Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Tuesday, 29 January 2013

New Year Detox: Hopium Shots and Kool-Aid (Part-III - China)





The Myth of China's Infinitely Sustainable Growth

The third hopium induced hallucination which has made a comeback at the start of this year is China’s infinitely sustainable growth. Recent data have reinforced the market’s belief that China managed a successful soft landing and is now headed towards a muted (if it can be called that) growth of 7-8%. To put these expectations in perspective, when the US reached a GDP level comparable to China now (circa $7.3trn) in 1995, the average growth it could manage despite “irrational exuberance” in the next 6 years before the dotcom crash was around 4% with the maximum being 4.87% in 1999. While it is true that countries which develop later develop quicker because of technological advancements which enable them to leapfrog but expecting the pace of growth to double in less than two decades is a bit optimistic to say the least.

However, merely stating that growth rates look optimistic is not a sufficient argument. It needs to be backed up by data. This leads to the first problem in investigating this permanent-growth story: Establishing the credibility of data. Economic numbers from China are notoriously suspect. Conspiracy theorists assume perfect manipulation while an unsuspecting market assumes perfect accuracy. The truth as usual lies somewhere in the middle. An academic paper (Carsten H, China’s Economic Growth Statistics: Trustworthy in the Long Run, Less So in the Short Run, APARC Dispatches, Oct 2004) states that actual annual growth rates can lie anywhere within a 1.5-3% band of the announced official growth rate. However these deviations mostly cancel out in the long-run. A more recent study (featured in FT Alphaville here) has found that China’s growth rates seem to be rounded-up. Therefore to celebrate, as the markets did, on a number which beats expectations by a slender 0.1% requires a stiff drink of Kool-Aid.

Even if one considers the numbers to be accurate, the question of sustainability still remains to be answered. Although the lopsided and ultimately unsustainable nature of China’s growth is universally acknowledged but in an Orwellian twist this knowledge sits alongside the contradictory belief of China’s perpetual growth. The rationalising factor which makes such doublethink possible is the hope of a “rebalancing” where private consumption takes over from investment as the primary GDP driver. Unfortunately this hasn’t happened and nor is it likely to without a major mishap. The inequality of wealth and absence of a safety net leading to forced saving amongst the majority preclude any sudden boost to consumption. Moreover, directed development and symbiotic relationship between the government and wealthy elites have caused a gross misallocation of capital (popular stories about ghost towns are just one part).

This misallocation has been sustained by the increasing leverage in the system. Unsustainable companies and projects are being artificially kept alive by advancing them more and more credit. It is this misallocation and increasing leverage which have made high growth a necessity. Growth is required to validate asset prices otherwise the entire system of Ponzi finance crumbles down1. Since consumption cannot do the trick, massive and ever increasing doses of investment spending are required to achieve the desired growth targets. Investment spending has become a tiger which the Chinese elite dare not dismount.

History shows that whatever is economically unsustainable will eventually end. China is no different. The unsustainable Chinese credit boom and financial vulnerabilities of the system have been documented in an eloquently argued white paper published by GMO (Feeding the Dragon: Why China’s Credit SystemLooks Vulnerable). It is highly recommended to anyone trying to dispel the hopium haze.

China at some point is going to experience not just a hard landing but a crash landing. The strains may be showing but the trouble as ever is predicting when it is going to occur. Given the difficulty in discerning what is actually going on within the Chinese economy, one can only conjecture based on extraneous factors. An obvious one is global growth. A resumption in global growth pushes the day of denouement further into the future while a western relapse brings it forward very quickly (due to diminishing marginal returns to credit and investment and greater systemic leverage). A more subtle factor is confidence in Chinese authorities to keep the game in play. In this respect, capital outflows, kryptonite to any Ponzi scheme, may be the canary in the coalmine.
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Conclusion
 
The year has started with a bang with global stock markets making new highs, risky yields compressing further and safe havens being sold. A wall of money has cascaded down sweeping aside disappointing data and smothering returns. Every day the denouement is postponed is a day which gives credence to those arguing that the inevitable will never happen. It is a bit like concluding that since someone hasn’t had a cardiac arrest today and appears healthy, they never will have one despite their unhealthy diet. Or at least they won’t have one in the near future. Economics is a long game which requires the player to eschew Kool-Aid. The short-termist Mr Market with his predilection for hopium and Kool-Aid plays it very poorly indeed. This time he has risked everything on the central bankers throw of dice mistaking their fatal conceit for omnipotence.


