'When' is harder to predict than 'if'!

Sep 18, 2014

In this issue:
» India could continue to see FII activity in the coming months
» Now, its China's turn to print money
» IMF warns of high valuations!
» EPFO changes its mind on exposure to equities
» ...and more!

The past few months have indeed been very good for investors as most would have made money. Everyone would be feeling wealthy and thus feeling good. But we believe one could take this as a sign to be wary. We say this because it is during such optimistic scenarios that investors tend to get carried away and take poor decisions.

And thus, having someone put things in perspective and remind us of the ground realities every once in a while is required. This time around, it's Seth Klarman, noted American investor and founder of the Baupost Group, who will play this role.

In his recent letter to investors, Mr. Klarman has gone on to remind people of all that's wrong in the current scenario. What stuck out, amongst the many topics he covered in his correspondence, was the 'bubble of complacency' amongst investors.

Despite economic parameters not showing signs of improvement, US stocks continue to rise. The revision of US GDP to -2.9% in 1Q2014 going unnoticed is one example cited by him. Such a sharp fall would have otherwise led to a major sell off, simply because it indicates a recession.

Mr Klarman is of the view that investors have reached a stage of complacency. With ECB interest rates being negative and talks of Europe and China going in for more QE activity, there are bound to be consequences. However, it is due to such developments that investors are discounting the risks and expect the strategies taken up by the central banks to be effective.

As put by him "Increasingly, hopes and dreams are being capitalized as if the future is certain and nothing can go wrong, as if up cycles such as the present one don't inevitably sow the seeds of the next decline." Sooner or later the effects of these developments are bound to have an impact on the market - in the form of higher inflation (a trend that seems to be emerging in the US).

Further, the risk appetites for investors seem to have increased substantially as well. So much so that the demand for sub standard credit and increasing leverage are the methods being used to improve short term performances; as per him, the market cycle has reached such a stage where investors are willing to give up on returns they would usually be looking out for; and instead are going in for the next best options.

"How would everything feel if the S&P 500 were suddenly cut by one-third or one-half? Would such a drop drive astonishing bargains, or would the U.S. economy soon falter, with festering problems such as unemployment, the federal, state and local deficits, the long-term fiscal situation, and the creditworthiness of most sovereigns suddenly seeming ominous? It's not hard to reach the conclusion that so many investors feel good not because things are good, but because investors have been seduced into feeling good-otherwise known as 'the wealth effect'."

The above lines pretty much sum up Mr. Klarman's views.

Is something similar happening in India? Well... to some extent. Major negative events such as the de-allocation of coal blocks have been shrugged off by the market in recent times.

While growth prospects of the country remain intact, the fact of the matter is that the increased FII activity has made the Indian stocks quite vulnerable to foreign investors. And thus keeping an eye out for how the above mentioned developments play out would be essential.

And with seasoned investors such as Mr. Klarman raising red flags for quite some time, it would not be surprising to see a collapse and increased volatility sometime in the future. As put by Mr. Klarman, "When is harder to predict than if".

Do you agree with Seth Klarman's views that the QE efforts of central banks have made investors complacent? Let us know your comments or share your views in the Equitymaster Club.

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 Chart of the day
It is common knowledge that the foreign institutional investors (FIIs) have a disproportionately heavy influence in the direction of Indian stock markets. It would not be wrong in saying that the sharp uptrend since the outcome of elections in May can be attributed to FII optimism. In this context the results of a survey by Bank of India Merrill Lynch (BofA - ML) holds importance. As per Mint, the results of the survey clearly indicate that emerging markets including India could continue to see FII activity in the coming months. The allocation to emerging markets is currently below historical averages. Hence if the allocation increases, India could certainly see more FII inflows. As the chart shows, FIIs have, only recently, been net overweight on emerging markets since May 2013.

No major crash expected in EMs?

Now, besides the continued availability of cheap liquidity, the possibility of higher growth rates in emerging markets, particularly India, has been the main lure. If the growth does not mineralize, history suggests that the FIIs will be the first group of investors to look for greener pastures. Hence long term investors should not read too much into FII trends.

