Finally another post

Well, its been a long time since I posted anything and so thought that I would post an email that I had sent out to my investment club members written just before the beginning of 2010. I did highlight the sovereign risk issues that would plague 2010. Didn't expect it so early in 2010 though.

Guys,
Just wanted to put my view on what 2010 is probably going to look like for stocks. 2009 was a great year for stocks, a year much better than expected. The S&P gained 22% in the year while my U.S portfolio (lucky me) gained 40.64%. As to our shared portfolio, success was not as sweet as we managed to lag the benchmark, the primary reason being that our portfolio was under invested since I believed and continue to believe that Indian markets are overvalued. 2010 is however a year to watch out for when it comes to making investments because the easy money making period is over for a variety of reasons

1) Analysts tout the improved performance of the U.S economy as a reason to believe that stock markets will go higher. On the contrary, a strong performance of the U.S economy is precisely what will drag stock markets down. The rapid rise of assets in 2009 is due to a tsunami of liquidity in the financial system which combined with the near zero yield in risk free investments is being pushed into risky assets like stocks. An improved U.S economy would lead the Fed to withdraw liquidity (either through higher interest rates or other measures) out of the system which would bring asset prices down. This would lead the dollar to strengthen due to a flight to safety and an unwinding of the dollar carry trade and would further skew the currency mismatches in the financial system.

2) There are some analysts who believe that the EPS of the S&P would be $90. This is higher than any other year in history. I doubt if such a thing would be possible in 2010. Even if it were the case, most of these profits would be derived by cost cutting rather than revenue increases which would tarnish the quality of earnings. Maintaining a standard PE of 14 which would value the S&P at 1260 (a 14% upside from current levels) would be difficult.

3) Sovereign credit risk may turn out to be a wild card in 2010. Dubai has just been bailed out by Abu Dhabi and European countries such as Portugal, Italy, Ireland, Greece and Spain (labelled as PIIGS) have mountains of debt that they may be unable to pay for. These countries have Credit Default Swaps (the same instruments that caused the credit crisis) written against them and if any of these countries were likely to default, the issuer of these CDS instruments (primarily financial institutions) would have to pay up the counterparties. If this were to result in a near collapse of an institution, this could create another credit freeze and given the current public anger against Wall Street a bailout by the U.S government may not happen. However, since these countries are part of the European Union and therefore have Euro as a common currency, it is likely that the richer countries like Germany and France would bail them out. However, Eastern European countries which are not part of the European Union yet have massive amounts of debt funded by the Euro countries in their books and the recent depreciation in their currencies has made it all the more difficult to repay. These countries may default creating similar problems if not smaller in magnitude.

4) An Elliot wave analysis shows that the market rebound is close to a 50% retracement of the S&P. The retracement will be achieved when the S&P hits 1120. Elliot waves have been fairly accurate in the past. The theory states that when such a thing happens, there is a good likelihood that markets will take a turn for the worse.

5) The next financial crisis is going to be worse than the recent one since the mistakes of the past have been repeated. It is also likely that this crisis will happen sooner than later due to sharp rise in asset prices. Whether the impact will be seen in 2010 is too early to tell.

6) The mismatch between debtors and savers are increasing but the currencies are not reflecting this. In fact, currencies are behaving very much in the opposite direction except for the Japanese Yen. All this points to a massive unwinding in the currency market which could lead to another currency crisis. When this may happen is a matter of debate.

7) And lastly, too many people are bullish on 2010. This makes me bearish as history has always shown that when everyone is in one camp the market behaves differently. Dont ask me why!!

I am making an implicit assumption here that what happens to the U.S market will occur with increased magnitude in the Indian markets. Therefore may analysis is more tuned toward the dog that will wag the tail.

regards
raghu

The Bad Loan problem

Looks like the new plan to take over $1 Trillion worth of toxic assets will not solve all the problems at banks such as Citigroup, Bank of America and Wells Fargo. The TARP plan covers for toxic assets which are generally classified as “held for trading” securities to which mark to market accounting rules apply. Therefore, these toxic assets have been written down in value to varying degress based on whatever little pricing information is available. However, the banks mentioned above have made loans on assets such as housing which are held in their balance sheets as “held to maturity” assets. These assets are not subject to mark to market accounting rules which means that they can and have been listed at book price i.e at the price of the assets when the loans were made. These loans have not been priced at lower levels given the reduction in the collateral asset values. A realistic valuation of these loans given the lowered asset values would punch a huge hole in the balance sheets of these banks. The government would therefore be loath to purchases these loans at its book value since this would mean giving away taxpayer money at a sure loss while banks would be loath to price down these assets since they would have to raise additional capital. 

This is a tricky situation and it be interesting to see how this will play out.

