Monday, 27 August 2007

Weather and Equities: A connection?

After venting my thoughts on the state of India, the country, I return to the world of equities – and sanity - with this post.

Seasons come and go, years go by…but to suggest some connection between the weather and the equity market would sound somewhat ludicrous, won’t it? I had this strange hypothesis of Summer being the worst ‘season’ to trade Indian equities, and Winter the best. Did the actual numbers support this theory? Apart from the intellectual exercise, I wanted to see if a trading strategy could be built around the Indian seasons. Here’s the outcome of my curiosity...

In this post, I take a look at the performance of the BSE Sensex since its birth. A ‘filter’ here is that I have split up the months of the calendar year based on the ‘Indian Seasons’. So, I have June to September representing the Monsoon season, October to January representing Winter, and February to May representing Summer.

Summer Effect

There are some sound reasons for Summer being the worst season to trade equities. First, there is the much awaited yearly budget, which brings with it an air of uncertainty and volatility, both before and after the announcement. In the world of equities – and indeed investing – uncertainty implies that market players are reluctant to commit to one particular view on the market. Result…money is taken out of equities and people play a wait-n-watch game. End result: Gains are muted, or, in some cases, markets exhibit negative return tendencies.

Second, the Indian market generally follows the April-March financial year. Money managers whose bonuses are hinged on their portfolio values as at financial year end are most wary about a sudden downturn. Why should I let go of my hard-earned bonus to a suddenly fickle market? Result…they book profits and take money out of the market. End result: Again…gains are muted, or…well...

Third – and this is my hypothesis – summers are psychologically the worst for human beings. The heat tends to make people highly susceptible to the slightest of provocations. A couple of avoidable incidents on the way to office…and the mind is inclined to succumb to impulse decisions. Psychologically, human beings are wired to lose their heads when the requirement is just the opposite. So, one bad decision generally precipitates to another...
“A bad head…is often a sad head…” – Yours truly.

A combination of the above (and some more that I haven’t mentioned for want of space) made me believe that summers ought to be the worst season to trade Indian equities. (Was I correct? Wait a while…)
Conclusion: Go away in Summer.
After the unwanted uncertainty in summer, the monsoon brings with it an inflow of new investments. Now that there is ‘certainty’ regarding market direction, market players find it comfortable to initiate or scale up their exposures in equities. End result: Markets rise.

Another not-so-subtle reason for the rise in the markets in monsoon can be traced to brokerage houses. The beginning of the new financial year sees brokerage houses publishing their expected EPS figure for the market index over the next couple of years. The expected EPS culminates in next year-end targets for the indices (which invariably is higher than prevailing levels). End result: Money flows in…and markets rise.
Conclusion: Good season to go Long in Indian Equities.
Cool Winter Probably the most significant development in the investing world over the past decade has been the mobility of capital. Money managers now have the entire globe as a playing field. The rise of the emerging markets –particularly India – has been a key driver of Indian equity markets. The high return is just too juicy for money managers to act blind and stay in the sidelines.

Global money managers generally follow the January-December year. With their variable pay linked to year end portfolio values, there is every incentive to inflate the values towards year end. What better way than to invest in emerging market equities? Portfolio rejigging happens at the beginning of the year and fresh allocations for emerging markets are set. Given the attractiveness of India as an investing destination, shouldn’t the Indian Winter be a good one for going or staying Long on India?
Conclusion: The best season to go, and stay, Long in Indian equities.
The Result Here’s the table...
Looking at the long-run numbers (1979-2007), clearly Monsoon is the best season and Winter is the worst (albeit marginally) in terms of average return.

But the more recent – and probably more relevant – 2000-2007 period tells an interesting story. The Winter season emerges as the best with the highest average return. And the higher return has come at a significantly lower standard deviation, indicating the strength of this season from a trading perspective. The Summer season – as expected – has delivered an average negative return over the period. The Monsoon has delivered a reasonable return, albeit at a very high standard deviation.

I have also added the number of Up Moves (defined as >0% return) and Down Moves (defined as <0%>The Winter season has witnessed greater number of Up Moves (19) and lower number of Down Moves (9) compared to the other two seasons. Most significantly, the Winter season has not had a down season since 1997-98. The other seasons, sadly, cannot boast of this!

The above exercise – apart from massaging my ego – could form the basis of a trading strategy. Of course, there is no certainty of the trend continuing in the coming years, but (sorry to reiterate), markets have memories. Longer the time period, stronger is the memory (and inertia). Things continue the same way until some external force breaks the pattern! The trade is simple: Enter in Monsoon, increase ones position in Winter…and exit in Summer.
It would be naïve to discount fundamental factors at play in the markets. But this strategy, as with any technical trading strategy, will work only if the user sticks to the rules of the game. If the premise on which a trade was entered changes, its best to change ones opinion!

