The lesson investors cannot afford to ignore

Feb 6, 2010

In this issue:
» Impact of Eurozone crisis on gold
» Krugman: Budget deficit not a concern
» US$ 1 bn bet on interest rates
» Disinvestment plans could go awry
» ...and more!!

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'It seems to us both foolish and improper to risk what is important for some extra returns that are relatively unimportant' says Warren Buffet. However, the greed for extra returns has led many to lose their shirt. If 2008 was not proof enough, we may have more examples to cite in 2010. The biggest crisis staring at the modern economic world seems to be managing excess debt. Be it individual, corporate or government. The best and the biggest corporates globally succumbed to leveraged bets during the collapse of subprime mortgage. It is now the turn of governments at the brink of insolvency to ask for bailouts.

Portugal, Italy, Greece and Spain (now satirically acronymed as PIGS), once thriving economic bellwethers of Europe, are the new contenders for bailouts. Today they are economies grossly misbalanced in terms of high debt matched with low prospects of economic growth and productivity. Infact, their crisis has now snowballed into one for the euro zone challenging the Euro's competence to global currencies. If Dubai seemed to be hazarding the economic stability in the Emirates, the PIGS are far more capable of ruining the Euro zone.

The key lesson that investors must take away from these crises is the malady of excess debt. Companies promising to borrow and grow have a limited future unless they can generate sufficient cash flow to repay the debt. While they may temporarily lure investors by their superfluous returns, their leveraged balance sheets can soon come back to haunt them. For investors it is a choice between a marginally higher return and safety of capital.

 Chart of the day
Gold and silver witnessed some panic selling during the previous week as investors drew caution from the crisis in the euro zone. Incidentally the European economies that are at the brink of insolvency have most of their reserves in gold. As today's chart shows, economies like Portugal and Greece have the maximum concentration of gold in their reserves. Hence the economic crises in these countries have raised concerns about them having to liquidate their gold reserves, resulting in a correction in gold prices. The strengthening of the US dollar also had a negative impact on gold prices.

Source: IMF; Data as on December 31,2009

We are of the view that there will be pullbacks along the way. Some big and some small. But as long as central banks, most notably the US Fed continue to print money, gold will be an important asset class to have in one's portfolio. Like we always mention, please do not go overboard with it.

Economists and authors have their ways of contradicting popular notions. And during times of a heated economic debate their contradicting views make a very interesting read. In yesterday's issue of 5 minute Wrapup we had quoted Nassim Taleb's view on US Treasuries. He says that if there is one trade that every human should have, it should be shorting US Treasuries.

Interestingly, Nobel Prize winning economist Paul Krugman has a pretty conflicting view on this. He believes that the US Treasuries would continue to find buyers. And that the federal budget deficit is not a looming disaster for the US economy. In an op-ed in The New York Times, Krugman writes that "contrary to what you often hear, the large deficit the federal government is running right now isn't the result of runaway spending growth." Rather, Krugman contends, more than half of the deficit was caused by the ongoing economic crisis, which has led to a plunge in tax receipts, federal bailouts of financial institutions. We believe that whether or not the US Treasuries find takers, the US economy is certainly digging its grave by not paying sufficient heed to its burgeoning deficit.

Legendary hedge fund manager George Soros was quite emphatic in his endorsement of the US dollar recently. He's known to have said that the US dollar is not about to lose its status as the world's primary reserve currency anytime soon. This is because there is no attractive alternative to the US dollar currently. With the debt woes of European nations such as Spain, Greece, Portugal and Italy that have come to light recently, even the Euro's image, which was seen as the number-two choice, will now take a beating. And so, it seems like 'flight to safety' will continue to mean 'flight to the US dollar' for some time to come.

After the battering that US banks received due to the subprime crisis, one bank has decided to adopt a conservative stance. Even if that means foregoing US$ 1 bn in returns. We are talking about Wells Fargo, which bet US$ 1 bn on rise in US interest rates. The bank chose to cut down its bond holdings last year betting that the interest rates will rise. This is in stark contrast to what the other 3 biggies did, notably add on to their holdings. While Wells cut its bond portfolio by US$ 34 bn in the second half of last year, JPMorgan Chase, Bank of America and Citigroup increased their holdings by an average of US$ 35.5 bn.

