Sunday, 8 August 2010

A Bonded future?

Quick rallies make me a little more skeptical than usual. The bond markets seem to tickle the skeptic in me. In times of doubt, I turn to history for a new perspective through which to view the present moment. As I browsed through the past, I chanced upon this article on the Great Bond Massacre of 1994. As with almost all instances, the 1994 bond market episode is instructive as much for the parallels with the present moment as for the uniqueness. Back then, as today, bond yields were at historic lows and inflation was muted. Wages were subdued and companies were struggling to raise prices. At the same time, idiosyncrasies exist, making the comparison an interesting and instructive exercise.

In 1994, euphoria ran high and the big spread between short and long rates saw speculators loading in on the carry trade (borrow short, invest long). The Fed kept rates low as the Clint
on administration contemplated ways of slashing the deficit and Mr. Greenspan worried about inflation. Then Mexico sneezed, setting off a bout of contagion that quickly spread across the globe. US responded to a strengthening economy by bumping up short rates. Bulk selling of bonds began, pushing rates up, causing a death spiral for leveraged, long-duration longs. And as with the current crisis, hedge funds were promptly blamed. Some things are timeless indeed...

Cut to the present. Bond issuances have picked up strongly. July was the strongest month on record for global high-yield issuances ($24 bn). Companies sold $90 bn of U.S. corporate bonds in July, the most since 1999. Average yields on the securities fell to 5.01% on July 31, the lowest since April 2004. Bonds have outperformed equities YTD and Purchasing Manager's Indices have beaten expectations in
several regions (barring China). The consensus seems to discount a low interest rate environment in the near-term and deflation seems to be at the top of the agenda. A sustained uptick on the indices could see GDP growth expectations headed in a direction that would make the deflation argument less forceful as time passes by. Could a surprise rate hike see a repeat of 1994?

Here's a quick capture of economic data from 1994 compared to the present.


Budget deficit was $200 bn back then. It is $1,500 bn today. Debt-to-GDP ratios have jumped sharply over the years and average GDP growth rates were vastly different between then and now. Increasing indebtedness and an unprecedented economic slowdown have led to interest rates hovering at near-zero today. US consumers are emerging from a period of historically low savings rates. As they grapple with a sluggish economy and a period of personal balance sheet retrenchment, the government's stimulus/quantitative easing (QE) programs are likely to have only a limited effect in jump-starting consumer spending. The Fed wants consumers to spend at precisely the moment when they seem most ill-equipped to do so! Low rates notwithstanding, I think consumer spending will take longer to recover than in previous instances (1973/75 recession a good example). The QE could see inflation rearing its head in the future but the probability of this scenario playing out in 2011 seems remote.

This would imply two things; (1) interest rates will continue to be low for a longer period than in previous instances and, (2) there is a risk of the US getting stuck in a Japan-like deflation spiral. I believe the consensus is focusing on these two broad factors, explaining the rally in bonds YTD relative to equities.

However, a couple of things force me to consider the alternative hypothesis.

(1) The encouraging corporate profits as a % of GDP number compared to 1994. Since bottoming in 4Q2008 (~8%) , this metric has been on an uptrend.

(2) The room for maneuver of interest rates. Rates are at near-zero bound and the low rate/deflation hypotheses largely seem discounted in prices.

When the weigh balance of investor preferences tilts to one side, it is always useful to consider the other side of the weighing scale. Consensus seems to be firmly behind bonds currently. From the above exposition, and
YTD outperformance of bonds over equities, I think risk-reward favours equities relative to bonds in the near-term. Bonds may not pop as in 1994, but the risks of a GDP spike increases the risk of a rate hike, which would impact bonds more negatively compared to equities.

Saturday, 7 August 2010

Conjectures and reality

I have always loved writing. Investing, it turns out, provides ample opportunities to pander to the writer's urge in me. Apart from serving as a repository of my misses (which have been way more instructive than the hits), the blog has been a storehouse of investment conjectures over time.
I strongly believe the best gauge of one's guessing ability is to periodically note down investment conjectures and test them against reality. This has helped me get better at guessing over time. One can never get everything right all the time (I have had the good fortune of numerous humbling experiences), but net-net if one's guessing right, I think things will be alright over the long run.
Below are excerpts from my writings in the past. A check of predictions versus subsequent performance.