Friday, 17 August 2007

One Small Voice

Continuing in the spirit of Haphazard Linkages, I look at the consequences that a false sense of ‘progress’ has on an economy. Things may look ‘good’, but is it a true and justified reflection of the resources at a country’s disposal? Can things be made better? An economist aims for efficiency. A state where one individual cannot be made better off, without making another worse off in some way.

On the 60th anniversary of India’s independence, patriotism and a sense of well-being abounds everywhere. People are mostly unanimous in their verdict that India had arrived and bask in glory…The Times of India headline, “60 and getting Sexier” couldn’t have captured it better. Every news channel and celebrity waxed eloquent about how much progress India had made during this time. Waxed eloquent about India’s stupendous GDP growth…about India Shining.

Did this appraisal reflect reality? Or was it just another day where patriotism oozed out of wherever anybody cared to look? As much as I want to believe the stuff expounded by the channels and newspapers, I am forced to objectively evaluate the opposite.

What follows reflects my personal opinion about the way I perceive India today. I will keep patriotism out and write from an economist’s point of view. From where I stand, I am forced to conclude that we as a nation need to drastically change the way we see reality. Or run the risk of being obliterated in the long run by smarter economies.

Firstly, there are lots of things that are right about this country. Standard of living has moved up, demographics are excellent; the Indian middle class has arrived and is shaping the way entrepreneurs do business. Of course India has progressed. But am I happy with the speed of progress? There seems a void. A void of incompetence and lax attitudes that seriously threatens our future if left untouched.

I begin by looking at our attitude towards education.

Education = Equality right?
Reservations are an old story now. Everybody knows the perils of it but it just keeps going on and on. So I won’t write about it. The thing I am worried about most is the prevalence of what I will call ‘Equality’ in education.

‘Equality’ which was supposed to imply equal opportunity to education, now seems to have taken a slightly different meaning. The word now implies ‘equalizing’ individuals so that there are no ‘outliers’. Here’s a true story. (I won’t take names).

A smart guy decimates his competition in class (Class of 50). He is the only one who manages to pass through a series of tough assignments and rightly expects his reward. What awaits him at the end of the tunnel? ‘Equality’!

The powers that be decide that it’s not a great idea to show-off to prospective recruiters that only one guy in the whole class had passed! So they decide to normalize the marks awarded to the class, resulting in 98% of the class ‘passing’ the assignment. Some find themselves happily vaulted to the Top-5 from nowhere. Not surprisingly, the smart guy is very upset. In a whiff of a wand, the institute takes away his USP…Superlative performance in a difficult situation.

The institute did what it thought was in the best interests of the students…and itself. Leaving morals out (evidently this is a case of unethical and immoral behavior), the economic consequences of this apparently harmless act are profound.

The ‘passers’ (pardon that term) find plush jobs with salaries that are disproportionate to their competence (the same is true for the smart guy). They start off and for quite some time their incompetence doesn’t show up. Once these sheep are left to tread on their own, disaster strikes.

Small errors get magnified into big ones very quickly, and most of these get laid off. In an expanding economy, most manage to find alternative jobs and so the disease stays hidden for some more time. When the economy turns for the worse…well, a quote borrowed from Warren Buffet is appropriate here…

‘Its only when the tide goes out, that we know who is swimming naked!’

Unemployment rises…the ‘incompetents’ start cribbing about what a raw deal they got from the business world…they find it easier to curse capitalism than to own up to their short comings…And if nothing changes, they go and beg to the government for a solution; which in most cases, obliges happily.

Where does this lead the country? A growing bunch of incompetent working class is the last thing that a growing economy needs. The costs of nurturing them in a growing economy are high, because in most cases their salaries are disproportionate to their skill level. The costs are also high when the economy turns for the worse, because the same level of wealth now needs to be divided over a larger proportion of unemployed people, who aren’t contributing to the GDP.

Result? The country stays a ‘developing’ one for longer than anybody desires. But nobody seems to bother…India shining?

What happened to the smart guy? Well…the guy, smart as he is, decides to leave the country. And makes a living elsewhere. I hear farcical pleas of Brain Drain somewhere.

The above example to me is a classic example of inefficient allocation of resources. The act of ‘equalizing’ led to the country losing out on one smart fellow to make room for 49 others. Admittedly, one guy cannot contribute as much as 49 others. But over a long period, the contribution made by a group of smart fellows far outweighs the ‘contribution’ made by a collection of 49s (if we can indeed call it a contribution). Contribution to the GDP and taxes (the smart guy’s income goes up, his taxes go up, assuming he pays taxes!). The 49s languish, and since they are out of sync with reality, most won’t be able to earn much…and by extension, their contribution to the country for once mirrors their skill level. And they become liabilities.

