Investors, don't commit this mistake

Apr 16, 2010

In this issue:
» A dangerous side effect of cheap credit
» Why the RBI lets the Rupee to rise?
» Bad maths to blame for financial crisis
» BRIC nations want financial reforms
» ...and more!

What if stock prices never fall from here? That is a question we get a lot these days. Although we do not claim to be fortune tellers, but a glance at the past should help answer the question. In 1998, the global economy trembled under the Asian Crisis. The system was bailed out using a strategy of borrowing and spending. That led to a bubble, which burst ten years later in 2008. The bail out strategy this time around is also no different. As the legendary investor George Soros points out, "We have added to the leverage by replacing private credit with sovereign credit and increasing national debt by a significant amount." He adds, "Unless we learn the lessons that markets are inherently unstable, and that stability needs to the objective of public policy, we are facing a yet larger bubble."

We frequently look at companies on a case to case basis and find that most of the good ones are now trading at rather rich valuations. But remember, the US Fed will have to deal with debt of at least US$ 10 trillion in the next decade. Some estimates are even higher. The generous valuations we see around us are a side-effect of the bail out strategy. And the strategy itself is far from fool-proof, as the period between 1998 and 2008 has shown. So, to answer the question - don't bet your money on the hypothesis that prices will never fall from here. In fact, projecting current market conditions into the future is a common mistake investors commit.

 Chart of the day

Note: GDP per capita as corrected by purchasing power parity
Source: World Bank

As the chart of the day shows, India steadily improved its rank among 109 nations for which data of income per head, adjusted for purchasing power is available. In 1975, India was the 90th poorest nation. By 2004, it was the 75th poorest nation. The one nation that outdoes India's performance - no prizes for guessing - is China. It has moved up from 108th rank to 58th during the period, crossing over India somewhere between 1984 and 1994. Surely, both India and China can be expected to move further up in the ranking in the coming years.

Imagine what would have happened if Albert Einstein would have been an investment banker? Or if Newton would have been a top notch trader? One, the world wouldn't have seen their fantastic inventions at all. And second, if many experts are to be believed, we would have had the financial crisis like the one we just witnessed, during their times as well. Luckily, that did not happen and we are reaping the fruits of their amazing breakthroughs. But our future generations may not be that lucky. Because the brightest and the best over the past few decades decided that they would take a shot at Wall Street. And the results have not been overwhelming. An article in FT argues that all these people may have taken the wrong models to Wall Street. Hence, it is high time that there is an overhaul. But is the financial world willing to accept new models? The article goes on to say that while there is some sort of enthusiasm in Europe, the US has shown to be far more resistant to change. It has not come as a surprise though, given the vested interests at stake. But a beginning will have to be made. And bad 'math' and bad 'economics' will have to be shown the door.

As far as foreign investors are concerned, India and China are usually spoken about in the same vein. Both are developing, rapidly growing Asian economies. Both have shown rapid growth, even as the rest of the world staggers. But similar as they seem, there are still deep differences between the two. Probably the deepest is diversity. India's complexity in terms of caste, religion and cultures makes the reforms process an arduously slow task. Another stark difference is that despite India being a democracy, politicians are seldom thrown out of power for not delivering on promises. This is not so in China. Its citizens do not have so much power. Yet the government there seems to have delivered much more in terms of basic amenities to its citizens. So while India and China might appear as close cousins, there remains a sea of differences that beckons much deeper study.

The Yuan is currently grabbing the headlines as the Chinese are reluctant to let it appreciate against the dollar. The Indian rupee has not garnered the same attention that its Chinese counterpart has. But of late it is making news for appreciating against the dollar. The rupee has risen about 17% from its record low in March 2009, and there are expectations that it could gain at least 3% more by the year end. Interestingly, the RBI has refrained from intervening in the forex market to prevent the rupee from appreciating. The reasons are not hard to find. India is already grappling with high inflation led by soaring food prices. Intervention by the central bank to stem the appreciation of the rupee would only add to the liquidity and worsen the inflation scenario. Further, an appreciating rupee does have its advantages. This is because imports become cheaper. The fact that India is a net importing country only strengthens the case for the appreciation. This is especially because most of the imports are of commodities, whose prices are expected to rise. Exports, however, will be impacted and the sectors at the receiving end would be software, pharma, textiles and gems and jewellery.

You can call this the beginning of the new normal. The developed economies are used to enjoying their clout where it mattered. But no more. With the change in world economic order, a lot is set to change. Including the ability of the new economic powers to voice their opinions on global reforms. The BRIC economies are set to voice more opinion at the World Bank and IMF. They have insisted on bringing in swift reforms to make global financial markets safer. The BRIC nations therefore have set a deadline by which the reforms should be brought in. Having said that, with China unwilling to change its currency policy or let go of its US dollar reserves, it remains to be seen how far the BRIC economies remain on the same page when it comes to implementing the financial reforms.

Meanwhile, after starting the day's trade on a negative note, the broader indices largely languished deep in the red during the day. At the time of writing, amidst broad based selling, the BSE-Sensex was down 91 points. Weakness in realty, metal, power and auto heavyweights were weighing heavy on the indices. Stocks from the FMCG and consumer durables sectors were the only ones to witness some buying activity. Most of the other Asian markets also displayed weakness and closed in the negative. The European markets have also opened in the red.

 Today's investing mantra
"A good business is not always a good purchase - although it's a good place to look for one." - Warren Buffett

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5 Responses to "Investors, don't commit this mistake"

Shrikant D Puranik

Apr 17, 2010

the issue made interesting reading with particular reference to the FT article- about best brains being allured to wall street with wrong economic modules.. can we have the details/link to the article? It would really worthwhile to note that the attempts to measure the human behavior in terms of maths has proved to be abysmally wrong... It is urgent and expedient that this wrongdoings must be reviewed from time to time and be undone at the earliest..

Shrikant D.Puranik



Apr 16, 2010

There is absolute truth in the statement that Stock Markets are inherently unstable.Every investor should keep this in mind. Market trends will certainly have fluctuations, sometimes even violent. That is why speculators burn their fingers many a time while prudent long-term investors get good returns.

As rightly pointed out, India's diversity, based on caste, creed, religion, languages etc., certainly retards the country's development. We always take pride in announcing to the world that there is unity in diversity. None can, however, deny the fact that there are glaring deficiencies in this regard. Unless we learn to sink our differences based on these factors, the growth will continue to be slow.



Apr 16, 2010

long perspective approach article, a little bit of confuse to say either to buy or not


narendra Goidani

Apr 16, 2010

Hi readers...I think this issue is indeed very interesting. Keep it up.

Can we also have clear guidelines as to what to do now onwards?




Suresh Aithal

Apr 16, 2010

Even though China is superior for investing.I think India is Far more better country.India is Not a MILITARY POWER.INDIA is democratic one.But the politics is the drawback.Even though INDIA is RAPIDLY Growing in all ways as we see

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