Why we don't invest in financial markets? - The 5 Minute WrapUp by Equitymaster
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Why we don't invest in financial markets?

Jun 2, 2014

In this issue:
» SEBI looks to bring pension money in stock markets
» Ponzi schemes swindle investors due to lack of regulation
» Are the US stock markets rigged?
» Is the US GDP data pointing towards a recession?
» ...and more!

 Chart of the day
The Indian markets are in a buoyant mood. Hopes are high that the new government will be able to bring in big ticket economic reforms. Foreign institutional investors (FIIs) have already pumped in huge amounts of money into the markets. However, the market euphoria seems to have affected retail investors too. The optimism on the street is being driven by the hope of better days ahead. At such a time we would like to point out a sobering reality that may not change anytime soon. This reality has prevented investors from creating wealth.

As the chart below shows, the share of household savings in financial assets like stocks, bonds, mutual funds, bank deposits and pension and insurance funds, has fallen (as a % of total savings) since 2008. While the government has not released the data for FY14 yet, the situation is not likely to have changed much from FY13. As of today, nearly two thirds of household savings are in physical assets like Gold and Real Estate. Thus it is clear that retail investors have missed out on this market rally. It is indeed sad that when the markets were trading at reasonable valuations over the last three years, savings of Indian households did not find their way into the stock markets. Instead, a disproportionally large amount of savings went into Gold and property. Why did this happen?

Trust in financial savings has eroded

There is a two part answer to this question. Firstly, over the last five years, the Indian economy has suffered from negative real interest rates. In simple words, this means that the rate of inflation was higher than the interest rate offered by banks. Thus people had no incentive to keep their hard earned savings in bank deposits (or any other financial asset). To preserve their wealth, they moved their money into assets like Gold and property. The second part of the answer can be summarized in one word: Trust. Time and again, investors have been swindled by unscrupulous people and have lost their shirts in the stock markets. Even in the current up move in the markets, we have seen how brokers have tried to lure investors in to the markets with claims of high Sensex levels. Investors are being tempted by their so called 'advisors' to speculate in the markets with their hard earned money. Corporates, desperate to raise money, have already begun to draw up plans for expensive IPOs. We are all aware what can happen in times of euphoria. Rational thought is often sacrificed for quick profits. This can lead to huge losses as we had seen in 2008. It is such losses that scare away retail investors from markets. In a case of 'once bitten twice shy', they park their funds in so called safer investments like property and Gold.

However, the shift of household savings from financial assets to physical assets can have grave consequences for the economy as well. If savers prefer land and Gold over bank deposits and equity, then corporates will find it harder to raise money from banks and the stock markets. This has caused many corporates to delay their capex plans. In such a situation, corporates are unlikely to hire in large numbers. If the private sector does not create jobs, any economic recovery is likely to be an illusion.

The only long term solution is to bring inflation under control as soon as possible and improve regulation in financial markets. A healthy combination of positive real interest rates and better regulation will bring back the trust of retail investors. We certainly hope the new government will not disappoint investors in this regard.

Do you think that that new government will be able to restore investor's faith in financial markets? Let us know in the Equitymaster Club or share your comments below.

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As if almost on cue, we have the capital market watchdog SEBI requesting the new Government to allow pension fund money into equities. SEBI has suggested that a small portion out of over Rs 5.5 lakh crores pension fund corpus can be invested into equities and mutual funds. BSE too has jumped onto the bandwagon. It has put a similar request before the Finance Ministry.

Well, we just highlighted the need of ploughing more financial savings into assets like equities. And what better way to start this trend than investing a portion of the provident fund corpus into stocks. Besides, it could end up providing a self-sustaining security plan for the ageing population of the country. It is no secret that if invested sensibly, a well diversified pension portfolio would end up making much more money than debt securities, the preferred vehicle of investment for pension funds today. And since the investments are strictly from a long term perspective, the volatility aspect also does not come into the picture that much. Therefore, this is one move the Government would do well to seriously ponder over and implement as early as possible.

We had written earlier about the scam involving, Kolkata-based Sharada Group. While the Members of Parliament had then come down heavily on such ponzi schemes, turns out that was not the end of it! In fact Ponzi schemes continue to flourish! As per Business Standard, a company accused of money-pooling by the Securities and Exchange Board of India (SEBI) has been organizing grand meetings for millions of its agents. The Rose Valley Group in Kolkata has been one of the many private deposit raising companies in West Bengal, Odisha and Assam. Due to loopholes in regulating the business model, such fraudulent companies continue to lure depositors looking for instant riches. The companies have dabbled in a range of instruments to raise public money.

Post Sharada Group scam, a clampdown by the regulators and more stringent laws, most deposit raising schemes are out of the picture. However, what has stood out is an instrument seldom heard of in financial markets - 'time share'. Time share is a common scheme in the tourism sector. Through this, hotels and resorts give long-term membership, or use rights, against a lump sum amount. Several companies continue to use this concept to raise crores as advances for hospitality and realty projects. Thus, unless and until there is enough regulatory clarity on such deposit schemes by SEBI, Ponzi schemes are here to stay. Depositors on their part will also need to create awareness about the downsides and risks to such schemes.