I am a firm believer in meritocracy. The not so competent guys need to make way for the better ones. There is every incentive for the former to get better in a world where meritocracy is awarded transparently. The disbursal may take an inefficient path, but it shows up in the end.

Bad Infrastructure = Political whim = Gargantuan loss of productivity = Encouraging mediocrity = Demand for subsidies = India shining?
Every day, I waste 15 minutes in traversing a 100 meter stretch of road due to traffic. I have a few 200 people for company. 200 men wasting 15 man-minutes equates to 3000 man-minutes of lost time. That’s 50 man-hours lost only in the morning. Add another 50 for the evening journey back home, and we are already staring at a loss of 100 man-hours every day. That is a conservative estimate. Extrapolate it to the whole country and what we see isn’t India shining. Talk about productivity?

A politico’s convoy zooms down the road, and traffic on both sides of the road is held up for ages. Most of the people on the roads aren’t aware that they will be held up for quite sometime and leave their engines running. Wastage of fuel? The convoy zooms down after ages, farting soot on the faces of the traffic cops.

Ask anybody who follows the Indian economy and he says that infrastructure is one area that demands attention. But is the attention there? Innumerable delays result in wasteful cost over runs and it’s the poor tax payer who foots the bill. The incentive system encourages the powers-that-be to keep delaying the projects. “What if some one else takes credit for this after my term?” Thinks the politico, whose time horizon is often not more than 5 ‘long’ years. “What will happen to my annuity?” Thinks the road company that is awarded the contract.

In a system, where the emphasis isn’t on accountability, there is every incentive to keep things inefficient. The powers-that-be find it easier to handle queries by irate masses rather than watch the ‘credit’ being snatched away from them.

China’s labor productivity has grown at twice India’s rate over the past decade and a half. While it’s simplistic to attribute the above as the only cause for this, the beauty of layered connections ensures that the above is one of the primary reasons behind this. Consequence?

Businesses demand more ‘sops’ and ‘subsidies’. The appreciation of the Indian Rupee causes a lot of pain to exporters, who line up with the government with pleas for more sops and subsidies to alleviate the ‘pain’. While I can understand small businesses asking for subsidies, I cannot digest thriving large IT/ITES companies demanding the same. Companies that enjoy consistent 30% net margins and loads of cash asking for subsidies, is tantamount to Bill Gates begging for a living.

Germany’s exports grew about 10% despite a strong appreciation of the Euro. How was this possible? Weren’t we taught that an appreciating local currency is supposed to hurt exports? Is Germany an ‘outlier’ that demands ‘equalizing’?

The answer lies in the huge difference in the competitiveness of the products exported by Germany and those exported by India. Instead of thinking up ways to enhance productivity and competitiveness, most find it easier to demand sops. Sops are like drugs; they ease the pain and provide temporary relief, but cannot cure the disease. Curing the disease demands the patient to bear short term pain for long term gain…but…

The other grouse that I have against the sops system is that it encourages mediocrity. When businesses know there is an easy (and profitable) way out of a problem, there isn’t a strong incentive to make things better.

Sports = Reflected Glory?
A country of 1 billion people struggles to produce a world class cricket team. We are nowhere in Soccer and Tennis. Cricket and Hockey is a classic case of reflected glory of the golden years gone by long ago. A few sporadic wins, like Halley’s Comet, engages media attention; which resurfaces after the next sporadic win.

While superiority in these can hardly qualify as a reason for a country shining, the attitude is what is paramount here. The way the players approach a game speaks a lot about their attitude. Can we see a hunger to win? More importantly, is there an incentive to pursue a game as a profession? Is there meritocracy?

But India continues to shine…

India Shining?
Every country has its short comings, but the moot point is, “Are we doing justice to the resources that are at our disposal today to the desired level?” I am tired of this attitude of being satisfied with mediocrity and reflected glory. L N Mittal acquires Arcelor to become a steel czar and India falls over to salute him. I am a huge admirer of Mittal’s business sense, but get furious at the media’s immediate act of basking in reflected glory of how an Indian is now at the forefront of the global steel industry. The media and the politicos who hail him to the heavens need to introspect and ask questions like, “Why did he leave the country? What made him successful in another country? Is there anything that we can change for the better to help grow over achievers? Are we creating an environment where entrepreneurs can build businesses profitably? Are we creating a meritocracy where each individual knows that if he gets better, the rewards are there for the taking? And if he chooses to sit on his backside and do nothing, he will be blown away?”

Mittal’s competence didn’t change dramatically when he left the country. But the external factors probably did…for the better. And maybe therein lies the answer. A Reliance and Infosys in a country of 1 billion cannot be forever used as shining examples of successful businesses.