The following was written on July 31, 2007 when the S&P 500 index was ~1,500.

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....On most occasions, equity markets have lagged developments in Credit Spreads and this time seems no different. If history repeats itself, it wouldn’t surprise me if the equity markets corrected in the short-to-medium term.
S&P topped couple weeks later and broke sharply soon after...down 27% through today.

And this is from earlier this year (Mar 23, 2010).


In sum, the divergence in market values from underlying GDP performance is unlikely to be sustained in the future, in the absence of strong catalysts. Positing a scenario of a high inflation future coupled with deleveraging and sluggish growth, gold (and other precious metals) as an asset class appear attractive relative to equities.
S&P fell 13% to its trough; has recovered since, down 5% through today. Gold is up 10%...

This exercise has helped me learn a great deal about my investing style, my comfort zone and my weaknesses. I believe the world is inter-linked, which means opportunities exist across geographies and asset classes. The natural skeptic in me feels a wee bit more comfortable scouting around for things that are ripe for corrections. Someone, somewhere, is going bust all the time! And as life is a zero-sum game, this implies there is a beneficiary lurking somewhere...


While the hits are encouraging, the markets ensure there are enough misses to prevent the unwanted growth of a big head.
Capacity for objectivity is inversely related to head size.
The pleasure - quoting Richard Feynman - lies in finding things out!

Saturday, 27 March 2010

Greece: A 2,500 year parallel

Old habits die hard. So the adage goes. As the Greece bailout drama unfolds, the curious mind began prodding, 'Maybe its in their history?'. The questioning mind always seems to find a way to some provisional answers. Till more questions goad it on to continue the journey. 
5th century BC Greece's economic history, interestingly, provides some thought-worthy parallels to Greece's present-day problems. 
History
The discovery of gold and silver mines at Siphnos provided Greece access to easy revenues. As was the flavour of the day, once the Gods took their share the rest of the profits from the mines were distributed among the subjects. The Greek citizens abhorred direct taxes but approved taxing foreigners, taxing property and indirect taxes. The easy prosperity somewhat fuelled imperial ambitions and marked the beginning of a sense of entitlement among the subjects. 
While rulers in Asia managed to impose a direct tax on their subjects, Greece continued living off its bounty of riches. Attempts to impose direct taxes by unfortunate rulers ended with the rulers being expelled from power. To fuel its 'defensive' ambitions, Greece resorted to relying on 'contributions' from its allies. Notably, Greece's citizens did not contribute to this effort. Propelled by the twin engines of mineral riches and 'debt' from allies, Athens went through a period of persistent budget deficits. The profligacy manifested in the erection of ornate structures and paying citizens to attend public festivals.

The Peloponnesian War provided an outlet to the build-up of military offensive power. But it also led to the destruction of Greece's accumulated wealth. Athens then underwent a laddered borrowing cycle that eventually ended in default. The War had destroyed Athens.

Subsequent attempts by Greek 'politicians' to cut back distributions generally ended in failure. The average Greek continued to feel entitled to riches that were now history. Athens lost much of its influence and never really regained its pre-war prosperity. The burden of the war fell largely on the wealthy through taxes and the visible destruction of a democratic Athens by an autocratic Sparta was perceived as a failure of democracy by the citizens.

A mountain of debt followed by default, imposition of taxes and pressures on wages caused Athens' gradual descent into a state of civil war and the decline of democracy.

Post the war, traces of ideas based on socialism/communism (equal share of wealth, land etc.) emerged (Plato's Republic). The Athenian economy subsequently went through years of painful adjustment that included among other things, focus on exports to fund imports of essential foodstuffs. Its main export engine - pottery - steadily waned in quality as competitive pressures built up from neighbouring nations. Athens' export competitiveness was blunted at precisely the moment when her import prices were rising. The resulting balance of payment problems continued to confound Athens several decades after the war. Revenues continued to be raised from liturgies (reliance on donations from the wealthy) and property taxes. Direct taxes were avoided as far as possible.