For more information on this read the first section of http://www.smartmoney.com/Investing/Short-Term-Investing/3-Stock-Picks-BAC-UAUA-WSM/

Organization policies and their financial impact

You may be wondering why I am writing about something relating to HR practices in a finance blog. Well, I just learnt yesterday that a 300 people odd unit in AIG caused the collapse of the entire firm. These 300 odd cowboys wrote close to $ 2.7 Trillion of credit default swaps on an equity base of just $100 billion. When things soured, the capital based vanished in a trace and now even a $167 billion infusion of federal funding does not inspire much confidence in the firm. No one knows how much more money this can suck from the system but the belief is that the consequences of letting this firm collapse are far greater. 

A key lesson from all this is the way human behaviour works and for this it is important to understand the audit and incentive procedures adopted by the company. AIG has had a history of corporate governance misdeeds and such incidences can no longer be taken lightly. Such misdeeds often prove fatal especially when markets turn for the worse.

Time to buy??

The sliding European economy is propelling European Central Bank President Jean-Claude Trichet toward the zero-interest-rate world he sought to avoid.  What this possibly means is a stronger dollar and lower commodity prices. Crude oil slid below $40 a barrel and the BSE commodity index took a big hammering.

 

India’s industrial production unexpectedly rose in November, after declining in the previous month for the first time in 15 years amid a global recession.  However, markets chose to shrug off this data being more concerned about corporate governance issues in corporate India impacting near term earnings.

 

On a personal note, the markets seem to have hit low technical levels. I believe this is a good time to buy. Personally I have bought L&T, Axis bank and Educomp. I am also keenly looking at SAIL. 

Weekly wrap up

Markets ended on a weak note on Friday with the BSE going down by 2.5%. It started on Monday at 10080, peaked at 10180 and ended at 9238. The fall on Friday could mostly be attributed to advance tax numbers which were down 22.4% YOY. Advance tax numbers are a reflection of what companies earnings will look like and these numbers were worse than expected. The fall starting from the beginning of the week can be attributed to technical resistance points at 10200.

 

Banks outperform the index due to lower than expected inflation numbers. It fell by 6% for the week compared to 6.5% for the BSE. The expectation is that the RBI can now aggressively cut rates which should benefit banks and kick start the lending process.  The oil & gas index fell by 9% while the metal index fell by 9% and the IT index fell by 8%.

 

The possibility of war between India and Pakistan will have a negative impact on market sentiment.My view is that the markets will continue to move downward and will bounce at 8900.

 On other global news, Manufacturing in the U.S. probably shrank at the fastest pace since 1980 as the deepening global recession forced customers in North America, Europe and Asia to cut back. For more information check out http://www.bloomberg.com/apps/news?pid=20601084&sid=aiV5FT1F6hfk&refer=stocks

 The TED spread, the difference between what the government and banks pay to borrow for three months, fell for a fourth week. It declined one basis point to 1.48 percentage points, down from a record high of 4.64 percentage points Oct. 10. This indicates that banks are now far more willing to lend to each other. This also ties in with a rise in treasury yields this week as investors rely less on treasuries to keep their cash. The rise in yields is also due to an increased supply of treasury bonds.

For more information check out http://www.bloomberg.com/apps/news?pid=20601009&sid=aiw3cE2FfsLU&refer=bond

Market summary for Dec 17

Dollar is at 13 year low against yen and expected to weaken further due to the fed’s rate cuts and its statements it will continue to use unconventional methods to boost economic activity.  So far, this has not triggered an unwinding of the yen carry trade. However, could this be on the cards? If so, we could see a quick decline in emerging markets equities. My feeling is that if it has not happened yet, it is probably not going to happen

Fed sets the fed funds rate at a range of 0-0.25%. This is the first time I have heard of it setting a range as opposed to a number.  However, we can see the 13 week T-Bill trading at around the range which almost seems to be the norm nowadays. The T-Bill is always ahead of the curve when it comes to predicting rate cuts.

 Opec decides to cut production by 2 million barrels but oil prices barely budge. Markets have already factored that cut in and even a fed rate cut that led to a decline in dollar did not boost oil prices. There seems to a realization that demand destruction has well and truly hit home.  What I hear is that Chinese processing of crude oil is down as well and that Americans have driven 100 billion fewer miles between November 2007 and October 2008, compared to the prior year.  However, this action provides a good support for gold and barring a massive deleveraging effort that took place in October, gold should hold its value. It has already rallied significantly though from $720 to $850 so any gains could be limited.

 Indian markets are on the verge of a downtrend. The BSE and NSE hit technical resistance points post which it corrected despite favourable global cues. I believe the rally is most likely over. We should see sideways to downward movement.  I would not be surprised to see it go below 9000 given the enormous negative news flows out there.