The Rules of the Game are Changing

Whew! What a week this has turned out to be! It was the worst weekly performance ever for most of the key markets including India’s. The fall in Nifty since January has been about 47 percent and the trailing PE multiple is back to what it was in 2005 at14. The trailing PE of CNX Midcap index is at 8.5, last seen in 2003. The pundits in this game are still not sure if this is a good time to buy, some feel with major earnings downgrade to come, the market is still not cheap.

Policy measures globally are coming thick and fast to stem the rot but appear to be of no avail. The outcome of the G7 meeting would be crucial and the rescue package that was recently approved by the US lawmakers itself is likely to take a new face with the contingencies provided their-in being invoked with Paulson talking about taking direct stakes in the troubled banks to infuse liquidity quickly. Also talk of guaranteeing all the deposits is also on. The EU still has to put up a common plan with diversified interests playing their role.

The Indian government has done its bit to release liquidity into the system by reducing CRR to 7.5% from 9% which would release about Rs.60000crs. (Rs600bn. i.e. approx. USD12bn), which other wise was held by RBI and was not circulating in the banking system. RBI has also been injecting temporary liquidity into the money markets since the beginning of the crisis. Assurances have come that more measures to ease liquidity will come as the situation evolves. ICICI bank has gone a long way using various forms/platforms to assure that things are fine with it.

For those who want to understand the why and how of today’s situation I recommend the following radio show which albeit an hour long, explains it in a lucid manner.

http://www.thisamericanlife.org/Radio_Episode.aspx?episode=365

Future - What Holds?

What does all this mean? How will the future look like? A question that is arising in everybody’s mind and frankly, no one knows. Most people can only speculate. To feel and act contrarian looks compelling to a lot of professionals given where the markets are today. Contrarian thinking calls for thinking against the tide assuming the one way move has been overdone, which could be both when moves are sharply up or down. This CONT process (CON – Contrarian, T- Thinking), if you will, is more a sense and feel to be devils advocate and compelling mindset that says that this one sided move has been over done and hence should correct and therefore positions opposite the trend should be taken. Many contrarians are also value seekers and feel the stocks relative to asset values/book values/replacement costs are undervalued.

Prima facie with the kind of fall we have seen this would be very valid thought process and many may succeed with handsome rewards with this strategy. I would like to put a warning note here. The events that have unfolded over the past couple of months are unprecedented and have very little resemblance to some of the key market falls of the recent past.

http://www.nytimes.com/interactive/2008/10/11/business/20081011_BEAR_MARKETS.html
While it is true that most bull markets have taken roots in easy money/low interest regime and fallen into bear zones as cost of money/interest increased and liquidity tightened, the level of leverage/borrowings seen in the preceding boom period is unprecedented. Borrowing 30 to 40 times net-worth (the investment banking phenomenon), the outstanding derivatives (worth USD600trn. plus - visit
http://www.nytimes.com/2008/10/09/business/economy/09greenspan.html?partner=rssyahoo&emc=rss), the sheer size of the assets funded through these borrowings which have no price or quote etc. has not been witnessed by many of the past falls and bear markets.

Further the global interconnect that has been witnessed this time has no parallel in the past as these cheap funds/leverage found its way to all the key country-markets-asset classes. In this sense the concept of risk reduction through diversification into global or international markets has fallen on its face. This realization has come a little late and the first signs were witnessed when a coordinated rate cut by all central banks happened last week. But this is not going to be an easy task, as each governments has its own constituencies to address and have to see congruence in their political and economic agenda.

So what does all this mean? To me it appears that the rules of the game are set to change and to assume CONT thinking may not be the way to go. And the way the game is going to played in the future is very likely to be different. We need to move to what I call ‘Calibrated Thinking’ or CLBT. The elements of CLBT would be influenced by a number of factors. Some of the key ones which come to my mind are:

1. The leverage levels that currently prevail (even after de-leveraging to the current level) are still high. Overall the world economy, after this experience will look to maintain a level of leverage that is much lower than that we have seen in the past two decades or so. So globally the tendency to spend on borrowed money is going to come down substantially.

2. The level of mistrust between banking institutions will take some time to repair. As of now it appears unless the central banks of some of the western economies stand as counterparties, the flow of credit between banking institutions at a reasonable cost is going to be difficult. Even in the future the internal norms of these institutions of assessing each others credit risk and provide credit limits to each other is going to become extremely conservative. This in turn means lots of checks and balances and delayed decision making resulting in low velocity of funds/credit flow.

3. So, even if the cost of credit comes down over time to help the world economies overcome/ride the downturn, the flow would be stagnated as risk aversion and bias against credit – both on the lending & borrowing side – would make the players extremely cautious – both sides having burnt their fingers.

4. With investment banks gone, gone are the days where large proprietary positions are taken aggressively using leverage. Even the commercial banks which can leverage 10 to 11 times would be extra cautious. The so called hot money flow/foreign funds flow/foreign portfolio investments/ which were essentially arbitrage funds would see its scale diminish drastically. The movement in the markets is therefore going to be much more muted than what we have experienced over the last four years or so. This would suggest that the markets will take a long time to adjust to this new reality before any meaningful move can happen.

5. Following from this is the uncertainty about the fate of so called Hedge Funds where leverage was a large element in their operations. A number of new laws and regulations are going to sprout once the dust settles. No body can be sure what shape and depth this can take. Regions like the European Union (EU) is going to look take a hard look at the future of political and economic congruence of objectives. The coordinated effort has been difficult to come by given the internal politics in each country and the common economic agenda of the EU. We may see Euro vanish and the old country wise currency system back.

6. The effect on the real economies of the world could be really bad if the resolution does not come quickly. This could spill on the main street in terms of job losses and the attendant consequences leading to unrest like situations.

While I believe these are the important factors, there may be other factors which I may have missed and those which come up as this turmoil unfolds further. With all the uncertainties discussed the only thing that is certain now is that the landscape in which future investing and trading will take place is going to be dimensionally different from what prevailed till recently. As these emerge and some sense of its direction comes forth, taking a blind contrarian view may not be the best thing to do. It may work in the shorter term, to play the technical bounces, but can be disastrous in medium/long term.

This is where CLBT comes in where the methodologies used for investing needs to be recalibrated as those which succeeded in the past are unlikely to work in future. You need to think like a maverick, take a measured view and be cold and calculative as the scenario unfolds to understand its influence on the flow of money, its direction and the sectors to which it is likely to be attracted in the new landscape. Remember this new landscape itself may take a year or two to establish itself.

Right now cash is king!

I look forward to exchange of views and would look to update this blog weekly to begin with.

Best luck for the coming week.