1. Growth being a requirement for the Party to maintain power is a mistaken assumption since autocracies can easily exist without economic growth.

Saturday, 26 January 2013

Gold And Silver: A Wealth Hazard

My latest column in Mint Indulge seems to have touched a raw nerve with Goldbugs. Full article here. Excerpt below.

 
The fascination for gold and silver has transcended millennia and ruined many a rational investor. After falling out of fashion at the start of the 1980s, both gold and silver have staged a comeback with nominal prices near all time highs (graph 1).
photo
Perhaps, it is some primeval hoarding instinct that clouds our judgement as soon as we behold these shiny metals. The modern investor who considers himself above such atavistic impulses is only rationalizing his purchase of precious metals by proclaiming doom-laden end of world scenarios. The perilous state of the global economy and voodoo central banking has unnerved investors and made them seek out the comfort of traditional stores of value. In addition, gold and silver have enhanced their lustre in the eyes of investors by outperforming almost every other asset and returning an annualized 17% and 20%, respectively, since the start of 2003.
 
However, your chasing the herd, which itself is blindly chasing returns, may lead you by the shortest path to the poor house. Moreover, the investment case has become muddied as gold and silver prices have stalled with only a 4% increase last year. In conjunction, more contrarian voices are being heard, notably Warren Buffett’s, who called gold a sterile asset, compared with productive investments in companies.

Go to full article.

Thursday, 24 January 2013

Is the Hopium running out?

The day started with a great Chinese PMI number. Then the Eurozone manufacturing PMI beat expectations. True, the debt bomb which must not be named disappointed with its PMI reading but it was still 2-1 in favour of the bulls. Data from peripherals are not counted for the score as it would tilt the playing field too much in favour of the bears. Therefore unemployment in Spain (new record at 26.02%) and retail sales in Italy (down 0.4% month-on-month versus expectations of being down 0.1%) were discounted.

Then the afternoon saw US claims falling to a 5-year low, manufacturing PMI coming out higher than expected and leading indicators pleasantly surprising. Final score 5-1. So the following market performance is a bit strange to say the least:

China linked assets disappointed
Shanghai (SSE Composite): Down 0.79%
Hong Kong (Hang Seng): Down 0.15%
AUD/USD: Down 0.64%
Copper: Down 0.18%

US linked assets disappointed
S&P500: Flat
EUR/USD: Up 0.44% (dollar weaker)
Treasuries: Up

Not something one would expect unless the hopium has been metabolised by the system. However, no prognosis can be made based on one day's worth of data. In any case hopium is still coursing through where it matters: ye old continent.

FTSE100: Up 1.09%
EuroStoxx50: Up 0.54%
DAX: Up 0.53%
CAC40: Up 0.70%
EUR/USD: Up 0.44%

And the clincher: Madrid funds its entire year's budget in one day. No change in hopium levels here. Buy on.
 

Wednesday, 23 January 2013

India’s Slide Into Medievalism



The traditional feudal society behind the fa├žade of a modern liberal democracy has been revealed after the Delhi rape. It has also highlighted the increasingly bitter clash of civilisations within a civilisation. Although column inches, candles and slogans have been liberally expended over yet another tragic case, it is far from a turning point in India’s inexorable slide towards medievalism.

The deteriorating statistics on reported rape cases (Graph) (which themselves represent only about 10% of actual rapes[1]) is only one facet of India’s regression. Increasing corruption, institutional decay and wanton use of state power are all visible symptoms of this trend. Perhaps the greatest manifestation of it is the decline of democratic decision-making to the point where the Prime Minister is a mere figurehead and real power lies with those without responsibility. A point not lost on rape protestors who chose to demonstrate in front of Sonia Gandhi’s residence rather than the Prime Minister’s[2].

