In May 2006 when the BSE-30 Index declined by 17% in eight sessions, we wrote about the bubble in the Middle East markets - Markets Do Fall (PDF) and said, "Better economic and GDP growth is not an assurance to a perpetually booming stock market".
The earnings power of a company is a function of the business of the company, its management, and the overall growth rate in the economy in which it operates. There is little change here in our view and we should safely assume that India's GDP will grow at a 6% to 6.5% per annum rate for the next few years. (Many more optimistic people have a higher GDP growth rate for India at 8% plus but we don't subscribe to that view as yet.)
Habits die hard: TBTF - Ajit Dayal
Understanding liquidity & sub-prime debt
How much people are willing to pay for those earnings is a function of what economists call "liquidity" and though there is no clear definition of what "liquidity" is, one can assume that it is how much money is sloshing in the system. Imagine you are at a bar and everyone is feeling a little good from the various other liquids that the bar tender has to offer for a price, of course. Then the bar tender says, "Hey, folks, how about I cut the price of the drinks by 50% - anyone want some more?"
You bet! The crowds get bigger and people feel even more elated. With all those drinks available on the cheap, they lose their sense of judgment. Human nature is anyways tuned to drift into flirtations. With a few more drinks, the drifting becomes a reality. The poor bloke standing next to you in this bar - a total stranger - suddenly feels like a friend. You begin chatting. By the end of the fifth glass, the poor fellow who works as a waiter in some corner restaurant in some obscure town in USA now looks like a promising young man who could one day start his own restaurant, build his own mall, and maybe have a chain of restaurants. So you lend him money to buy a house. He is actually what the credit rating agencies would call a "sub-prime credit risk". But, because that bar tender gave you all those free drinks, in your eyes he becomes a good risk and better still, you turn to the other drunk next to you and re-sell the loan you made to this sub-prime fellow for a profit. And why do you sell the loan for a profit? Because the guy you sell it to (a European, Japanese, Middle Eastern, whoever) is more drunk than you because the bar tender in his country also gives him free drinks. And he cannot assess the risk profile of that sub-prime American any better than you can. So all the drunks are happy. And you use that profit to make another loan to another poor sub-prime fellow and so on and so forth......
Since 2003 all the drunks are having a good time, lending and buying and selling sub-prime loans to each other.
All the sub-prime folks who got this silly money in 2003, 2004, and 2005 from the folks at the bar thought they were rich and started buying big houses and big cars and spent money which was not earned, but borrowed.
The bar tender is serving the drinks because he needs to make sure everyone feels good. There may be an election around the corner. Or if he serves his drinks quick and fast, some big bank group may come in and hire him as a consultant or make him a chairman of a global financial conglomerate riding this tide of global liquidity.
So the central banks were the bar tenders, doling out drinks and money as if their printing presses had to print, and print and print. Rather than being the men in grey suits with grumpy faces worried about the fate of the financial world, they became the stars on TV channels and the toast of conventions: their suits were grey but they were talking about this perfect world and this goldilocks, fairy tale.
And that fairy tale found its way to India and the rest of the emerging markets. From being the poor countries with corrupt governments and inept governments that have consistently failed to look after the needs of their people, these countries got a new name: BRIC. They became the darlings of the drunks. Yes, while there have been significant improvements in many countries - including India - the perception of the depth or the sustainability of these improvements were exaggerated when the drunks at the bar came calling.
India has seen nearly US$ 50 billion of foreign inflows - of which US$ 40 billion have come in since 2003. Yes, the Indian companies and the Indian stock markets did deserve a lot of that but the assessment of risk has been, in my opinion, absent.
The sub-prime fall out
The sub-prime blow has so far seen some US$ 2 billion of losses from funds that have been closed down. There is maybe another US$ 50 to 100 billion of losses that may yet be exposed, according to people who track this industry. While US$ 100 billion is nothing in a world where the market cap of stocks is US$ 30 trillion (300 times the potential losses) and where bonds worth maybe US$ 100 trillion float around, the bar tenders are now serving less of that booze. The drunks are getting more sober. They now see that sub-prime person as someone who may be lucky to keep his job in a restaurant as opposed to their previous assumption (over the rim of their liquor glass) that they were lucky to stumble on the founder of the next new big restaurant chain in USA. And they will price that loan accordingly.
And they will see the investment opportunities in the emerging markets with a little better understanding of risk. Don't get me wrong: the fundamentals for India are fantastic, and money will flow in to India over the next decade. Sensible, risk-assesses money. But for now, the silly money will go out. The P-Note folks will vacate and that will cause the Indian market to suffer.
India has, via its P-Note policy, linked itself to silly money. We enjoyed the ride for the past 4 years, now we will feel a bit of pain.
Keep your money ready to invest. Stay disciplined, never be carried away, politely tell the bartenders to keep their extra, free drinks. And you will profit: steadily but surely.
Ajit Dayal is Director, Quantum Advisors Private Limited. Ajit is the founder of Quantum Asset Management Company Pvt. Ltd. and also Quantum Information Services Pvt. Ltd., which owns Equitymaster & Personalfn.