As Greece went about rebuilding her naval capacity, she relied on Persian finance to fund her 'defensive' ambitions. A jittery Persia ceased funding beyond a certain point and Greece was forced to rely on 'contributions' from its other allies to continue the rebuilding effort. This too failed beyond a point.

The war had had a debilitating effect on Greece and the economy went through several decades of painful adjustment. Reliance on direct taxes were minimal but the economy gradually limped back to a new normal, largely on the back of the engine of mining.

Present: The Parallels
Several centuries apart, the Euro gave Greece access to cheaper finance. The secular bullish wave of the global economy lifted Greece, leading to reliance on debt-funded growth. Things looked rosy and debts and budget deficits built up gradually...till the 2007/08 recession played the role of the Peloponessian War several thousand years earlier.

The recession has brought Greece to its knees, teetering on the brink of bankruptcy. As it looks forward to years of austerity to undo the damage, the government's proposal to raise taxes hasn't gone down well with the public. The move to impose a greater incidence of tax on the wealthy has had the same effect. Rioting, protests and bombings followed...civil unrest is increasing.

Greece now hopes for a bailout with Germany, France and the IMF playing the role of the Persian financier. As it finds itself in a position to forcibly increase exports to solve its balance of payments crisis, the Euro poses its own set of problems for Greece. Years of lost competitiveness which were masked during the boom years have resurfaced starkly. The traditional means of regaining competitiveness through cut in wages has proved unpopular so far and is likely to remain so in the future. Reducing the budget deficits through slashing expenditure, raising taxes, borrowing all look sketchy at the moment. As with 5th/4th century Greece post the war, there is a good chance that Greece is entering a period of sub-par growth.

Greece doesn't have many options on its plate as it braces up to meet the challenges that confront it today. It can either leave the Euro and face a step change currency devaluation which will boost exports, but will also hurt it badly as most of its fat debt is denominated in Euros. The defection will also raise its borrowing costs at precisely the moment when it looks desperately for ways to slash its interest servicing costs. But staying on the Euro will come at a heavy price. Germany is almost certain to demand strong austerity measures of Greece in return for a bailout, to prevent a recurrence in the future.

Through history, economically sound solutions (slashing wages, raising taxes, cutting spending) have often proved to be exceedingly difficult to implement politically. Greece almost certainly faces years of stodgy growth ahead. I can't help but question the sustainability of the Euro. Monetary dependence with fiscal independence serves to encourage profligate countries to indulge in excesses, protected by the safety of a bailout in an eventuality.

Friday, 26 March 2010

Book review: In the Long Run we are all Dead

In the Long Run we are all Dead: A Macroeconomics murder mystery
The US economy faces a deep recession, raging inflation and an impending run on the dollar. President Wedik likes economics as much as a fish likes land. Should he listen to the Keynesians, who favour government intervention or the Monetarists, who favour market fundamentalism?

Unable to decide, he delegates the tough decision to his Chief of Staff, Admiral Harcourt Green. Green laboriously goes through the process of coming up with an economic policy package...only to be mysteriously murdered on D-day. Details of the economic package dies with him...

Something has to be done soon to avoid an economic collapse. What? How?

Who committed the murder? And why?

The murder story could probably have been constructed better but the crux of the book is economics! Recommend it to those looking for a light read on macroeconomics without running the risk of drowning in jargon.

In this delightfully light read, Wolfson & Buranelli, weave macroeconomics lessons around a murder mystery. One is led through the age-old tussle between Keynesians and Monetarists, but the writers manage to engage the reader's interest amid the backdrop of the mysterious murder. The authors beautifully present the contradictions and trade-offs that perennially confront economic policy makers. The key take-aways are that policy-makers often are in no better position than market participants to predict the future path of an economy, and there is a large reflexive element at work in economies that, sadly, economists choose to ignore. Should policy makers listen to short-run focused Keynesians or long-run focused Monetarists? How does one strike a balance between the short and the long-run? Indeed, what is the short-run and long-run? Life is full of trade-offs. What's good for the short-run may not be for the long-run and vice versa.

