What worries us the most? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

What worries us the most? 

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In this issue:
» Steve Forbes calls for a return to gold standard
» The paradox of the Indian realty sector
» Fiscal deficit exceeds 56% of the full year target in 1QFY15
» Rising supplies lower oil prices
» ...and more!

00:00  Chart of the day
'Dow declines by 317 points!' read the headline on a financial portal this morning! And with the US stocks crashing by so much, it seems 2014's gains have been wiped out entirely.

"Everybody knows a correction is coming and it will come. " is a line we came across in an article published on moneynews.com. Key reasoning for the same is the artificial bubble created through the Fed's money printing exercise over the past many years.

Mr. Ruchir Sharma - the head of emerging markets and global macro at Morgan Stanley - pointed out in the Mint that the US economy has staged its weakest recovery since World War II, with output up by 10 percentage points over past five years; a point that does prove that the Fed's measure of keeping interest rates near zero has not be giving the desired output.

While the printing money phase was done with an aim to give a boost to the economy, the fact of the matter is that this money has been finding its way to financial assets, as can be seen by the performance of stock markets in many parts of the world. And things seem to have heated up so much now that the valuations that US stocks are garnering at the moment are amongst the highest 10% levels seen in the past century!

If this is not a good enough sign of the possibility of things about to go pop in the US, here are some other scary points. Prices of commodities are up by about 40% since 2009, double the usual commodity price rebound witnessed in post war recoveries. The rising prices of staples will definitely affect people forming part of the lower income group considering that they spend about a third of their incomes on such items. Not to mention that the median real estate prices in the US have risen at their sharpest pace since the lows of 2011; in the process putting homes out of reach for first time buyers.

Then there's the point related to how the low interest rate regime has led many corporations to take on higher debt levels, a significant part of which has gone towards financial engineering - in other words, towards buybacks and mergers - in recent times. This is a point that we at Equitymaster have covered a few times as well. At the end of the day, these are just temporary steps taken to boost stock prices.

Readers may do well to recall that not so long ago, value investing legends had started raising red flags over how the Fed's policies are distorting asset prices in various parts of the world. But with the way the markets have been moving, they seemed to have been proved wrong. However, with experienced investors such as Seth Klarman giving such views, we believe retail investors should not simply ignore such comments.

How does all of this matter to Indian markets? Well... it does because of the positive correlation between the US and Indian stocks that has strengthened over the past many years.

Today's chart of the day shows the annual change in Indian (represented by the BSE-Sensex) and the US stocks (S&P 500 Index) over the past many years. And gauging the same, one can easily identify the positive correlation between the two indices - especially in relatively recent periods.

US and Indian stocks move in tandem in recent years

With the opening up of Indian share markets to global investors, this would definitely be the case. As such, the seemingly "bubble" situation in US stocks is something that Indian investors should be concerned about. After all, FII ownership is at its highest levels in India. And the possible underperformance of US stocks, coupled with the Fed's withdrawal of buyback program would only send global investors in panic mode.

While valuations in India may not be in the 'it's time to be overcautious' zone yet, we believe it would not be a bad idea to have some cash ready for some good buying opportunities.

Do you think the US stock markets are headed for a correction? Let us know in the Equitymaster Club or share your comments below.

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Imagine what would happen to your measurements if the ruler you use keeps changing its scale every day. Or imagine instead of a fixed 60 minutes in an hour, the number fluctuates wildly from say 42 minutes to as many as 72 minutes in an hour. Well, all our measurements and our planning will go haywire isn't it? Our lives would turn chaotic we believe. Noted financial commentator Steve Forbes has used this interesting analogy to highlight a flaw in the American monetary system. As a matter of fact this flaw is present across all the monetary systems in the world.

With the dollar no longer on the gold standard, there is effectively no control on how its value will fluctuate. And this makes financial decision making extremely difficult as per Forbes. Little wonder, he has called for a return to the gold standard. And he has great statistics to back his demand.

