interesting perspective: another long read for a Saturday morning
>From Vedant Mimani
The window of relative calm in the financial markets over the past 3 months has afforded all of us time to think and reflect about what happened and where we are going. By now we have all heard the various opinions ranging from those that feel things will get a lot worse to those that believe we are seeing once in a generation type opportunities. Who is right?
My Interpretation of What Happened
Since July 2007 we have seen a decline of about 50% in the value of most asset classes and this destruction in wealth has been attributed to the "Credit Crisis of 2008." Supposedly the pipes of capitalism were clogged and Mr. Paulson and Chairman Bernanke would have to play plumber and fix the credit markets to make sure our otherwise healthy economy got the lifeblood it needed to function smoothly. What I find particularly interesting is that during this so called "Credit Crisis" both money supply and credit were growing fine (you can see for yourself at the Federal Reserve Bank of St. Louis' website research.stlouisfed.org) and liquidity was never the issue. So then what happened and what were Paulson and Bernanke doing?
Let me share with you my theory. As I've mentioned before some people believe markets are smart and have predictive powers and some believe markets are irrational and manic depressive, and I believe markets are both and the challenge is to differentiate between when a market is being wise and when it is being foolish. I think starting July 2007, the markets started anticipating the destruction of credit and money and thus liquidity, which has yet to actually materialize on an economy wide basis and investors collectively abandoned the relatively more illiquid asset classes for the most liquid (government bonds, cash and gold). This is why almost every specialist believes they are seeing the "best opportunities they have seen in their entire careers." As usual the markets are a step ahead of reality.
The decline in asset markets did bring into question collateral values and loan quality resulting in "marked to market losses," which in turn affected the banks' solvency and ability to lend, but it was the asset markets moving first, not the other way around. Since I believe asset markets are ahead of the curve and actual credit and money destruction will follow, I am expecting asset markets to become even more dislocated as investors will continue to flee almost all asset classes in favor of the absolutely most liquid ones. Please note I am not implying all asset classes other than cash and gold are worthless; they are just and will remain for a while illiquid. This means in the intermediate term the owners of those assets will not benefit from price appreciation (unless there is a trade sale), but only from the cash flows those assets are able to generate for its owner.
Now what I think Mr. Paulson and Chairman Bernanke were doing by expanding the monetary base by swapping good money for "toxic assets" and forming agencies like TARP to deliver credit was really getting prepared to counter the upcoming credit deflation. I suspect the bond market will limit the Government's hand and so not enough money will be able to be created to counter the upcoming credit and money destruction, which will then force the Government to follow some more "out of the box" policies, but let's take it one step at a time.
My Comments on the Precious Metals Complex
Gold is the most liquid asset in the world because it is the only asset that cannot default; it is pure money. Given my thesis that we will continue to see a flight to liquidity, the intermediate and long term future for the precious metals complex looks bright. It is a sector we have been involved with for the past 8 years and will continue to be involved with going forward.
At the same time, there is a lot of "Johnny come lately" money in the sector and the complex seems to have the habit of initiating newcomers by absolutely annihilating them. I have no reason to think this time will be different.
Will Things Get Worse or Once in a Lifetime Opportunities?
So who is right? Those that say things will get worse or those that think we are seeing the opportunities of a lifetime?
Well it is both (although I believe most that think they are seeing the opportunities of a lifetime will be proven wrong). The reason things will get worse is because we have yet to see real credit and money destruction and liquidity will become a real issue. At the same time, as liquidity becomes an issue for almost everybody, we will see even greater dislocations in asset markets thereby creating huge opportunities for those that can provide liquidity. The key will be to balance your liquidity needs with the opportunities.
The challenge of striking the fine balance is compounded by the indebtedness levels of most Governments and the implications to their respective currencies, but again let's take it one step at a time.
From Rahul Saraogi
Stimulus
The credit crunch has created full fledged demand destruction around the world. While the first objective of governments around the world was to fix the credit markets and to fix the flow of money, the focus has rapidly shifted to stimulating demand and arresting its vicious collapse.
Keynes was a reluctant Keynesian, but governments around the world have become Keynesians with reckless abandon. Will the stimulus really work? The odds don't look very good.
There is a natural state of aggregate demand. While this demand can grow below potential for an extended period (thereby building slack in the economy), it can also grow above potential for an extended period, thereby borrowing demand from the future. The natural state of demand is an abstract concept and is dependent on hundreds of variables including, age of population, savings rates, propensity to consume, confidence and outlook for the future, ability to borrow etc.
Unemployment is only a symptom of the state of aggregate demand in the economy. It is by no means the sole indicator of slack in the economy. With savings rates in the US economy at 2% and confidence in the future low, the propensity to consume is rapidly declining among Americans. Chinese auto sales exceeded US auto sales on a monthly basis in January for the first time in history. This cannot be explained only on the basis of availability of finance and clearly indicates the differences in propensity to consume between the Americans and the Chinese. It is not clear therefore, whether the latest stimulus package by the Obama administration will do anything to make people consume more. The government might be able to take the horse to the water, but can it really make it drink.