Economic policy decision making is akin to steering a ship. Ever so often one gets caught in a storm and the ship wobbles as it hits wave troughs and crests. If the skipper steers forcefully in the opposite direction as the ship wobbles to one side, he runs the risk of over-steering if the wobble is temporary. On the other hand, if he does nothing and the wobble lasts longer, he runs the risk of imperiling the ship with his inaction.

Economic policy setting is a scientific art and achieving equilibrium is an Utopian dream. A dynamically evolving system calls for flexible policies that frequently set off unintended effects. Indeed, certain policy actions have damaging and long-lasting effects on the economy. The period of adjustment that the economy has to subsequently go through to undo the damage is painful (think Japan). Finally, fortune and randomness play a bigger role than anyone is willing to allow or admit.

"Chaos...is certainty."

Wednesday, 24 March 2010

A Scary Scry?

I feel much like the protagonist in Microsoft's Age of Empires game; at the beginning the only rays of light shine on me and my target at the other corner of the map. I need to get to the target but there's a problem. Everything is dark out there. I don't know the way. The darkness camouflages danger but also opportunities. I don't lose if I don't move, but I don't win either. As I start moving around feeling my way, the blanket of darkness lifts gradually, revealing reality. Sometimes I hit a dead end, forced to backtrack and embark on a new path, but at other times I get lucky and hit jackpot soon. There is a huge premium attached to action and adaptability to a dynamically evolving environment.

Investing is similar in many respects. The ghost of unc
ertainty lurks in the darkness at every turn in Investorville. But decisions have to be made. Often based on an incomplete, uncertain and biased perception of reality. As in the game, ones experiences are coloured by the paths one chooses over time.
Is the gilded past a harbinger of a bleak future?

In this post, I conjecture the prospects for US equities as an asse
t class, viewed through the lens of economic history.

Growth or Stability?
Do investors pay for growth or stability? A combination of both determines the price investors are willing to pay for in the long run. Growth initially tends to fetch a premium and the basket of growth companies/economies that fail to take the step up fall by the wayside. The ones that do make the cut eventually see the pace of growth slowing but perceptions of stability emanating from size, market positions, moat etc. support premium valuations.

Turning to US real GDP growth rates over the past 40 years and thinking along similar lines for the economy, the present position seems weak on both fronts. GDP growth averaged ~3% over the 1970s up to 2000. The 30 years witnessed its share of recessions, battles with periods of high inflation and slow/negative growth. Growth has since slowed to average 1.6% in the past decade...and then the economy hit the dreaded iceberg.
While the worst may be behind us, the near term is unlikely to see a jump in recovery. If anything, the debt-fuelled growth of the past plus the debt to keep the economy afloat will call for years of austerity. Growth is likely to be muted over the next decade. How much will it be? I can't pluck a number out of the brain, but I suspect one would be content to see a repeat of the trendline growth of the past decade.

The Equity story?
thechartstore.com has an interesting chart plotting the Market Cap/GDP ratio for US equities over the past 85 years. The ratio saw a big jump in the 90s breaking away from trend, reacting to years of strong, sustained economic growth. The bubble popped in 2000 and the ratio has been on a downtrend since, but has remained above 100% for most part. The recession pushed the ratio down to 70% but has returned back to 100% levels.

When I think of the underlying factors that could support this ratio, I find myself
soon running into a void. Sure the US economy is 3x its 1970 level. But the weights of debt, inflation and slowing growth have been gradually piling up on the other side of the value weigh-scale, almost unnoticed. A future of likely anemic growth and years of deleveraging makes me circumspect on the long-term prospect for equities.

I don't know if the ratio will fall to its long-run average of 60%. I would assign a low probability to that, given the structural changes to the global economy over the past century. But when I search for catalysts that could propel the ratio, I can't seem to see very many to get me scampering to hit the Buy button. On balance, I feel equities are in for a period of flat-to-down movement.

