Time to keep some cash as assets shed 'artificial prices'?

Apr 17, 2013

In this issue:
» Companies cutting down on working capital
» SBI's red flag on gold loans
» AIG, Goldman Sachs, government friends once again!
» The biggest losers in gold price correction
» ...and more!

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We are living in interesting times. Until a few days back prices of every asset class seemed to be touching the stratosphere! Stocks, treasuries, realty, gold...even junk bonds were finding buyers! After all, who cares about risk when free money is flowing? Plus there are trillions more on their way. Once the Japanese central bank starts printing, there will be trillions of new dollars flooding the market every month.

But the news of Cyprus selling its gold spooked short term investors. Lower GDP growth data for China further hit sentiments. And it is very unlikely that the yellow metal will have a peaceful ride for some time to come. Opinions about the prices of gold going in either direction are flooding publications. Moreover the correction in gold prices has led to further speculation about prices of bonds and treasuries. With investors losing appetite for precious metals, the Foreign Institutional Investors (FIIs) are expected to flock to safe haven US Treasuries again. But with the economic and fiscal condition in the US showing no signs of 'real' recovery, can a bond bubble be ruled out? We do not think so. In fact the basis of cheap capital chasing asset classes seems to be unfounded. There is nothing more than relative comfort in the assets that are doing better than the others. Hence, while it is gold now, we will not be surprised if stocks, bonds and realty are taken to the cleaners sooner or later.

What should investors do in such a scenario? Well, according to an article in Moneynews, Mohamed El-Erian, CEO of Pimco, believes that the prices of most asset classes are currently 'artificial'. Hence there is little doubt that the prices that are not backed by fundamentals will reverse to the mean. So, for one, investors must brace themselves for a necessary and meaningful correction in asset prices. Two, it would be safe to assume that liquidating assets will be very risky if one tries to time the market. Hence it would be a good idea to keep some safe cash aside. Having done that, as prices correct, investors should look out for opportunities to buy assets that fit perfectly in their long term portfolio. Particularly blue chip stocks and a little bit of gold. It would be wiser to be prepared rather than panic when markets shed artificial prices.

What do you think should investors do to prepare themselves for the impending correction in asset prices? Please share your comments or post them on our Facebook page / Google+ page

 Chart of the day
Real estate prices are conceptually different from the prices of goods and services. While the demand and supply dynamics determine prices of other products, in the case of real estate, the market's expectations of future prices come into play. And as the 2008 subprime bubble showed, such expectations could be faulty. Too much speculation on housing prices could eventually lead to dramatic adjustments.

The Reserve Bank of India (RBI) keeps a close watch on realty prices with the help of housing price index. As per the data from the central bank, the average real estate prices in the country have nearly doubled in last 4 years. Given the unsold inventory, and banks' unwillingness to lend to realty sector, we are not sure how long will the sector cater to speculative interests.

Source: RBI

Working capital management is a key to any business. Having a negative working capital cycle is a blessing in disguise in this tight liquid environment. It effectively means that the company receives its money faster from debtors than it is making payments to its suppliers. In effect, having a negative working capital cycle means that the company has managed to get an interest free loan for itself! This can happen when the company is large enough and has a strong bargaining power.

In this tight liquid environment, most global giants are on a look out for cheap source of funding. And the best way to do that is to manage the working capital cycle. Take the case of Procter & Gamble (P&G) for example. It is trying to reduce the money tied into its working capital operations by extending its credit terms. Not only P&G but most large companies in US are doing this right now.

This tendency of extending payment terms and doing business with other people's money is called as float. In this case, the large companies are pinching suppliers by extending the payment terms and using that cash in their business. This reduces their dependence on borrowings and gives them the flexibility to manage their bills. We believe this is a huge positive for any company. However, companies with strong bargaining power can extract such a float. Thus, only companies like P&G or DuPont for that matter can do that.

Growth is good. But can it also be dangerous? Yes, if the growth has been powered by excessive debt. This appears to be the case of China.