Graph: Total Rape Cases Reported Across India


Source: National Crime Records Bureau
 
To the outside world this regression is masked by the veil of modernity and liberalism which educated urban India is at pains to showcase. This narrow focus on urban India and an even narrower English speaking elite misses the reality of India. The truth is that modern liberalism which arose under British rule is now in decline as a traditional conservative belief system reasserts itself. When the chairwoman of Chhattisgarh State Women Commission stated that women are “equally responsible” for crimes against them[3] due to their revealing dress and behaviour it was not so much a gaffe or misquote as a statement of this belief system.

India today is caught in a clash between these two broad belief systems. On one side are modern liberal beliefs which balance individualism and liberty with civic duty and rule of law. They assume equality of rights and opportunities notwithstanding gender, class or caste. The urban elite cling on to these beliefs or at least pretend to even as the majority of the country reverts to the norm which prevailed before the spread of liberal ideas. This is the diametrically opposed feudal belief system which is based on clan loyalty. Here liberty is at the discretion of the master and duty to him supersedes all else. In such a society women are traditionally subservient and only those who have power have rights. The glib dismissal of corruption allegations against those in power and their families by sycophantic courtiers fits this worldview.

Examining why the slide has happened is contentious and no doubt sociologists will have myriad explanations. However, for any system of belief to perpetuate and become dominant three essential conditions need to be met. First, the system must have adherents who multiply and convert others leading to an ever increasing mass of followers until critical mass is attained. Second, there must be an indoctrination system which inculcates and strengthens professed beliefs. Third, it must both inspire and coerce to sway people to its beliefs and win over opponents. For example, European enlightenment started with philosophers and scientists propagating reason and scientific method. Universities and institutions such as the Royal Society of London contributed to the spread of rationalism. Rapid scientific advances and the industrial revolution together led to a sea change in the belief system.

In India liberal and rational ideals were imposed rather than being allowed to evolve as in Europe. The lofty aim of the British, as stated by Macaulay in 1833[4], was to educate Indians into a capacity for better government leading to self-rule by Indians instructed in European knowledge. However, operational necessities of the Raj and the unfortunate identification of these ideals with western thought and British imperialism meant that only a tiny elite had been converted to liberal ideals at the time of independence. This failure to attain critical mass was never going to be sustainable in a democracy. Representative government, expansion of education and opportunities meant that politicians, civil servants and industrialists who held the majority worldview would always seize the levers of power. Contrary to what one would expect, increase in level of education has not engendered liberalism and neither is it likely to. According to Michael Shermer in ‘The Believing Brain’[5], our deeply held beliefs are immune to attack by direct educational tools. They are affected more by the economic, politico-social and religious environment. It is in this context that the apparently cretinous remarks on rape by sundry politicians[6][7], bureaucrats and even spiritual leaders[8] can be understood.

As their star has dimmed, modern Indian liberals have increasingly disengaged. The lucky ones have either exited the country or cocooned themselves in a bubble of wealth while others go about their lives looking the other way. Perversely this disengagement weakens their cause further and condemns India to an irreversible slide into medievalism. In any case India was unlikely to be a liberal democracy in the guise of the West as implanted liberal ideals were too foreign and the environment too hostile. The only hope now is that the genius of India at assimilating different values into a chaotic and unique belief system ensures that at least some progressive ideals are adopted. Indeed the process is already underway. Enlightened demands for women’s rights have come to the fore amidst the medieval baying for summary justice through ‘fast-track’ courts, mandatory death penalty and chemical castration for rapists[9].

The widespread and spontaneous protests following the Delhi rape are heartening. It is an attempt to take back the republic from an atavistic establishment. The protestors have won the initial skirmish but an arduous battle lies ahead. This generation which is coming of age in a globalised and liberal world will decide whether India becomes a feudal state or a modern republic.
 
