|»5 Minute Wrap Up by Equitymaster|
On This Day - 18 NOVEMBER 2008
25 years to reach previous high?
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And many are comparing the current financial turmoil with the Great Depression and the crisis period following it.
So is the current crisis a repeat of 1929? Are you, as an investor, staring at another 25 years to get your money back from stocks? We believe not really.
The 1929 stock market crisis was built on immense speculation in stocks. And banks were a key party to this mania. They (banks) aggressively expanded their loans given out to buy stocks. Investors could easily borrow up to 75% of the value of a stock purchase. In fact, by 1929, when the bubble reached its peak, almost 40% of US banks' loans were lent to buy stocks.
Auto majors like GM and Chrysler who are staring at bankruptcy now, were making tens of billions of dollars available to their employees as stock purchase loans. And as the Wall Street Journal reports, a company called Cities Service issued new shares, collected cash and used this to make loans for people to buy stocks. Such was the mania!
And when the bubble burst, the already weak banking system was crushed under its own weight. Over the next two years, almost 1,300 banks had closed. And since there was nothing like a Federal Deposit Insurance Corp. (which provides deposit insurance which currently guarantees the safety of deposits up to US$ 250,000 per depositor per bank), depositors lost everything.
During the depths of the depression, around 25% of US population was out of work. The Dow Jones Industrial Index had fallen almost 90%. The entire US banking system was shut for four days by presidential order.
Now you may wonder, aren't we facing a similar situation today? Banks are failing worldwide, markets are panicky and unemployment is rising.
Before arriving at any conclusions, it is important to understand the big differences between the crisis of today and the Great Depression and what would not make the latter repeat itself. The biggest difference is the massive intervention by the world's central banks. The US Fed, for instance, is now doing what it was intended to do when it was formed - not to prevent recessions, but to prevent the implosion of the financial system.
And they are trying to do just the same, by infusing liquidity in the system and by cutting interest rates to spur growth (the Fed has cut interest rates nine times since the credit crisis began in September 2007). The US$ 700 bn bailout bill and the fiscal stimulus measures that have been enacted this year, although controversial, also show that the US government is willing to intervene in the financial system to keep it afloat. Similar measures are being taken by policymakers across the world, including India.
Contrast this with what the Fed was doing post the crash of 1929 - it raised interest rates, thereby draining liquidity from the system, deciding that it was best to stamp out speculation. Although economists still debate the exact causes of the Great Depression, the Fed's moves are often considered one of the prime reasons the economy tumbled so hard.
Another difference between 1929's and today's crisis is that this time around banks made loans against houses, assets that should continue to have at least some value.
So, while we remain unsure as to where the stocks markets will head over the next few months, we believe that the wait to respite won't be 25 years ahead. Central banks' actions, though controversial at times, have raised some hopes.
Specifically for India, we believe that the economy is going through an absolutely critical point in its own transition, and see a lot of opportunity for companies across sectors like financial services, information technology, manufacturing, materials or energy.
India is a market, a story, a country and an economy domestic and international investors need to take seriously. The transformation in India has always been in fits and starts, meaning one step forward and one step back. But we now see more steps forward than we see steps backward and that encourages us a lot. And in the long run, the country is surely going to pull it off.
You as an investor need to stay the course. Live within your means. Reduce your debt. Keep saving...and investing. When the cycle turns, and it will, you will be glad you pulled the trigger.
Now the global financial crisis has not spared these small firms either. Many of the biotechnology stocks have seen their market capitalisation erode as risk averse investors are shying away from making investments in these companies given the high risk nature of these businesses as the probability of the experimental drugs failing is high. Cash is the lifeline of these small startups and in the current scenario, the only way for them to stay afloat is infusion of money into them by large pharma companies. But that is easier said than done given that large companies already have their own problems to deal with.
Not surprisingly, amidst this ongoing crisis, the participants of the summit pointed fingers to banks, imprudent investors who sought high yields without fully understanding the risks and the regulators who failed to address the danger bubbling in the markets. As a result, these leaders are now demanding that banks, hedge funds and credit rating firms maintain strong risk management systems and adequate capital which means that the potential for profits is likely to get scaled down going forward. And the ones who are likely to come under intense scrutiny will be financial companies with presence across borders.
Just to give a perspective of how bad things are, as reported on Bloomberg, a report by the Bank of England published last month showed that capital ratios at US commercial banks plunged to less than 10% of assets from over half in the mid-19th century. Of course, while stricter regulatory practices are definitely the order of the day to ensure that a financial volcano of such magnitude does not erupt again, governments across the world have to also make sure that in their zeal they do not end up 'over-regulating'.
An asset-allocation problem called the "denominator effect" is forcing the selloff of billions in private equity and alternative investments. Portfolio managers in private equity firms have strict guidelines for asset allocation. They can allocate only a certain proportion of their funds to a given asset class. However, to keep the same sacrosanct, the value of the overall fund (the denominator) must be under regular scrutiny. As the credit markets collapsed and the prices of liquid assets plummeted, the value of the overall portfolio, or the denominator, shrunk. However, the PE guys failed to adjust their investments (the numerator) with the changed value of the denominator. Resultantly, allocations to venture funds, buyouts, and real estate rose in proportion. So, a slice that once accounted for 10% of a portfolio now suddenly accounted for 25%. The latter starting to happen, the funds had to sell of their assets at a huge discount. Case in point being Lehman Brothers, which sold part of its US$ 3 bn private equity portfolio at a 50% discount.
Probably, before dwelling into the complex derivatives, some basic math needs to be revised.
Mr. Yang has held the position for the past one and a half year. His main agenda on becoming CEO was to reverse Yahoo's slowing sales growth and profit declines. Yahoo's sales growth declined to 3% last quarter from 14% a year earlier. The company's profit has dropped in 10 of the past 11 quarters. This year's third quarter net income fell 64%, and the company recently lowered its revenue projections for the year.
The crisis has caused major advertisers in the fields like finance, travel, retail and automotive to cut back on internet spending. Thus, how much of his actions were negated due to the global economic crisis will always remain a question mark.
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