The 20-year itch
The past 110 years have seen alternating bull and bear cycles of roughly 20 years each. There is no law that demands adherence to the 20-year itch but the psychological aspect of history and the balance of odds seem to favour horizontal-down movement.

Gilded past...gilded future?

As gold levitated in the 1970s the ratio floated down eventually bottoming in 1980. Then as gold settled into a multi-decadel horizontal/down range and equities performed strongly in the 1990s, the ratio shot up towards the end of the 90s. The end of the equities party marked the beginning for gold's and the ratio collapsed again.

Two factors further strenghten my hypothesis for soft equity performance.
  1. The alternating relative price movements for equities and gold leads me to think that its gold's time under the sun in the years ahead, relative to equities.
  2. There is a good chance of the mountainous stimulus packages leading to a high inflation future. Japan's experience with re-inflating its economy over the past two decades failed and there could be a repeat in US' case. Given the structural differences in the economies, I would bet on a high inflation future...which is favourable for gold.
In sum, the divergence in market values from underlying GDP performance is unlikely to be sustained in the future, in the absence of strong catalysts. Positing a scenario of a high inflation future coupled with deleveraging and sluggish growth, gold (and other precious metals) as an asset class appear attractive relative to equities.

The scary scry may not be scary after all!

Sunday, 7 March 2010

The Pig's resurrection

With many banks continuing to dance with death, there’s one bank that is smiling. The Pig’s.

The long period of declining savings rate – or an increase in consumer spending – was one of the reasons fuelling the boom that popped not-so-long ago. As over-indebted consumers look forward to an extended period of deleveraging, the US government hopes that with interest rates hovering close to 0%, consumers will be incentivized to borrow and jumpstart the Great Consumption story! Simultaneously, lending norms are gradually being tightened, stoking fears of rising defaults in the near term. The poor Fed can only encourage, but not compel, banks to lend. As consumers mend their profligate spending ways of the past, it looks difficult in the current environment to see either banks lining up to lend or consumers lining up to borrow.

Then there’s Bernanke-speak about keeping interest rates low for an ‘extended period’. With nominal rates close to 0% and inflation hovering around 2%, negative real rates of return do little to incentivize saving. The real return on US Treasury bills was >-2% in 2009. Consumers looking to save were penalized for indulging in frugality! The Fed desires consumers to spend at precisely the moment when they seem most ill-equipped to oblige.

So is current consumption a better option? Indeed the Fed and the economy would be happy if this were to happen. While the economic rationale for current spending sounds compelling, I don’t see it happening. High unemployment and the deleveraging cycle is likely to keep spending in check.

So if the consumption story is nearly dead and banks are unwilling to open their wallets, what will serve as the engine for future growth?

The Phoenix is not yet ready to rise from the ashes…

Friday, 5 March 2010

77th anniversary of the '1933 Bank Holiday'

Today is the 77th anniversary of the global Bank Shuttering that was initiated by President Roosevelt in reaction to the crisis that engulfed the system at that time. I thought today was an appropriate day to look back at events surrounding those dark days of 1933 for parallels today. What I see resonates eerily.


The Great Depression in 1929 triggered a series of events that had unintended global secondary and tertiary consequences. As always, the invisible hands of Haphazard Linkages and Reflexivity ensure that seemingly harmless stimuli set off a chain of rippling consequences that spread out rapidly. While circumstances, market characteristics and regimes shift over time, there is an element of temporal neutrality to man-made economic and financial disasters. Often, I have found practical lessons in economics, markets and human behavior residing in the treasure trove of history.
I turn first to similarities between the build-up of events through the 1920s and the 2000s decade. The table is mostly self-explanatory.
20s Smartie: We have the Gold Standard, inflation's dead and credit is easy. The war? Well, that's history. Long forgotten. We guys have a short memory. Its the age of booms; real estate, stocks, bonds...what are you doing Sir?


30s Realist: Apocalypse! Bailout! Bank runs! Debt did us apart...


