Bulls, bears, sheep, moths, and the madness of herds

22 AUGUST 2011

The price of any product in the financial markets, it has been rightly said, is set at any point in time by the interaction of various emotions, thoughts, views, opinions, and reactions that different people have at that point in time to any known set of "facts" or new bits of "information".

But whatever that price set by the market may be - it does not mean it is right.

Take the case of US government debt.

On August 5, 2011 S&P - one of the 3 agencies that dominate the rating business - downgraded the debt of the US government from 'AAA' to 'AA+' with a negative outlook. They cited the political gridlock in the US decision making bodies on the need to take on more debt (to borrow more) and the how the US government was planning to fix its inherently weak economy where the revenues raised by the US government are less than the expenses and obligations it has committed to.

To quote from the Overview section of the rating report issued by S&P:

The political brinksmanship of recent months highlights what we see asAmerica's governance and policymaking becoming less stable, less effective,and less predictable than what we previously believed.

And another quote:

Our opinion is that elected officials remain wary of tackling thestructural issues required to effectively address the rising U.S. public debt burden in a manner consistent with a 'AAA' rating and with 'AAA' ratedsovereign peers.

What S&P was saying, in plain English, was that investors could no longer fully trust the US government to repay its debt obligations on time. Any lender to the US government should be aware that the interest the lender is due to receive or the return of the capital is not 100% guaranteed. There is some risk of the US government not fulfilling its debt obligations to the lender. Hence, the "downgrade" by one notch from AAA - the best ranking possible that is still enjoyed by 16 sovereign nations - to AA+. As an aside, Moody's and Fitch - the other 2 rating agencies - did not downgrade the US debt.

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Hi, I'm broke, can you lend me more at lower rates of interest

Much of the debt in the world is priced off the "risk-free" rate of interest set by the market for US government debt, best reflected in the rate of interest offered on its very liquid 10 year bond: the US 10 year treasury. Given that "risk-free" was no longer "risk-free" - a severe jolt to the very foundation of the current financial system even if only 1 of the 3 rating agencies judged so - a rational investor would demand a higher the rate of interest for lending more to the US government.

In fact on August 19th, two weeks after the downgrade, investors were happy to invest in 10 Year US Treasuries for an annual rate of interest (the yield) of 2.0623% - far lower than the 2.5585% before the S&P downgrade.

If your neighbour took a loan from you at, say, 8% interest and a friend tells you later that your neighbour was having financial difficulties and may not be fully able to honour his debt obligation to you, would you lend him more money or less money?

And if you did lend him more money would you want a higher rate of interest or a lower rate of interest?

Well, the rational or logical view has been proven wrong by the market.

The market for US debt just got better from the government's perspective. The US government can borrow that extra USD 2.1 trillion approved by their politicians on August 1st - at a lower rate of interest.

There is, we are told, a "flight to safety".

Investors are so scared of what is happening in the world that they are fleeing to the "safety" of the US.

The bulls who believe that the US is the best place in the world to invest are buying, the bears who think the Eurozone and Asia will collapse are buying, the sheep who follow the crowds are buying and the moths who like to fly close to dangerous fire are buying.

Like the innocent dolphins in the heart-wrenching documentary "The Cove", the noise of sovereign debt busts in Europe is forcing investors to seek refuge in the comfort of owning more US debt. And like the hundreds of dolphins who are senselessly slaughtered by the Japanese fishermen in that deadly cove, my guess is that owners of US government debt will be slaughtered in time. A few lucky ones with the sweetest smiles may wind up at sea parks where they will be made to jump and do tricks for their survival.

Again we don't know how long it will be before this price bubble bursts - the tech bubble of 1999 lasted 12 months; the Asian Tigers bubble of the early 1990's about 3 years; the BRIC bubble of the mid-2000's about 2 years - but burst it will.

The US economy is in need of a massive overhaul. At one end of the spectrum, US companies are sitting on huge cash reserves of over USD 1 trillion. But the city, state, and federal governments are sitting on large potential liabilities in terms of retirement benefits and medical costs - with declining revenues due to low economic activity. It is estimated that the state of California alone has an unfunded pension liability of about USD 250 billion. With a 9% unemployment rate, unpaid credit card bills, soured housing investments, and lower salary levels, the US consumer needs to spend less. If the promised pensions are cut further - as is happening in Greece - the US consumers will have to save even more for their future retirement. And consume less.

Investment creates jobs - outside of USA?

Despite their cash war chest, the US companies are under no obligation to invest in their home country - they will go where the consumers are. Ford recently announced a USD 1 billion investment in India.

In India, as in many parts of the world with varying degrees, salaries are generally increasing. And while the cost of living - as measured by inflation and by our desire to live better lives and consume more goods - is increasing, we are still able to balance the growth in our levels of consumption with a 30% plus rate of savings. Sure, India has many challenges - creating 120 million new jobs by the year 2025 is one of them - and corruption is a big issue. But I would argue that many of these are addressable and we have started addressing them. And we still have time to reverse the undeclared strategy of relying on roads as a primary way to move people and goods (not a good idea because we import much of our oil) and stop the decay of our traditional joint-family system - a great blend of baby-sitting and old-age care rolled into one!