As an Indian I wish I was happy at the progress that the country has seen over the years. But the realist in me poses difficult questions. Of course, nothing is perfect in other countries too. Some even contend that the Yuva needs to take to politics to change the country. I differ. I believe that each man should identify his strongest competence and work upwards from there on. As a tax payer, my focus on getting better at my craft makes its way to the country’s coffers by way of ever increasing taxes. What the country does with this money is now a prerogative of the politicos. Adam Smith’s concepts of Self Interest and the Invisible Hand will ensure that the country sees tangible progress over the long term. We have a choice of being happy with the way things are at the moment, or raise the bar and make things better.

Maybe then, I will have a lot of conviction in saying that India, is truly ‘Shining’.

Wednesday, 8 August 2007

Update - Lessons from Credit Spreads

History...once again triumphed...The gloomy story painted by the behavior of Credit Spreads played out in the equity markets (again). The S&P 500 finally fell by over 7% from its high in response to the developments in the credit markets. Expectations of ever higher premiums in takeovers finally receded into the background.

The markets seem to be rational again...Or, is this just the proverbial tip of the iceberg? Another hedge fund, Sowood Capital, succumbed to the sub-prime disease. It seems there will be more casualties along the way. Evidently, private equity buy-out firms - for whom credit is equivalent to blood - are finding the going tough. But few seem to be openly accepting it.

In more ways than one, the tightening of credit is good for the markets, in terms of adjusting investor perception towards risk. This article from this week's Economist makes for good reading.

I am going to be watching the happenings in the credit markets with rapt attention in the coming days...

Wednesday, 1 August 2007

Lessons from Credit Spreads

An army of market watchers around the world spend a lot of time predicting market direction. Some follow the fundamental approach and base their views on things like earnings growth of corporates, P/E multiples etc; while some follow the technical approach. The latter express a view on market dirrection by reading charts. They talk support, resistances, head & shoulders, negative and positive divergences etc. While neither of the methods are per se ‘wrong’, it would be rather intuitive to learn about movements in one asset class by looking closely at what happens in another asset class. Credit Spreads is one such ‘indicator’.
Investors in ‘Junk’ bonds - bonds issued by companies that are teetering on the brink of disaster are classified as ‘junk’ - need to be compensated adequately for assuming higher risk by investing in the junk bond as compared to investing in a government backed Treasury Bond. So they demand a higher yield for investing in these bonds. The difference between the yield on a ‘Junk’ bond and a Treasury Bond can be termed as a ‘Credit Spread’.
Credit Spreads and Equities High spreads indicate that risk-appetite among investors is very low. Low spreads indicate the opposite. When investor appetite for risk is low, they tend to invest most of their money in ‘low risk’ bonds. Less money flows into equities and hence, equity markets tend to stay depressed. When risk appetite increases, investors shift money out of debt and direct them towards higher risk asset classes like equities. Result? Equities start rallying. As a consequence, changes in conditions that lead to changes in investor risk appetite…lead to gyrations in equity markets!
Lessons from History In 2003, something led to a contraction in Credit Spreads…and a rally in equities! (Chart helps! Data from Oct-03 to Jul-07)
Low interest rates led to a boom in lending. Corporates re-leveraged their balance sheets enhancing returns for equity holders. Something else also occurred during this period that led to a surge in lending. Private Equity. The LBO (Leveraged Buy-Outs) wave reared its head once again with returns that caught the attention of even conservative investors like pension funds. Demand picked up so much that lenders found it extremely lucrative to lend to the ‘sub-prime’ segment. For a while, returns from these investments far outweighed the inherent risks, as a sub-prime market collapse seemed unlikely. Attracted by the huge returns that these funds were generating, more money started moving out of low risk asset classes…

...Leading to a contraction in Credit Spreads (refer chart). The equity market reacted after a while and the rally began…taking the S&P 500 from 800 to over 1500 levels in the next four years.
The needle that burst the bubble eventually came in the form of higher interest rates and housing market slowdown. The string of interest rate hikes instituted by the Fed, gradually resulted in rising defaults on home mortgages. Rising defaults led to slowing household sales…leading to drop in house prices…leading to more defaults as people found the prices of their properties dropping and buyers hard to come by!

The sub-prime market blew up as a consequence of the housing market slowdown. As the risk of defaults increased, the effect was seen in the credit spreads…which started widening sharply since Jun-2007 (refer chart). Investors, burned by the meltdown, moved into low risk asset classes. Where was the equity market correction?

Current Scenario?
Credit spreads have widened sharply over the past few months after bottoming out at historic lows, but the equity markets, as usual, haven’t begun their reaction. I think the lure of higher premiums for equity by private equity firms is supporting the current rally in equities. On most occasions, equity markets have lagged the developments in Credit Spreads and this time seems no different. If history repeats itself (again!), it wouldn’t surprise me if the equity markets corrected in the short-to-medium term.
As usual, time is one’s best friend…or worst enemy!