00s Smartie: We have securitization, pack-n-sell products, move-em-risk products, CDO, CDO-squareds, CDS, trend following algorithms, inflation who?, credit is easy. Risk? Well, that's history. Long forgotten. We guys have a short memory. Its the age of booms; real estate, stocks, bonds, commodities, things-I-can't-remember-or-name...what are you doing Sir?


2010s Realist: Apocalypse! Bailout! Bank runs! Debt did us apart...


There was no securitization, no razmataz, no hedge fund quant demons thirsting after mispricing back in the 1930s and yet...the boom-bust cycle played out. Nearly 80 years down the line market sophistication (and the jargon) has increased manifold, engineering has been extended to the realm of finance and new products allow investors access to asset classes that a 30s charlatan could only dream about. But something is structurally and mentally constant in us human beings. The temporal overlap above may be coincidental but the behavioral pattern is perceptively self-evident. With the ever-so-faithful benefit of hindsight, it is easy to point a finger at the government back in the 1930s for acting too belatedly in tackling the crisis. It is important to recognize that the guys back then were uneducated in Depression history.
But this time its different, isn't it? It always seems like it is....but is it?
1930s: The Reconstruction Finance Corporation was setup, capitalized with $2 billion, to extend credit to lubricate the frozen markets. The government eventually took stakes in institutions, infusing money to invigorate the sickly economy. President Roosevelt's rousing swearing in seemed to do the trick as far as emotional will was concerned. As the economy rebounded, the government exited through stake sales to private investors and/or banks. Best estimates point to a break-even on this trade for the government. Adjusted for inflation, tax-payers lost a bundle. The 1930s was characterized by the rise of economic nationalism, bloc economies, trade protectionism and a move towards unilateral policy setting, factors that are absent today.


2010s?: A slew of stimulus packages, within kissing distance of $1 trillion, instituted to stimulate the economy. The governments - learning from history - acted speedily and decisively in concerted action to arrest the downturn.


A few observations before rounding out.
  1. While it looks very likely that the pattern of exit will resemble the 1930s, timing is the uncertain variable. Exit too early and you jeopardize a nascent recovery. Exit too late and you stoke monsters (hyperinflation, credit glut, asset price bubbles etc.).
  2. Inflation behavior was a divergence between the 1920s and 2000s. Inflation back then was rather benign and on a gradual downtrend. Contrastingly, inflation was generally rising through the past decade and the massive monetary infusions almost certainly will stoke inflation in the near/medium term.
  3. Some of the biggest problems confounding global politics today is the interconnected problems experienced by peripheral countries in the Euro zone. Should Greece (and others?) be bailed out? What are the omens for the Euro? Indeed, can it survive as a currency? If yes, would this necessitate massive structural changes to the very fabric of the EU system?
The big lessons from history is that while regimes change and markets evolve, certain things remain timelessly constant. It is impossible to predict the next bubble-pop with any degree of accuracy. But it is fallible human beings who make policies, economies and it is fallible human beings who participate in the markets. Contrary to opinion, I think trend-following algorithms are fallible too.


In a paradoxical way, the only thing that can be predicted with conviction is the repeat of emotional excesses that has afflicted human beings through centuries. The low interest rates of today are very likely to sow the seeds of a bubble in one or more asset classes, which will pop at some point in the future. It would be folly to blame the causes of that bust to 'low interest rates'. The low interest rate environment is a necessity today given the present state of the economy. If it sets off a bubble elsewhere, it is haphazard linkages at work.


The more things look different, the more they look the same...and the more things look the same, the more they look different.


I part with a 1933 quote:
"As a group, bankers have demonstrated repeatedly their incapacity and greed, and yet in their hands has rested the decision to say who shall have credit, what manufacturer or merchant shall control goods and how much. They have misued that power, they have shown that banking should no longer be left in the hands of irresponsible private groups. The emission of credit, to be constant and sound, must be supervised from the standpoint of its public welfare rather than of private profit."
- Bernhard Ostrolenk


Sounds familiar?
We live through interesting times.