Continuing our discussion on trust deficits seen in the market... What would be your reaction to the fact that institutions receive data feeds on stock prices 15 to 20 minutes before you do? Well, it would definitely be something that would curb your confidence in the markets. High frequency trading (HFT) has become a hot topic of debate in recent times in the US; with the help of high powered computers, thousands of trades per millisecond can be made. This, coupled with the fact that companies making such trades receive information well in advance is pretty much a green signal to making a lot of money. And that too legally! And how is it that the US HFT companies get such information? By paying higher fees directly to the exchanges.

While HFT may not be considered illegal yet, it definitely does make one ponder over the disadvantages retail investors have and whether such developments can maintain fair, orderly and efficient markets - the ultimate mission of regulators.

Is the US just a quarter away from recession? Well, the US economy contracted for the first time after three long years in the January-March quarter by 1%. And if we go by the standard definition of the recession, next quarter's negative output could spell doom for the country. However, economic experts do not think so and the numbers have been shrugged off as a one-off event. As per a feature in business week, few experts have blamed inventory accumulation by companies (due to bad weather) and bad weather itself as temporary blips which have resulted in the negative GDP number. It is their strong belief that there is a pent-up demand for housing and autos and an increase in consumer spending will give a stronger GDP number in the next quarter. They have thus brushed aside any threat of a recession. But what if the actual contraction is worst than this? Well, if a study is to be believed, the Bureau of Economic Analysis (BEA) has calculated GDP using inflation numbers that seem understated. If the adjusted CPI-U index and the price index reported by the Billion Prices Project (BPP) were used; the US GDP contraction could have been as bad as 3.64%.

Having said that, whatever the extent of contraction; it has a backing of other economic indicators; which too have not been very impressive. Be it real annualized per-capita disposable income, household savings, wholesale price index. Add to it the disappointing corporate earnings and the possibility of Ukraine-Russia war and you have every reason to believe that the US economy could indeed be stalling! These are too many signs to ignore. Hard times do seem to have arrived.

In the meanwhile, the Indian stock markets continued to surge. At the time of writing, the benchmark BSE-Sensex was up by 416 points (+1.7%). All the sectoral indices, barring FMCG and pharma, were trading strong. Capital goods and banking stocks were the biggest gainers. Majority of the Asian Indices were trading in the green with Japan being the biggest gainer. European markets also have opened the day on a strong footing.

 Today's investing mantra
"I think you should read everything you can. In my case, by the age of 10, I'd read every book in the Omaha public library about investing, some twice. You need to fill your mind with various competing thoughts and decide which make sense" - Warren Buffet

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4 Responses to "Why we don't invest in financial markets?"


Jun 7, 2014

This relates to both the topics of "High Frequency Transactions" (HFT) and "Why we don't invest in the financial markets" highlighted in your Wrapup. (I have liberally used material from the Business section - Stockmarkets column of Jill Treanor of the Guardian of June 6 2014 and Marketnews from Moneynews.com)
The basic injustice of making available market information to select people (hedge fund managers, HNIs and so on)in advance of others investors so that they can trade to their advantage, at the cost of savers and investors in pension funds, is being addressed through a class action suit in the Southern Distric Court in New York in the US. Thirteen exchanges and their subsidiaries are being sued by eight legal firms, one of which belongs to Michael Lewis, famous for the Mississipi class action suit of 1994 against 13 tobacco firms that had to pay out $368.5 billion eventually to compensate 40 US Sates for the cost of treatment of ilnesses arising from the tobacco they used to sell so aggressively those days. Though Michael Lewis dscribes his class action suit as "a small skirmish against the larger backdrop of the vast accumulation of wealth and political power", we should not understimate its beneficail fallout eventually because, after the Financial Meltdown of 2007-08, no one can deny that the G-20 leaders and Central Bankers of major economies have indeed created some synergy and traction in addressing the systemic ilnesses that afflict global financial markets. What they have together acheived or not acheived is a debate for another day. Suffice it to say that some regulations like the Dodd Drank Act, automatic flagging of very large transactions that immediately trigger regulatory intervention and so on are working, though they can be made to work better. Also wealth and political power is not a one way street of all greed and callouness. Sensitization to human suffering due to misuse of such wealth and political power has started to happen because of the instantaneous and graphic spread of news and information that empowers ordinary people to cross the t's and dot the i's and see for themselves the true colours of those among the wealthy and the powerful who are disruptive and damaging to the greater good.
Reverting to why we don't invest in the markets, small investors are yet to enter the markets in a significant way because they have burnt their fingers badly during the last meltdown. Even now there is a strong opinion among knowledgeable people that the present bull phase either here in India or abroad is fraught with risks. Swiss advisor and fund manage Marc Faber says, "we are in a gigantic financial asset bubble....it could burst any day". Billion-dollar investor Warren Buffett is rumored to be preparing for a crash as well. The “Warren Buffett Indicator,” also known as the “Total-Market-Cap to GDP Ratio,” is breaching sell-alert status and a collapse may happen at any moment, says Newsmax Wires, Friday, 06 Jun 2014 03:40 AM, in Moneynews.com.
“We have no right to be surprised by a severe and imminent stock market crash,” explains Mark Spitznagel, a hedge fund manager who is notorious for his hugely profitable billion-dollar bet on the 2008 crisis. “In fact, we must absolutely expect it." (Again from the same source quoted above).
Since these dire warnings are followed by a mild sales pitch for seeking to know investment strategies given by people like Sean Hyman, founder of Absolute Profits, we may cut out the hype and go for the substance : macroeconomic fundamentals are steadying a bit in many economies but they do not call for this level of a bull run which is primarily attributable to easy money. Also political and geopolitical developments are more strongly impacting economic activites than any other time in the past several decades we can recall. Therefore the small investor will wait till he sees stablity in the markets and greater consoldation of geopolitical peace and trade-related multilateral cooperation before he comes back in any significant way in markets across the world.
It is my reasoned belief that the new Government in place in India will deliver on several fronts and not drag their feet. I reiterate what i heard somewhere : the next phase of the bull run in India, with intermittent profit booking of course, will see the small investor returning to the market slowly but steadily.