What is true for the consumer holds true for businesses as well. If businesses are not optimistic about the growth of aggregate demand and are pessimistic about the outlook for profits, they will not invest in new capacity or infrastructure even with negative interest rates and handouts. In such a scenario, the government might have to step in and employ people directly and consume on behalf of them. It might also have to take the onus of infrastructure and capacity creation in its direct control. Whether the government even has the bandwidth and capability to execute the overwhelming number of projects that will be needed is untested and remains to be seen. As with all government interventions, the risk of misallocation of capital runs very high.
India on the other hand is on a very solid trajectory of growth in natural aggregate demand. A young, poor and aspiring population empowered by media, telecom and connectivity to the global economic system are a natural engine that cannot be suppressed (forget stimulus).
Gloom Deepens
The gloom everywhere on the planet is so thick that it can almost be touched. It is an almost a 180 degree turn from the collective euphoria the world had witnessed during the technology boom. Then it was believed that the Internet would solve all the problems of the planet and now it is believed that the US economy will run the whole world into the ground.
The reality as always is somewhere in between. It is entertaining to see forecasters write off 2009 and 2010 and to see them predict feeble growth for 2011. It might be interesting to go back and take a look at their 2007 forecasts for 2009 and 2010.
It might also be worth looking at forecasts for oil prices for 2009 and 2010 issued in July 2008 when oil was making new highs. Forecasts always say more about the forecaster than the future.
As investors, we have to make decisions based on facts: facts that are known today. As Warren Buffett says, "You are neither right nor wrong because the crowd agrees or disagrees with you, you are right because your facts are right and your reasoning is right."
Terms of Trade and Purchasing Power Parity
One of the biggest trends of the last 250 years was the continuous shift in terms of trade. This trend really accentuated in the last 100 years. The shift in terms was away from agriculture toward manufacturing and later away from manufacturing toward services.
As a result, developed economies like Britain could import more and more of the developing world's agricultural output in exchange for less and less of their own manufactured output.
The second half of the 20th century saw the shift of terms in favor of services away from manufacturing. This trend was driven by the growth of the US and its financial services industry. The dollarization of the world's financial system enabled the US and it's willing partner, the UK, to finance growth and consumption based on debt and deficits.
The underlying theme throughout this shift was the virtual monopoly over innovation and technology. During the entire period the wealthier countries invested significantly in research and innovation and were able to maintain their advantageous terms of trade. The Internet, telecom and air travel revolution changed all that. Technology and innovation is becoming democratized at an unimaginable pace. Already more than half of all scientists in the US are Indians and Chinese. The speed with which so called developing countries are moving up the innovation chain is mindboggling.
India through its space agency, ISRO, is commercially launching satellites at 25% of the cost of the Europeans. China has already started assembling the Airbus A320 passenger aircraft in China.
With technology no longer a monopoly and with a fracture in US hegemony over the global financial system, the reversal in terms of trade has started in earnest. Do keep in mind that this was a trend built over the last 250 years, it is unlikely that its symptoms and impact will be visible tomorrow. Even Britain took 60 years to decline into irrelevance after World War II. However, the trend and momentum have shifted.
Another concept that has been widely tracked is that of Purchasing Power Parity. The concept widely referenced using the Big Mac Index developed by the Economist newspaper of the UK states that the value of output in countries is misstated using nominal currencies since the price levels in different countries are different. Its direct inference is that currencies will strengthen or weaken over time to nominally reflect their purchasing power and to achieve nominal parity.
The anomaly has been that differences in purchasing power of currencies have remained intact for decades, raising cries of mercantilism and currency manipulation by exporting countries. However, this has changed completely. Competitive devaluation and currency manipulation will no longer help emerging economies. With a structural destruction of demand in developed countries (caused by the end of the credit superbubble), weaker currencies will no longer help emerging economies export more.
On the other hand a stronger currency will enable countries to attract global capital and to build their domestic infrastructure and markets. As the world moves to a multiple small engine economic system (as opposed to the single large US engine system), competitive revaluation and strength of capital markets and institutions will become more desirable for countries than competitive manufacturing export prices.
Labor Shortages in an Indian Textile Hub
As every economic watchdog on the planet lowers its forecast for economic growth in their respective countries and in the world, the specter of job losses and rising unemployment looms large. China declared a few weeks ago that more than 20 million out of its 130 million migrant workers might not have jobs to return to after the lunar new year holiday.
In this context I was baffled by what I saw in the south Indian textile city of Tirupur. This city of about a million people located an hour's drive from the south Indian airport of Coimbatore at its peak directly and indirectly exported about USD 3 billion worth of apparel products. This is significant given that India on the whole exports only about USD 9 billion worth of apparel.