As per an article in the Financial Times, the red flag has been raised by a senior Chinese auditor. His accounting firm audited some local government bond issues. They were found to be very dangerous. So much so that his firm discontinued signing off on local government bond sales. As per him, the debt situation is "out of control". It is feared that this could lead to a massive financial crisis in China. And this would be much bigger than the US subprime crisis.

It's evident that a huge crisis is indeed in the making. When will the crisis strike? It is difficult to point at a timeline because the debt is long term and is being rolled over. This means that it is only a matter of time that the world sees another major crisis. And a major crisis in China would be the last nail in the grave of the global economy.

Gold has seen its prices tumbling down in recent times. This has led many investors to turn wary on gold in their portfolios. But the decline in gold prices has posed a serious risk to the banks. The banks that give loan against gold use the value of gold as collateral. The price of gold determines the loan to value (LTV) ratio for the banks. Typically the LTV ratio stands at around 70%. So if gold prices correct by 20% like they have corrected recently, there is not too much of a problem for banks. But as per the Chairman of State Bank of India (SBI), if gold corrects by another 10% there would be a problem. This is because a majority of gold loans would become higher than the value of the collateral. Given that gold is not going to become worthless, the risk that these loans would become NPAs is not too high. But decline in LTV would mean that banks have to record mark to market losses; a major short term risk that banks are facing.

Perception changes everything. And that is what is happening in the gold market. Investors across the world seem to believe that the global economy is on the mend and the overall macro scenario is improving. As a result of which they have been dumping the precious metal in favour of equities. Indeed, the pace at which gold is being sold off has been the fastest in the two years. Believing the recovery to have a positive influence on stock prices, investors are focusing on equities in search of better returns. And central banks have been the biggest losers because they own 19% of all the gold mined. That said, given the stupendous rally that gold witnessed in the past 12 years, some correction was bound to take place. There is not enough strong evidence to support the notion that a meaningful recovery is taking place. And more importantly, central banks have not really stopped printing paper money. All of which makes the case for gold still stronger over the longer term.

We are sure you would be aware of the expression that there are no permanent enemies in business. But Goldman Sachs, arguably the most powerful financial institution in the world, seems to have taken it one step further. Apparently, as per Reuters, the firm's new annual report has the famous insurance giant AIG highlighted as a client success story.

The reason this is eye popping is because not a lot of time has passed since the well publicized spat between Goldman Sachs and AIG. In fact, the battle with AIG was one of the reasons Goldman Sachs got dubbed a 'vampire squid' wrapped around the face of humanity. Cut to the present and everything seems to have been forgotten. AIG has repaid all the money it took from the US Government with Goldman Sachs acting as its advisor. What's more, Goldman Sachs is also going around town praising AIG and its own efforts in the whole transaction. Well, we wonder if this is what Goldman's CEO meant when he once said that the investment bank was doing God's work .

Selective buying interest in auto and banking heavyweights have kept the benchmark indices in the positive today. Backed by weak cues across Asian equity markets, the key indices in Indian equity markets oscillated to either side of Friday's closing levels. The BSE Sensex was trading higher by around 61 points at the time of writing. Other major Asian markets closed mixed while markets in Europe opened in the red.

 Today's investing mantra

"In security analysis the prime stress is laid upon protection against untoward events. We obtain this protection by insisting upon margins of safety, or values well in excess of the price paid"- Benjamin Graham

Editor's note: We are pleased to inform you that we have introduced a new section called What We're Reading. In case you missed it, here's today's issue - History shows the real value of gold!

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1 Responses to "Time to keep some cash as assets shed 'artificial prices'?"

Raghuveer Singh Rathore

Feb 18, 2014

If I could ever know as to when the market was going to take nose dive, I'd have been the very first person to sell out all my holdings of stocks in hand, which have turned nothing but as like a rotten arrow and re-enter in equity's BSE market when markets went considerably down for recovering of losses. Alas... wishful dreams seldom come true !

Equitymaster requests your view! Post a comment on "Time to keep some cash as assets shed 'artificial prices'?". Click here!