Can financial models ever be trusted?

Feb 16, 2013

In this issue:
» Moody's Budget wish list
» Govt to earmark Rs 120 bn for GST rollout
» More bad news from the Euro zone
» 2G operators to shut shop
» ...and more!

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Issac Asimov the popular science fiction author states that the three pound human brain is, "as far as we know, the most complex and orderly arrangement of matter in the universe." Understanding the human brain has been a constant challenge for neuroscientists. So, if we can't even fully understand how a brain functions, can we really understand how broader economies function? Well, highly paid Wall Street analysts have made valiant attempts do so in the past. But, have failed almost every time.

October 19th 1987, more popularly known as Black Monday, remains the largest single-day market drop in history. To blame was a new kind of investment product known as portfolio insurance which was based on a mathematical model for pricing options. Ten years later, the failure of Long Term Capital Management was also blamed on models. Similarly complex formulas and excel sheets may have also been behind the subprime crisis and the London Whale fiasco. Quantitative models, at the heart of modern finance are often said to be mathematically complex and difficult to understand. Warren Buffett warns investors to beware of "geeks bearing formulas". But, are financial models really to blame, or is our interpretation of the same faulty?

According to an article in the Financial Times, financial models are actually dramatic simplifications of how complex the world is. Model builders make assumptions on how the world works. But these assumptions may not always hold true. And sometimes they fail drastically. The main trouble with models is that they are based on a normal or a 'base' case scenario. When markets go haywire, they may not be as useful. Investors need to make sure that they don't trust them implicitly. Just like humans, excel models or computer programs may also be prone to error. And stock markets also have likelihood to crash. If we remember these two rules, we may just save ourselves from trouble.

We are glad to inform you that Mr Bill Bonner, founder of Agora Inc and author of renowned financial column 'The Daily Reckoning' is visiting us in India very soon. Mr Bonner has been a long time 'gold bug' and is known for his unconventional and hard-hitting views on the global economy.

If you would like to hear Mr Bonner's views on any of your queries, please send in your questions comments or post them on our Facebook page / Google+ page

 Chart of the day
Youth unemployment has been a core socio economic issue across the world. Especially in India with youth claiming the highest share in population. Some of the grave issues like Naxalism, crime and social evils have their roots in lack of job opportunities for the millions of young in the country. Unless the issue is tackled, it won't be long before the young who are considered to be the country's biggest asset can become a huge liability.

Today's chart of the day shows a survey held by McKinsey and Co. on the growing skill gap globally and has come up with some interesting observations. While lack of employment opportunities is perceived to be the prime reason of the problem, the study focuses on another dimension of the issue - lack of right skill sets for appropriate jobs. Interestingly, this is not a problem confined to India alone but is a global challenge. As per the survey, an average of 39% of the employers across the world cited skill shortage to contribute to the entry level vacancies. Hence, while employers are keen to hire, the lack of right education system is holding them back. However, the situation is more alarming for us than most of the rest. Among the nine countries surveyed, India is the second worst (next only to Turkey) with 53% of the employers feeling the pinch. We hope that the Government will take note of it and take steps to tackle education-to-employment challenge by filling in gaps in the education system in the country.

Data source: Livemint

The roll out of Goods and Services Tax (GST) has been delayed for quite some time now. It was bound to be introduced in April 2010. But it is yet to see the light of day. There are various contentious issues left unaddressed which have resulted in delays. The primary one being the compensation for loss of revenues arising to the state government.

The basic aim of GST was to rationalise the indirect taxation system. And this would result in abolition of multiple taxation layers at state and centre levels. However, this may result in loss of revenues to states. For instance, in transformation towards the GST roadmap, both centre and states had agreed to gradually phase out the central sales tax (CST). CST is levied by centre on inter-state transactions but re-distributed to the state governments later. So, in order to compensate the states for loss of revenues arising from reduction in CST rates, finance minister is likely to earmark Rs 120 bn as provision in the upcoming budget. This is likely to support the state finances. It will also reduce opposition towards GST from states as their deficit is taken care by the centre to a certain extent. If the central government is indeed capable of addressing the state issues, we may well see a roll out of GST by December end as envisaged.