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But being positive on investing in India is the rational, long term view.

The bulls, sheep, moth, and dolphins have no time for that.

In a strange twist to the story, while the recent panic in global financial markets is being caused by fears over the US debt, it was the US debt that was a big gainer and was being priced as less risky! Lenders were willing to earn less interest.

Many stock markets around the world have been battered (Table 1). I can appreciate the fears over consumption levels in the western world and their impact on share prices of companies that cater primarily to those consumers. But we are in a broad sell-off, which could give rise to some interesting investment opportunities for us in India.

Table 1: The trouble-maker performs the best: the wisdom of the markets.
The asset class or ecurity% change from August 5 to August 19 (in USD)
US 10 Year Treasury Bond19.39%
S&P 500, USA-6.19%
FTSE 100, UK-2.57%
DAX, Germany-11.17%
MSCI World-5.30%
MSCI Emerging Markets-6.66%
IBOV, Brazil-1.62%
SHCOMP, China-2.82%
BSE - 30, India-8.68%
RTSI$, Russia-12.40%
Oil, WTI (USD/barrel)-5.32%
Gold (USD/ounce)+11.32%
Silver (USD/ounce)+11.89%
Source: Bloomberg, Quantum Advisors

I have often said that the price of Indian assets is determined by foreign investors, but the value of an Indian asset is determined by what happens within the Indian economy. That has not changed. Foreigners have sold some USD 1.5 billion worth of Indian stocks since so far this month. Their selling is causing the share prices to decline. But what is happening in the global economy may, in fact, help India. As the world slows down the price of various raw materials and commodities - from rice to oil to wheat - should keep declining and that will help the Indian economy.

But don't jump into the stock market because of the investment opportunity presented by lower share prices.

Any investment made, must be done with an understanding of your own situation including your ability to sleep well. You should recognise that the prices of many assets can - for long periods of time - be disconnected from what its estimated underlying value is. If you invest in stocks or equity mutual funds which decline by -50% from the time you bought it, you must understand why - and assess its impact on your needs. And then make a decision on what to do next.

And you should always re-balance your portfolio based on your changing needs. The bulls, bears, sheep, moths, and dolphins do what they do for they are who they are.

Investment is not a goal in itself - it is a way for you to get what you want over a period of time. Once you achieve your goals, get off the investment bus and use the money for the purpose you invested in the first place!

Though, my hunch is, many of us are still investing for our future needs and should evaluate the various investment opportunities that such dislocations offer us. I know that I am.


Suggested allocation in Quantum Mutual Funds (after keeping safe money aside)
Quantum Long Term Equity Fund Quantum Gold Fund
(NSE symbol: QGOLDHALF)
Quantum Liquid Fund
Why you
should own
it:
An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% 20% Keep aside money to meet your expenses for 6 months to 2 years

Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"


Disclaimer: The Honest Truth is authored by Ajit Dayal. Ajit is a Director at Quantum Advisors Pvt. Ltd and Quantum Asset Management Company Pvt. Ltd. The views mentioned above are of the author only. Data and charts, if used, in the article have been sourced from available information and has not been authenticated by any statutory authority. The author, Equitymaster, Quantum AMC and Quantum Advisors do not claim it to be accurate nor accept any responsibility for the same. Please read the detailed Terms of Use of the web site. To write to Ajit, please click here.


Suggested allocation in Quantum Mutual Funds (after keeping safe money aside)

Quantum Long Term Equity Fund, Quantum Equity Fund of Funds, Quantum ESG India Fund Quantum Gold Fund
(NSE symbol: QGOLDHALF)
Quantum Liquid Fund
Why you
should own
it:
An investment for the future and an opportunity to profit from the long term economic growth in India A hedge against a global financial crisis and an "insurance" for your portfolio Cash in hand for any emergency uses but should get better returns than a savings account in a bank
Suggested allocation 80% in total in both; Maybe 15% in QLTEF and 75% in QEFOF and 10% in Q ESG 20% Keep aside money to meet your expenses for 12 months to 3 years
Disclaimer: Past performance may or may not be sustained in the future. Mutual Fund investments are subject to market risks, fluctuation in NAV's and uncertainty of dividend distributions. Please read offer documents of the relevant schemes carefully before making any investments. Click here for the detailed risk factors and statutory information"

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12 Responses to "Bulls, bears, sheep, moths, and the madness of herds"

Jayvanthy

Aug 23, 2011

As usual very interesting, illuminating and forthright.
So far our markets have depended heavily on the FII money for significant upswings in the market. Do you feel we could do well without them?

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sanjeev kanda

Aug 22, 2011

excellent, easy to understand, worth a reading and multi facet view with rationale views .....i will give score of 4.5 on the scale 0-5 with 5 being excellent rgd and cheers K

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