Tirupur is suffering from acute shortage of labor. Tirupur is a hub for migrant labor from all around south India. The migrant labor comes from farms seeking employment in the labor intensive garment factories. The harvest festival of Pongal in the middle of January draws people back to their homes as they celebrate for a week with their families. This time, however, more than half the labor did not return. Factory managers I spoke with mentioned that they were running at 50% capacity because they were unable to find labor to operate the remaining sewing machines.
The buzz on the ground is that the harvest has been so plentiful and the prices being received are so good that working on the farm has become far more attractive than working in a monotonous garment factory. This is a trend that has been in place now for a few years but has become really accentuated this year.
This trend does not look likely to reverse anytime soon. The shift in terms of trade is underway. The world should be ready for higher prices of food and as a result, higher prices of manufactured goods.
The Conundrum of Dollar Strength
The angry protests from leaders around the world are that their economies are suffering more than the US as a consequence of sins committed in the US economy.
While on the surface the economic pain being experienced outside the US is more than the pain at home, the reasons for the pain are completely different. Since almost all capital in the world either originates or is managed out of the US or US financial institutions, a break down in the US financial system has broken down the flow of capital around the world.
A large number of countries around the world have been disproportionately impacted by the breakdown in the flow of credit and capital. The US on the other hand has been impacted by serious structural problems. Overextended and overindebtedconsumers and governments have put in motion a negative feedback cycle that will be very hard to break.
Out of the countries that have suffered due to the break down in capital markets, many have suffered economic breakdown that has taken a life of its own. The situation is likely to get worse for these countries. However, countries that have seen a deceleration in activity (for example India), due to a breakdown of capital flows are likely to resume their trajectories relatively quickly with the resumption of capital flows.
In the immediate term, the strength of the dollar is a consequence of the collapse of the US financial system. As injured and leveraged capital seeks to come home, a shortage of dollars is created that causes its value to appreciate.
The secondary consequence of the US financial meltdown will be the decline in US-centricism of global capital movements. As this happens and as the economic consequences to the US economy become apparent, a flight from dollars will resume. This flight will be structural in nature.
Is the world really prepared for zero interest rates? Capital like water seeks its own level. Where will all the newly created capital and stimulus flow? If there is any private sector participation left in decision making, then this capital and stimulus will find its way to those places where natural demand remains intact and where attractive returns can be earned.
There is a very high possibility that the actions of Ben Bernanke and Barack Obama might create an infrastructure building boom greater than the 1950s. The irony might be that the boom happens in India and emerging Asia instead of the US.
When It Rains It Pours
It appears that the Indian markets are moving from one piece of bad news to the next. First it was the collapse in credit that led to a crash in sales of commercial vehicles and durable goods (financed with credit). Then it was the terror attacks in Mumbai and now it is the fraud at Satyam. The final nail in the coffin (or so one is made to believe) will be a fractured outcome from India's general elections leading to a lameduckgovernment in May.
After a while, sentiment and bad news do not matter. When one can buy the stock of a company that is debt free, that has the equivalent of its market cap in cash and that is trading at 2 times earnings with a 7% tax free dividend yield, not much else matters.
What would matter is if the business of the company could deteriorate suddenly by any of the fears and worries possessing a gloomy investor base. The risk of such an outcome becomes significantly diminished when the earnings report of the Oct-Dec 2008 quarter demonstrates that the company made more money than before in the worst quarter for the world.
Valuations and Patience
Do valuations matter? When well run companies with honest and able managements trade at ridiculous valuations for extended periods of time, it is natural for one to cynically assume that there is no linkage between stock prices and underlying company valuations. But over time, the well run company will transmit that value to shareholders in the form of dividends, stock buybacks and performance.
When a crook is discovered in the marketplace, it is natural for one to assume that everyone in the marketplace is a crook. However, that is always far from the reality. It is for the investor to be diligent in separating the honest from the dishonest.
Patience? As investors, we invest capital to get back more in the future. We look to do this over a sufficient time horizon during which the investment has an opportunity to play out. How long is this time horizon? Isn't the long term just a collection of short terms? In the long run aren't we all dead?
As Ben Graham said, "In the short term the market is a voting machine and in the long term the market is a weighing machine."
The problem with patience is that we cannot put a time limit on it. Most of the time a two to three year investment horizon is sufficient for many investments to play out. However, many times this period gets extended due to exogenous factors or a series of exogenous factors.
As long as the underlying investment is headed in the right direction, it is prudent for an investor to exercise patience. The important thing to keep in mind is that, most of the time (for sound investments), as the time horizon gets extended the potential return from the investment multiplies.
It is very important for the investor to position himself such that he is not forced into selling an otherwise sound investment due to factors like leverage and cash requirements. Avoidance of time horizon mismatches is paramount.
e.
AI