The Finance Minister has ensured that expectations soar in the run up to the Union Budget. His assurance of keeping the Budget proposals in tune with the economy's needs however has not found many takers. The central bank, other regulators, industry bodies, investors and political parties have all drawn their respective Budget wish list. But we were rather intrigued by the wish list of sorts sent by rating agency Moody's. Certainly a first by a rating agency. It prescribes Budget remedies to India's fiscal and current account deficit problems. It reiterates that resolving the deficit problems through adequate policy initiatives could fetch India a much better credit rating. Attracting foreign and private investment, keeping inflation in check and cutting down subsidies also feature in Moody's advice to the government. We wonder if the FM will be able to be able to live up to all that is expected of him.

The Supreme Court of India had cancelled the 122 2G licenses that were issued by the erstwhile telecom minister. These were all the licenses that had come under the scanner with regards to the 2G scam. But with a view to not hurt consumers, the Court had given the affected operators time. Time to sort out their affairs. Time to bid for spectrum in the proper way. But that time has now come to an end. The court has directed that the operators, who were unable to get spectrum in the last 2G auction, have to shut shop. This includes those operators who decided not to participate in the 2G auction given the high reserve price. The directive given by the apex court is that they should shut down operations immediately. This has two major implications for the sector as a whole. First being the obvious that with lesser number of operators the fiery competition will ease up at some point of time. This bodes well for the remaining operators who have been screaming for tariff hikes. The second and not so good one is the impact on the consumers. They will get hit with the disruption in services. And even if they migrate to other operator services, in all likelihood they will see higher tariffs soon.

The week gone by was a mixed one for the global stock markets. UK and Hong Kong were the top performers during the week followed by Singapore and France. Brazil and Germany were amongst the top underperformers. Sentiments were mixed on the back of news of a slump in Europe's biggest economy Germany, which contracted by 0.6%. This is believed to be the country's worst performance since early 2009. Chinese markets were closed on account of the Lunar new year.

The Indian stock markets were down 0.1% during the week, falling to their lowest level in the year till date. This was the eighth consecutive session where the markets registered a fall. The jittery market sentiments are seemingly on the back of a cautious approach taken by investors before the Union Budget which is due to take place at the end of the month.

Source: Yahoo Finance

 Weekend investing mantra
"You get recessions, you have stock market declines. If you don't understand that's going to happen, then you're not ready, you won't do well in the markets." - Peter Lynch

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3 Responses to "Can financial models ever be trusted?"

Dr Arvind Bhome

Feb 17, 2013

This is for Bill Bonner:
Since he advises US investors to get out of stock markets which are rising thanks to Helicopter Ben's money printing machine & Obama has fooled them circulating fake stories of return of housing boom would he say the Indian investor is right in staying away from the market in the first place and being obsessed about piling up gold.Or is there one law for US and another for the poor Indians?Especially since our markets are also rising thanks to FIIs loaded with Bens Helicopter loot.


Valerian Menezes

Feb 16, 2013

My comments are related to the 2G operators shutting shops in India. This is happening because the market regulation is undertaken by the courts and civil right/anti-corruption crusaders who have an apathy for generation of wealth. If the policy making function in the sphere of marketing is left to the auditors like CAG, however high their constitutional position is, the markets will have to suffer. Market policies and financial manoevers are the prerogative of enterprenuers not auditors and the courts. The latter, if allowed to meddle in this sphere will prove to be the bulls in the china shop.



Feb 16, 2013

principle of relativity says nothing is perfect in itself but gives specification to be compared with similar objects on so nothing is fool proof as one may be going with his intelligence which is higher to all other existing mates so does his right thinking really matters when its going to be abstruse for others who also required to bring appropriate fruit of effort based on right thinking. Conclusively models need to be trusted until they fail.

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