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Footnotes:
[1] http://indiatoday.intoday.in/story/The+iceberg+of+rape/1/46911.html
[5] Shermer M, The Believing Brain, Times Books Henry Holt and Company, New York, 1st ed. 2011

Friday, 18 January 2013

New York Detox: Hopium Shots and Kool-Aid (Part-II - USA)




 
US’s long term problem and the myth of Bernanke’s invincibility
 
After the depressing picture in Europe at least there is a glimmer of hope when one looks at the US economy even though politicians and policymakers are doing their utmost to dispel it. Thanks to its flexibility and resilience, the US economy is on the mend. However there are two main problems facing the US. The first is the political impasse about which reams have already been written. A quasi-civil war based on uncompromising policy positions dictated by vested interests and senseless ideological purity is never good. Add a moribund economy and a desperate, reckless gamble by monetary authorities and the die is cast for long-term decline.

The second problem is one of overconfidence in the inherent strength of the economy. Although more flexible and resilient compared to Europe the US economy’s arteries have been hardening of late. Over time as industries consolidate and oligopolies emerge, free movement of capital and labour, an economy’s blood supply, is impeded. Companies use their clout to defend their position and eliminate competition. Creative destruction, so necessary for capitalism, is minimised. Graph-6 shows the increasing domination of established businesses over newer ones.

Graph-6: No country for young businessmen





Source: Source: Haltiwanger. J, Jarmin. R, Miranda. J; Where have all the young firms gone?

More evidence of this unhealthy shift in the structure of the economy comes from two issues garnering attention currently. The first is the much talked about increasing cash piles of big business. Capital lies idle with firms interested in maintaining current margins while entrepreneurs with new ideas are throttled. Firm start-up rate is at a 30-year low as Graph-7 makes clear. Even if somehow threatening new firms emerge then the incumbents remove them through buyouts.

Graph-7: Capitalist arteriosclerosis




Source: Haltiwanger. J, Jarmin. R, Miranda. J; Where have all the young firms gone?

The second is the issue of a patent system run amuck (rounded corners are a technological innovation apparently). It raises barriers to entry and helps sustain oligopolistic domination. In addition it retards real innovation as firms focus on patenting for competitive advantage rather than genuine research.

As economic arteries clog up, it takes longer to recover from each successive shock. The current recovery is symptomatic of this. True, recovery is slow after a housing bust but the present weak recovery has to be seen in context of an unusually supportive monetary policy. Even fiscal policy, despite all the talk of austerity, has not been contractionary as it has in Europe. Therefore the US economy’s long-term prognosis is not optimistic unless the doctors stop quibbling amongst themselves on pointless matters such as the debt ceiling.

However, this is all too long-term and boring for myopic Mr. Market. As long as the good doctor Bernanke keeps pumping the patient full of hopium and steroids it’s all good. It is ironic that disgraced doctor Greenspan prescribed similar easy money policies which are now blamed for the patient’s cardiac arrest in 2007.

Mr. Market’s love of Bernanke is easy to understand if one looks at the two graphs below (Graph-8 & 9).

Graph-8: The Bernanke put

 
Source: Federal Reserve, Yahoo Finance

Graph-9: Cry ‘QE’ and let loose the yield hunters
Source: Federal Reserve, FRED database

Unfortunately the good doctor is not achieving the same effect on the signs which really matter. Unemployment is still high with the apparent decline in the rate being mainly due to a sharp drop in participation rate. This is unique amongst post-war recoveries (Graph-10). Adjusted for participation rate, unemployment hasn’t budged much and the ratio of part-time to full-time workers (a measure of underemployment) is still elevated. Moreover, per capita personal disposable income (PDI) has only recovered marginally and is well below its peak (Graph-11).

Graph-10: "Jobless" recovery?

Source: US Bureau of Labor Statistics

Graph-11: Fed's impotence
Source: US Bureau of Labor Statistics


Even though the medicine has failed, the good doctor argues that more of it is required (I wrote on this earlier: Why more QE isn’t going to help). One of the arguments made by QE proponents is the recovery in consumer spending (Personal Consumption Expenditures (PCE)) showing that the economy is slowly limping back on track. It would be great were it true. As Graph-12 shows, the increase in PCE is largely because of the increase in the absolute number of employed people which has increased total disposable income. Recovery in per capita disposable income is more muted and has been accompanied by a decline in the savings rate (Graph-13).