Like (1)


Jun 3, 2014

You correctly said that the main problem is TRUST and this is comprised of dishonesty at one level, incompetence and inadequate knowledge on another, and lastly frequent changes in personnel at many of the 'Wealth Advisors'. After 2007/8 I have pretty much abandoned stocks as we got badly burnt !

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Thirumurthy R

Jun 3, 2014

This is about "Why we don't invest in financial markets".
Many people are hoping that the new government will not disappoint the investors in taming inflation to usher in positive real interest rates along with better regulation of the markets as mentioned by you. Let's wait and see.
One important aspect of making the markets healthy is making transparent the P-note business. (Participatory Notes). Why should there be such lack of transparency in this area? Who are the people who benefit by this lack of transparency? Do not P-notes promote "round-tripping" of black money from India through tax havens abroad, benefitting many shady entities en route? For all we know these big sharks using P-notes may be using the media and financial news dispensers including brokerages to lure gullible small investors only to rob them eventually. They can rig the markets because the amount of black money being "round tripped" could be very, very, huge for all we know.
One can only hope that the Justice Shah Commission of Inquiry (with Justice Arijit Pasayat)on Black Money instituted by the new Government will also unearth black money "round tripping" through P-notes and rigging our markets robbing the gullible small investors. In its White Paper on Black Money issued last year the previous Government had flagged P-notes as one of the routes through which black money sent out through hawala transactions comes back as white money! One can only hope the new Government will rid the system of this kind of financial parasitism here and abroad through greater transparency and regulation. I don't know if there is such a thing as investments through P-notes in other markets, emerging or advanced, to the extent it is happening in India. Perhaps Equitymaster can do a story on that separately. Needless to mention, we should avoid the kind of extreme volatility in the markets witnessed during October 17th to October 29th, 2007, when SEBI tried to curb investments through P-notes. This can be done by enlisting the support of all friendly Governments who are signatories to the UN Convention Against Corruption and also simultaneously setting in motion quiet dialogues with recognized bodies of businesses and other powerful entities whose members have got addicted to hawala and "round tripping" through P-notes. The whole exercise must be seen as something we all owe to India beyond petty personal and political considerations so that this once great country regains her pride of place among the nations of the world. As the world's largest democracy it is highly doubtful if any advanced country of the West along with Japan and Australia will hinder India in this regard. As for other countries like China and Russia, well, Russia is a long time friend of India. No doubt about that. And China, being very pragmatic and centrally-powerful, has reiterated time and again that she wants friendly relations with India for mutual benefit. Now is the time when India will get all the support it needs from the rest of the world in cleaning up her Aegean stables, not merely in the area of Financial Markets but also in many other aspects of development and poverty reduction. If Indians themselves do not see this big picture now due to myopic cupidity for short term financial or political gains, future generations will judge us very harshly indeed.
I have indeed tangentially touched upon topics other than what we are discussing but I hope readers will readily see these are all very relevant and inter-linked.
I'll be happy to see healthy critiquing of what has been said above.

Like (1)

rameshwar gagrani

Jun 3, 2014

Sir-whenever sensex rises there is flow of scarring ads from income tax dept. as if it is any crime to invest in shares and mutual funds. When government has made dividend and long term capital gains in equities tax free, why hue and cry and scarring ads and scrutiny on this subject. When sensex falls and investors suffers huge losses then govt. does not come to their rescue then why make noise when sensex gives some return and that too legitimate and tax free. The attitude of dept. dampens atomosphere of investing.

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