between End Jan to Mid April and bullish lull between end oct to Dec). I see this muted periods getting compressed. In effect we may have crudely speaking one more cycle in 2014.

Thirdly, if you see the underlying macro/micro data it has generally worsened over this period though we are near to all time highs. It is quite parallel to US equity markets.

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Irrational Exuberance in Asia - Ghosts of Greenspan in India and China

William Pesek writes an interesting column about easy monetary policies (relatively) in Asia. The central point in the article is that there is a distinct need for reform in Asia; the reform is structural - fiscal and political in nature; the reform is ignored and monetary policy is being used to boost "sentiment"; this cannot last.

I agree with the undertone of the article though there are few distinctions I would draw:

1. The outline of reform in Asia Ex-Japan is well known. 
1. It is a well-trodden path by the developed economies. 
2. What is lacking is either the political will or weaker systems that need reform.
3. For political will there has to be some margin in growth. This margin was afforded by a developed country demand for developing country goods.
2. The other reason Central bankers of developing countries are a bit easy with the punch-bowl refills is because the principle strategy for growth is by tagging on to the developed country band-wagon and compete on differentials. 
1. This strategy requires competitive exchange rate mechanisms while maintaining investment-ability in countries assets.
2. The so-called monetary tightness / monetary reform have been triggered by either of these two requirements.
3. Thus, central bankers must keep relative position with developed country monetary policy and amongst each other. Thus if one developing country does QE then it becomes imperative for others to follow in order to maintain export competitiveness.
4. Changing track from this strategy is difficult during good times and becomes almost impossible when the developed markets are going through a weak economic growth phase.
5. Even Japan is attached to this strategy.

Thus the irrational exuberance carries forward from US monetary policy. It cannot be attributed to developing countries. What can be blamed on developing countries is their lack of will to develop an alternative model that can sustain the dreams and aspirations of their peoples.

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Baltic Dry Index's positive prediction

Have a look at the following chart of the Baltic Dry Index.

I am particularly enthused about BDIY's recent uptick. BDIY was a very strong indicator of Global Trade and economic strength before it lost a bit of credibility in the post-Lehman crisis. The reason I am excited is this:

1. Shipping industry went through one of the most intensive asset building phase between 2006-2010 with almost double the DWT built as was existing.
2. This industry-specific weakness was coupled with economic weakness stemming from the global financial crisis.
3. The Oil-accumulation during post-Lehman phase provided some respite but it tarnished the image of BDIY as predictor of economic performance.

I think the disturbances in BDIY are past us and its present uptick does bore well for us. This means it is time to dip your toes into shipping cos. In India I would go with Shipping Corp [which I have from the previous high :(], Great Eastern Shipping. These companies should benefit from the Iran-Iraq Oil deal.

We need to watch for any global weakness and potential head-and-shoulder formation as happened in 2010.

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2014: Images from the Crystal Ball

It is that time of the year again when I take my crystal ball and peer into the future. So lets get going.

The hand that Yellen plays

I think overall theme of 2014 will be determined by the hand that the US Fed plays over the first two quarters. There are two reasons why I say that. Firstly, Janet Yellen is clearly from the Bernanke School and people expect the QE -based easy monetary policy will continue. Secondly, contra the above Yellen is talking about modifying the nature of QE to be more directed and precise. I think that is full of risks which market has not fully understood as yet.

QE till eternity? Almost!

One thing is clear you cannot have QE taper till you have sustainable employment with a visibility over say a 10-15 year period AND reasonably deleveraged US household. Once that is achieved then you can consider a talk of taper and the resulting volatility will be allayed by stronger household balance sheets and things can progress from thereon. So in effect the following things must happen:

1. Employment must reach about 95% of the workforce. It should be reasonably certain employment.
2. Ideally, US need to see emergence of a new industry which has three characteristics - first it fits with the US competitive character; second, it is a mass employer employing relatively lower skilled people and third it has second order, third order effects. Most likely that industry could be in renewable energy or water conservation space.
3. There must be a reasonable clearing of Household debts and households must be reasonable deleveraged with margin to take on more debt if required.

But it won't happen in 2014
To gather up that kind of employment we need a Fiscal side action. A national overhaul of US infrastructure will raise my hopes though it does not promise the sustainable employment for at least 15 years. But it is a fair shot to say the least. The current Fiscal policy is far too short of any meaningful contribution in this regard.

Will QE lead to a US Inflation?

The whole idea of stimulus is that money will flow through the channel to the places where it can create value- therefore GDP growth- therefore jobs and this cycle will pull the economy out of the doldrums. Today the situation is different. 

First it is difficult to keep injected money within the territorial borders to create the desired effect. This means two things. First the quantum of stimulus required will be far larger considering the wastage. Second, the problems of world have bearing on the quantum. 