Graph-12: Greater number of employed will obviously earn and spend more







Source: US Bureau of Economic Analysis, Author's calculations 

Graph-13: No raise, can’t save but hope the Fed makes us all rich





Source: US Bureau of Economic Analysis

Therefore the real economy seems to be ‘fighting’ the Fed even if the markets won’t. It is courageous of Mr. Market to blindly trust the Fed as it embarks on a grand experiment in monetary policy whose results even it does not know. In addition, the various markets are sending contradictory signals. Equity market expects recovery and strong profit margins. The corporate bond market has imbibed more hopium and not only expects recovery but expects it to be associated with low interest rates. The Treasury market on the other hand is signalling the onset of Japanese disease but without factoring in ‘Helicopter’ Ben.

It’s all very confusing. However equity markets are better placed to handle the eventual outcome than bond markets. If recovery strengthens and sustains then profit margins should stay robust validating the P/E multiple expansion taking place currently. On the other hand if the experiment spirals out of control then equities afford at least some protection from inflation. Ever optimistic, equity holders are not factoring in a margin compression in a demand-destructive double-dip recession. The probability for this is reasonably high given the muted recovery and the current political shenanigans.

If equity market is optimistic then the bond market has drunk industrial quantities of Kool-Aid. A recovery will be negative as rates will rise. An inflationary environment will be negative as bonds lose value even if the Fed stubbornly sticks to an easy monetary policy. Finally a double-dip with consequent corporate distress will give a fresh perspective to current buyers of high-yield at sub-6%. The last case might be expected to favour Treasuries but in such an event the Fed will throw everything and the kitchen printer in desperation. Treasury holders will suffer the consequent loss of confidence in the USA and US Dollar.

The music at Ben’s party is too catchy not to dance but when the morning comes bondholders will wish they hadn’t drunk so much Kool-Aid.


Part-III to follow in due course.

Wednesday, 16 January 2013

New Year Detox: Hopium Shots and Kool-Aid (Part-I - EU)


Sticking to market tradition, investors took a shot of hopium and a swig of Kool-Aid and came back in the new year to chase return-free risks. The consensus seems to be that the EU is on the mend; US political brinkmanship is an opportunity to buy the dips; China’s managed a soft landing and its growth, albeit slower, has reached a permanently high plateau; Japan has imbibed Bernanke’s ‘can do’ spirit and is printing its way to growth; and all’s right with the rest of the world. Of course on sober reflection almost everyone will admit to risks but they are apparently deep in the future and as long as central bankers keep DJing, they’ll keep dancing.

Unfortunately having seen chronic hopium addicts buying Greek bonds at 9% yield and holding on until PSI, I know the damage that hopium can wreak. Therefore before experimenting consider the facts:

The myth of EU progress

Apparently the politicians have finally “got it” (as they have from time to time over the last 3 years). In addition Draghi’s bazooka brigade has cowed the opposition without firing a single shot. Which is just as well since the ammo is of dubious quality (remember SMP?) and there are serious doubts of the brigade ever opening fire in the face of German opposition.

The reality is that economic fundamentals continue to deteriorate. As Graph-1 shows, industrial production is declining across the board.

Graph 1: Recovery is here; only if seen in a mirror







Source: Eurostat, Author’s calculations

A wider picture (Graph-2) shows that the index of industrial production is now below levels seen at the end of 2003.

Graph 2: Rip van Winkle would not notice any difference








Source: Eurostat

Now even the German engine is spluttering as GDP fell last quarter. But there is no need to worry as analysts have sagely proclaimed that “The downturn should be short-lived. Key export markets such as US and China are starting to pick up, while improved sentiment surrounding Europe’s three-year-old debt crisis is expected to spur a recovery in the euro zone this year.” One only hopes that these purveyors of Kool Aid are right because a slowing economy is going to further erode support for bailouts.