Well, the pace at which it is spreading, it won't be wrong to call quantitative easing the Ebola of central banking. First it was the US that resorted to it. Then came Japan, the European Union and now the news are out that the central bankers of the world's second largest economy are showing symptoms of it. As per reports, the People's Bank of China is injecting some US$ 81 bn into the nation's largest banks. Thus, while on one hand the US is cutting down on its quantitative easing, we have countries like China and the European Union stepping on the gas. In China's case it is the fear of the weakest industrial growth since the financial crisis and moderating retail and investment sales growth that's leading the policymakers to take such a step.

Will it achieve the desired objectives though? We don't think so. Printing money is simply the exchange of something for nothing and all it does is makes some people rich at the expense of others. Consequently, while initially it may look as if it's working, it will eventually start having bad effects in the form of higher inflation and the need for even greater stimulus. And if an economy keeps going down the same path, there could eventually be a big price to pay in the form of some financial crisis or the other.

As we have seen above, the markets seem to be ignoring negative news. As stock prices scale new highs, investors - in a state of euphoria - have almost come to believe that markets can only go up. Voices of caution are not being paid any heed. Thus, we will not be surprised if the latest warning by the International Monetary Fund (IMF) also goes unheard. The IMF has sent a report to all nations in the G20 warning that investors may be taking excessive risks. The buoyant market conditions have resulted in valuations, in almost all asset classes, rising above their long-term historical averages. This is despite the mixed evidence of a global recovery. The IMF has, in our opinion, raised concerns that investors may be underestimating the risks in the global economy. This is quite relevant in the Indian context too. While Indian stock markets may not be over-valued right now; investors will do well to guard themselves against over optimism.

Just about a few days ago we wrote how the Employee Provident Fund Organization (EPFO) money could inject liquidity and drive market valuations to a new high. After all, the fund kitty of EPFO is so huge that it can easily overtake LIC as the largest domestic institutional investor in equities. However, it seems that within a span of few days, the EPFO has changed its mind. It now says that it is not considering any proposal to invest in equities.

EPFO has traditionally been a conservative organization. Since it deals with retirement money of employees, safety of the principal is paramount. Hence, it has been averse to investing in equities. However, considering that retirement money is invested for long term we reckon equities should not be completely ignored. Also, with rising inflation bond yields are unable to maintain the purchasing power for EPFOs subscribers. Hence, investing a smaller portion of the corpus in equities is a better option. Though equities entail slightly higher risk they also bring a prospect of higher return. And EPFO should consider this aspect as well apart from safety.

Indian stock markets continued to surge in the post noon trading session. At the time of writing, the BSE-Sensex was trading up by 428 points (1.6%). All the sectoral indices were trading in the green led by realty and consumer durable stocks. Most of the Asian markets were trading firm led by Japan and Taiwan. European markets have also opened the day on a strong note.

 Today's investing mantra
"A pin lies in wait for every bubble. And when the two eventually meet, a new wave of investors learns some very old lessons: First, many in Wall Street - a community in which quality control is not prized - will sell investors anything they will buy. Second, speculation is most dangerous when it looks easiest." - Warren Buffett

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2 Responses to "'When' is harder to predict than 'if'!"

Ravi Challu

Sep 19, 2014

Valuations are way above what is justified by companies financial performance. The markets are buoyant because of large amount of cash being infused into the system.

Unless corporate performance improves significantly the risk of a large market correction is very high. When... the day FIIs find greener pastures.



Sep 18, 2014

As an investor we have to keep the risk perception in our mind in a corner, but totally it should not be relied upon at this stage in Indian capital market since the market is totally driven by the forces, viz. FII's investment, changing improved economic scenario, improving fundamentals, green shoots, BJP's individual majority in parliament, etc. Especially, PM's major idea is to have a close and cordial and peaceful relationship with the neighbouring countries, viz., Pakistan, China and Myanmar, etc. which is now showcased with the signing of around dozen agreements with China to develop rail and road infra, promoting and development of industrial parks in India and to have clean cities with their help and strategies. With these financial commitments with the neighboring countries PM is endeavouring and avoiding border and military conflicts which will certainly help develop India and Indian Capital Market and so one can definitely can have more honeymoon periods ahead. As a small investor at least for another one more year one need not bother about the downtrend or crash in the market.
PM should concentrate more on other parts of India than Gujarat. Thumbs up PM and Thumbs up Indian Capital markets.
But one should not forget Seth Klarman's view of caution and it should ring always in one's mind.

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