Second the mechanism of money flow or money flow channel is not functional so you cannot get the flow to the lower rungs (i.e. from asset investors to asset owners). That implies that the money is sloshing into restricted space. It is spilling into global asset classes searching for a channel to reach the bottom. (EM equities being one of them).

There are two things that must happen before the money starts getting channelized properly. 

1. You need and investable industry to crop up. And not any industry will do - it must employ relatively lower skilled people in large numbers. When we find such an industry (as a few are being experimented with) we will see money being rapidly absorbed.
2. The current uncertainty of weak institutions collapsing must go away as in early investment stages any industry is quite vulnerable and ours will be no different. When there is adequate certainty that the weaker or failing institutions may be ring fenced into failing safely then it will start growing.

When growth gains traction it will lead to inflation. The trouble is that US FED does not want inflation but that inflation is decades away. But looking at that possibility it is doing nonsense like QE tapering etc. Naturally, if you want the industry to appear quickly then it is easier done through Fiscal policy than through monetary policy (no doubt monetary policy needs to be accommodative).

Therefore even inflation will not happen in 2014 and it is a good outcome.

The EU curve ball

I think the most weird scenario is that of European Countries. Some are following austerity, others are expanding and the effect is a mixed bag. In fact there is good chance that the next problem will arise in Europe rather than from US tapering.

I think there are more things fundamentally flawed in EU than in US. So I would bet on US in a US v EU debate. Further, I would be wary of developments in EU both political and economic because each has impact on the other.

Further, this problems may come to fruition in 2014. It could be the one almost certain headwind of 2014 unless some dramatic political strategies and monetary policies are put in place. The problematic part is that any meaningful resolution requires massive political coordination spanning different regimes that have different outlook to policies.

I think Martin Wolf has it right in his last video presentation here.

About Indian stock Markets

Indian stock markets are likely to move up till say Jan-Feb and then go through a period of extreme volatility related to elections and possibly few other global factors. The presence of strong and short cycles was critical feature of 2013. I believe this will continue in accordance with slosh-money hypothesis I explained in book and previously on this blog.

The flow and quantum of money means it will keep moving between various asset classes sloshing them with out of the world valuations and ridiculously cheap ticket sizes all in span of 4-5 months. 2013 we had 2 cycles in one year (2 peaks-2 troughs). In 2014 we will have at least 2 (2 peaks-2 troughs) and may be 2.5 (2 or 3 peaks and 3 or 2 troughs).

It means we need to be nimble in investment and must be ready to keep the money off the table. This, as I have experienced in 2013 is more difficult than it sounds. One need not be a daily trader, but the investment strategy must be tested more often than what we previously believed. The days of buy and hold are over and in fact buy and hold has become more destructive option today.

What about Gold and Oil?
To me it seems that Gold and Oil will not be as critical as thought previously. Gold will slowly gain traction and it will go past $3500. The nature and quantum of QE, already delivered and expected to be necessary, will have substantial bearing on the projected price of Gold. The forecast for medium term gold prices varies between $2000 to about $7000 primarily because the fact that the other side of the equation i.e. total amount of money in the system has a wide estimate. Once that clears up the Gold forecast will be much more saner. Having said that, the fact that the total amount of money in the system is unknown/varies drastically itself makes a case for Gold. Thus, I would be buying Gold if I was USD /developed economy buyer. In a different currency, the Gold trade may not be as compelling.

Oil may be more volatile in accordance with the QE news flow. Oil gaining its position as store of value (a story that had abated after Shale and other quasi-oil alternatives). Though Oil as store of value is likely to end disastrously. Oil is no longer the resource crunch story that it was between 2005-2010 period. We have never heard the real oil story. There is no dearth of oil if you set aside the environmental consideration and cost of drilling. So "Peak Oil" really refers to "Peak $50 Oil". The real constraints are in fact the environmental considerations and we may do well to move away from oil sooner than later.

War is coming
So long as US continues on its Japanese strategy, we are going to see possibility of war increasing. It is possible that China will induct 5-6 Aircraft carriers into its navy in 2014 if not more in preparation for war.

The new Chinese leadership will face tougher challenges converting its economy from a producer-driven economy to a consumer-driven economy. Further, the lack of sustainable global demand will not ease the pressure on Chinese government. When the problems of worker migration will ease the problems of worker wages will begin. It will take a great deal of proactivity on part of the new Chinese Leadership to manage these. Further, this is the first truly non-revolution leadership so we are yet to see their mindset.

All said, I see some notoriety involving Chinese sooner or later.

Finally,
As I head to the beach, let me say this, we seem to be in much saner times than we actually are. Insanity is quite a short jump from us at any time. So in such times let sanity prevail, let talents rise and pseudo-leaders fall and let peace be upon us.

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