Falling production and growth is reflected in European employment figures. Unemployment is the highest since 2001 (Graph-3) and not showing any realistic signs of improvement. Despite the Irish success story, unemployment there remains stubbornly near 15% (although it seems to be inching downwards).

Graph 3: If they can’t have jobs, let us have summits







Source: Eurostat

The sorry employment picture is mirrored in falling retail sales (Graph 4). Lower spending feeds back into production cuts and further job losses which again lead to lower spending. The depressionary spiral has already started.

Graph 4: People without jobs can’t buy “stuff”







Source: Eurostat

The hope is that politicians can break this vicious cycle through acting decisively. After all at the last summit they decided to be decisive and resolved to be resolute to keep the union together. The result was a watered down bank supervision framework with tough decisions on common resolution framework and deposit guarantees left for later. And about that bold initiative to break the sovereign-bank feedback loop: there has been a change of plans. To be fair, the Germans, Dutch and Finns had emphasised way back in September that ESM funds will only be available after private sector bail-ins and would have to be guaranteed by the sovereign. However, it hasn’t percolated through the hopium daze as investors “rediscover” Eurozone bank bonds. The quote from one high-yield portfolio manager encapsulates the daze perfectly “The world has changed in the last six months. It’s less risky.”

It is not as if nothing has changed for the better. Italy’s step towards an elected government is a step forward for democracy. Unfortunately the market’s beloved unelected technocrat isn’t polling too well as his centrist coalition is stuck in third place with 14.5% of the vote. The centre-left looks set to gain the highest number of seats with 37.8% of the vote. Tough reforms seem unlikely in such a scenario. Moreover if a majority eludes them, which is likely, fractious and unstable coalitions are going to make a reappearance.

The other set of elections which are potentially problematic are the German national elections. They are going to put a dampener on Merkel’s willingness to compromise and act. Remember the North Rhine Westphalia elections in 2010 which delayed the initial response to the Greek crisis? The opposition SPD may be more sympathetic to the European ideal but no party is campaigning to give carte blanche to Club Med. The Germans want Europe but they want it on their terms. Unfortunately those terms are difficult to stick to and create resentment in southern Europe.

So at the end of the third year of the European crisis there has not been an end in either economic or political trends. The only straw which can be grasped to support the thesis that something has changed for the better is Draghi’s bluff to quasi-monetise (OMT still requires sterilisation like SMP). This is not a solution but only an attempt to gain time for reforms to start working and growth to resume. Draghi has succeeded in this aim but unfortunately reforms have been half-hearted and with the pressure off the sense of urgency has also been lost again (eg. Spain). Meanwhile growth is still elusive and facing the twin headwinds of monetary and fiscal policy. For the former credit availability is more important than ECB policy rates which are largely irrelevant because risk premia and credit rationing outweigh them. And the picture on credit is not optimistic as Graph-5 shows. Although the level of interest rates have largely decreased, banks have imposed other costs to make up for falling net interest margins. They have also reduced loan sizes and increased collateral requirements.  

Graph 5: A banker loans only to those who don’t need it






Note: Net percentage = Percent firms reporting increase – percent reporting decrease
Source: ECB’s Survey on access to finance of SMEs in the Euro area (Apr-Sep12)

Add an austere fiscal policy and a structural framework which inhibits bankruptcy (leading to corporate zombification) and one has a perfect recipe for disaster. No wonder that the chefs are liberally doling out Kool Aid as aperitif to numb the pain of the main course.


Part-II to follow in due course

Friday, 4 January 2013

The "Foreign Hand" in Indian Equities


My month long sojourn in India led to lots of observations, ideas and experiences which I shall write about in due course. Although it was rewarding from both a professional and personal standpoint, overall it led to a tempering of the optimism I felt for the country’s prospects. There has been a palpable ebbing of ebullience over the past year since my last visit. However, not so much for foreign institutional buyers of Indian equities as the graph below shows (something which I have touched upon earlier as well).