He has highlighted how under gold standard, the dollar managed to preserve its value for as long as 100 years. However, once the gold standard was taken off, the dollar's purchasing power has gone down by more than 80%. Interestingly, about 25% of this devaluation has happened over the last 13-14 years alone. Consequently, it is evident which of the two systems is better for the Indian economy from a long term perspective. However, going back to gold standard would effectively mean the Government giving away its powers to control the monetary system. And this is clearly the biggest hurdle in the way of a safer and more stable currency regime.

Usually, the most common indication of a bubble is a situation which has a parodox within itself. One that even basic common sense would show to be unsustainable. One such situation has been playing out in India's real estate sector for quite a few years now. For example, a recent report in a leading daily opines that realty firms prospects are set to improve. It goes on to say how sentiments are improving and many developers such as Oberoi Realty and Prestige Estates have purchased land for new developments.

Yet, at the very same time, we have on the other hand a situation where homebuyers are constantly having to settle for smaller houses due to the high real estate price levels. Prices are and increasingly have been becoming unaffordable, especially in the cities. And for the ones that need to be within city limits due to work compulsions, the only remaining option is to buy smaller and smaller houses.

In the face of such a situation, we wonder how things will play out. Afterall, how can demand for a good sustain at a certain level if consumers just cannot afford it

One important point that the FM Mr Arun Jaitley talked about in his recent Budget was the government's commitment to bringing the fiscal deficit down. From a deficit of 4.5% of GDP in FY14, the FM has ambitious plans of reducing this to 4.1%, 3.6% and 3% of GDP in FY15, FY16 and FY17 respectively. If the data for the first quarter is any indication, this seems like a tall order. Indeed, as reported in an article in the Hindu Business line, the fiscal deficit has exceeded 56% of the budget target in the first three months (April-June) of the current fiscal. The main problem areas appear to be tax collections and subsidies. Both tax and non-tax revenue mop-up as a percentage of the Budget targets were less than in the last fiscal. Tax collection stood at 10.1%, against 11.5% of the target, while non-tax revenue collection was 7.2%, against 8.9% of the target. This quarter, the fuel subsidy stood at 39% of the Budget target, against 34% in the last fiscal. As such, it all depends on how the subsequent quarters pan out. Reducing subsidies could be easier said than done; which is why the true test will be whether the tax collections can be ramped up. If not, meeting its fiscal deficit target for FY15 will be quite impossible for the Modi government.

Just last month, record high bets were placed on rising oil prices due to supply disruptions in Iraq. However, oil prices have surprised once again. Despite the tensions surrounding the Middle East, Africa and Ukraine, the Brent crude oil price has slipped as OPEC has pumped more supplies. What has further kept price under control is the low demand from the US and higher gasoline inventories. In fact, all these factors are likely to account for the biggest monthly loss in oil prices over last 15 months.

While the trend bodes well for India, as it largely depends on oil imports, the risk to Indian energy sector does remain. This is because dollar still remains strong, supported by US economic growth data. Further, OPEC is quite known for changing supplies as per its whims and a further cut down cannot be ruled out. As India hopes to introduce regulatory reforms in the energy sector, a rise or volatility in oil prices is likely to slow down the pace of the same.

In the meanwhile, the Indian stock markets continued to trade negative in the post noon trading session. At the time of writing, the BSE-Sensex was trading lower by 104 points (-0.4%). Sectoral indices were trading mixed with IT and capital goods stocks being the major losers whereas realty and banking stocks were trading positive. All the Asian indices were trading negative with Hong Kong and Singapore being among biggest losers. European markets opened the day on a weak note.

04:55  Today's investing mantra
"While enthusiasm may be necessary for great accomplishments elsewhere, on Wall Street it almost invariably leads to disaster" - Benjamin Graham
Today's Premium Edition
Is it wise to go gung-ho purely on FII trends?
With the FIIs in heavy buying mode, should the retail investors also follow suit?
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