The strategy is clear. Wells Fargo is in no hurry to make immediate profits and is waiting for the right time for the returns to accrue to them. On the other hand, the others are looking to make profits before the rate hike occurs. Therefore, will the rate hike happen anytime soon? Given that the US economy has displayed some signs of recovering, raising interest rates does seem like the right thing to do. After all, it is the prolonged expansionary monetary policy followed by the US Fed which sowed the seeds of the crisis in the first place. But with the US unemployment showing no signs of abating as of yet, raising rates does not seem a priority to the government. Therefore will Wells' long term strategy bear fruit? Only time will tell.

Lately, the primary market has been buzzing with a slew of IPOs and follow-on public offers. However, most of them, including NTPC's follow on offer, turned out to be a flop show. Almost none of the issues this week managed to garner significant interest from retail investors. As institutional investors saved their day, they managed to get fully subscribed. Most experts attribute the poor performance of IPOs to very high valuations. There are others who consider negative cues from global markets responsible for the fiasco. All said and done, given the volatility in the secondary markets, government's disinvestment plans could certainly run into rough waters. It would be most prudent for the government to price the issues at reasonable valuations rather than get carried away by the prospects of milking its stake in the PSUs.

With the European crisis taking its toll on global markets, benchmark indices across major markets saw declines this week. Asian and most European stocks were amongst the worst hit. There was no escaping the selling, even for India. Concerns that some European nations may be on the verge of defaulting on their debt payments was on top of investors' minds. India's benchmark index, the BSE-Sensex ended lower by about 3.5%, making it amongst the top losers.

Note: Country names represent their respective stock market indices;
Data Source: Yahoo Finance, Kitco, CNNfn

 Weekend investing mantra
"If you can find a company that can get away with raising prices year after year without losing customers (an addictive product such as cigarettes fills the bill), you've got a terrific investment." - Peter Lynch

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10 Responses to "The lesson investors cannot afford to ignore"

ramkishan sonthalia

Oct 17, 2010

Impact of Eurozone crisis on gold
If Europian contries does have so much of gold in their reserve then why so much depreciation the currency Euro. Means impact of gold reserve is not seen.


Atul Shah

Feb 8, 2010

Very good information.


baljit kumar mehta

Feb 7, 2010

A very well reasoned and analyed writeup.Enjoyed reading
it. Keep it up. Regarda.



Feb 7, 2010

Are the days of difict financing are comming to a close?



Feb 7, 2010

thanks for giving a new name to crisis nation pigs


Dr H. Achyutha

Feb 6, 2010

About gold as % of reserves,there is no data how much Switzerland has in its reserves. US instead of printing dollar bills, it should sell gold from its reserves to China. As per chart of the day, China has the least % of gold in its reserves. As per some sources, recently,China has been buying gold. Do not know how far this is correct.



Feb 6, 2010

Impact of Eurozone crisis on gold

I fail to understand as to why conclusions are being made after the happening of a particular thing. In order that my comment does not exceed your tolerance levels I just restrain myself to PIGS effect.

Do not analysts like knew beforehand that PIGS country have large holdings of gold with them and they can liquidate them as and when desired by them in the hour of crisis. This fact should have been conveyed to us especially in those times when the GOld was its peak so that we investors who have start purchasing gold at your advice could off-load some of our holdings.




Feb 6, 2010

no comment



Feb 6, 2010

One could blame the global melt-down or the high pricing for the poor show of NTPC FPO. But, it is certain that the investors are going to watch how NTPC is going to perform in the market. If it makes a poor show, the forthcoming issues of REC Ltd. and NMDc Ltd. will have to be at affordable and reasonable price, unlike the NTPC FPO.


Krunal Gajjar

Feb 6, 2010

Exellent In Depth Report,
Top Class Report,
Top Class Research...

Krunal Gajjar.

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