Source: SEBI, www.moneycontrol.com

So why are foreigners rushing where locals fear to tread? The first explanation is that of investors blindly running away from zero yields and low returns in the western world. But BRIC mutual funds have posted outflows of $1.65bn according to Bloomberg. Some of flows have gone into ETFs but those have been mainly directed at Brazil and China not India. This implies that the FII inflow into India is due to focused ('smart') investors rather than retail ('dumb') investors. However, this makes the inflow all the more puzzling since the India story is in tatters as GDP growth has collapsed to 5.3% and the current account deficit reaches new highs. This growth rate will be unable to absorb the expected 63.5 million people which are expected to enter the workforce over 2011-16. A fractured, out-of-touch and increasingly corrupt polity has ensured an environment of policy stasis (for the FDI in retail drum beaters see this). Unemployed youth and a moribund economy serving the elite is a toxic combination. Therefore either the 'smart' investors are showing the same combination of greed and hubris that they have demonstrated over and over again through various Latin American crises, East Asian crisis, Russian default, etc. or there is another  more conspiratorial explanation.

The second explanation is that FII inflows are nothing but undeclared Indian wealth being poured back through various tax havens. The problem with this is that the biggest recipient of undeclared wealth is real estate and land in India. Equity is not favoured since value creation for the shareholder takes a backseat to political meddling or owner-manager ambitions as most listed companies are either government owned or run like fiefs by individuals/families who started them. Therefore for this to be true, the owners themselves have to be clandestinely acquiring shares in their companies through the FII route. This again seems improbable because there is no need for them to increase exposure to their own enterprises.

On balance of probability, FII inflows are likely to be foreigners trying to make a fast buck without appreciating the reality facing India. Over the last seven years FIIs have invested close to 4 trillion rupees into the Indian stock market (Graph below). 






Source: SEBI, www.moneycontrol.com

At current exchange rates it is equivalent to roughly 7% of total market capitalisation and 16% free float capitalisation (assuming a trillion dollar market cap at USD/INR rate of 55 and ratio of free float to total is the same as that for BSE-500, i.e. 45%). By investing on such a scale FIIs have created their own momentum which has also validated their investment thesis begetting a virtuous cycle. Usually the trouble with this sort of investing is that everyone believes that they can be first in and first out but very few manage that feat. The eventual denouement will be messy unless a political miracle happens to ensure that reality matches expectations.

Wednesday, 2 January 2013

Thoughts to start the New Year

A happy start to the new year for all risky asset owners. The world looks a better place but that may just be the aftereffects of my month long vacation. However, 2012 was the year of dogded bullets. China's PMIs started improving just as bears were starting to smell blood, Greece got more money to burn but more importantly the Eurozone not only made it in one piece but the outlook seems as sunny as the Mediterranean. Even the US fiscal cliff was "resolved" albeit a day after 2012.

So what will 2013 bring? Without writing several hundred pages on some 'Outlook for <insert asset class> in 2013', the most accurate prediction I can make is that the market may go up or down in a small or a big way. 

Broadly there are two forces battling for supremacy. The first is economic with slumping growth and steady long-term impairment of productive potential in the west. Against it is the political will to get re-elected and preserve grandiose visions at all costs. The central bank bazooka brigade ensured that the latter had the upper hand in 2012. Whether it can continue and for how long are questions whose answers separate impoverished blog writers from titans of finance. 

There are only two things worth noting. The first is that economic forces do not act on a calendar year basis, only investors do. Macroeconomic trends and variables are not reset like P&L and return targets. Therefore investment theses should not flip purely based on the date and the expected price action due to the change in date. (A very wise and experienced trader once told me that the new year usually brings a hopium rush).

The second is that economies have an inbuilt tendency to recover. The progress of human civilisation is a testament to it. Therefore for most part short sellers are fighting against this natural trend. In addition, policies usually retard or accelerate this trend only in a small way as long as they remain within a certain bound. However, current policies are pushing the boundaries significantly and their effects are going to be large and unknown. In terms of physics, economic systems have a certain resilience to outside forces but beyond a point internal stresses increase exponentially leading to catastrophic failure. Therefore chasing returns under the assumption of linearity when we are probably already in the non-linear zone is going to prove costly.