Bye bye 2008!

I never thought that world would see a 1929 again, however, I should have remembered that history always repeats itself. 2008 was a mixed year; while the first half began with a huge promise of making this world a happy place despite what had happened in August of 2007, the second half saw a free fall in the world markets. Situation went just worse from bad leaving thousands jobless and probably many more to go. The equity markets, commodities markets, currencies and fixed income markets have witnessed a once in a century event. Financial history text books in future would refer to 2008 as a year of error(s) ... "an error of optimism"

The world paradigm has shifted and to what extent - gone are the days of easy personal loans, gone are the days of making quick bucks in the stock / property markets and with that has gone down the legacy of many institutions around the world which were considered to be the best in their business. I don't have much experience of down falls. The first even correction known to me was the Indian market correction post the HM era. Second known was the dot-com bubble. However, this is my first ever live correction. I was one of the fotunates to have joined the market when the trend was always on the upside; only to see the fall now.

A lot of people ask me where has the money disappeared from the market? Who gained out from this kind of selling in the market? .. My answer to this question is 'No One'. Hard to believe isn't it. No one gain's..how's it possible? Like I mentioned previously, we all have been caught in an error of optimism at the same time. Bad luck! may be. Some of the common features of this error of optimism are as follows:
1. Banks start to lend money freely - they want to earn more and thereby risk more capital
2. Suddenly every one in the markets tries and discounts cash flows which are gonna occur in 3 years from now and sells you a forward 3 year P/E
3. Even a hawker on the street talks about investing long term
4. Growth becomes the ultimate goal of every soveriegn in the world, be it with inflation - doesnt matter
5. A lot of new players enter into the Asset Management, Private Equity and Real Estate business
6. The term 'Value' takes an entirely different meaning...

An error of optimism is nothing but the fact that every one around you is overly optimistic about the state of the world. Unfortunately, we all get stuck into the markets when things look bright and are caught for not exiting because we are too optimistic. Happens to everyone! ... even the writer of this blog ;-)

The good news is that 2008 is coming to an end and 2009 makes new promises about the happy state of markets. May be this correction will soon see its bottom and there will be some massive consolidation in 2009. I just hope 2009 doesn't turn out to be as bad as 2008 was. (I am still optimistic :-) ...hopefully I am not making that error again). Bigger, better, joyous and fruitful 2009 is all I want!

Emerging Markets...

In last few years emerging markets investments proved to be extremely fruitful and everyone on the street wanted to be invested in the emerging markets..why not? Between 2003 and 2007 MSCI Emerging Market index annualized 48% in returns. However at the begining of 2008, when we were deciding our allocations to long short managers we had done a small study if emerging markets were gonna continue to do well or not? In hindsight not increasing our emerging market exposure seemed to be fruitful this year to date.

The study done was really simple..we analyzed the significance of the Emerging Market Index against the World Index. The ratio of price between the world index and the emerging market index touched a low of 0.2446 in 1998 after hitting a high of 0.92 in 1994. This ratio stood at 0.8 at the begining of the year and things weren't looking that good fundamentally (I will explain this in the fundamentals sections)

Also, when we looked at the Alpha generated by the emerging markets over the world index we found that this alpha was never significant in the long run. The 20 years weekly data gave an alpha of 0.016 and the standard error of alpha was 0.011 (0.016 +/- 0.011*1.96 would include 0). However during the period between 2003 and 2007 this alpha was actually significant and emerging market index did produce excess returns over world index.


Fundametals:



So when do emerging markets tend to perform better?

1. Commodity boom: Commodity boom explains the most significant factor contributing to the positive excess performance of the emerging markets. If we look at all the emerging markets; they have one thing in common..excess commodity .. may it be minerals, oil & gas, agro commodities or most importantly labour

2. Global Liquidity: Global liquidity is another major reason for the emerging markets to do well. Liquidity drives consumption which drives demand for emerging market commodities. Hence, now when the global liquidity is drying up we see dwindling growth rates for the emerging markets.


At the begining of 2008 both of these factors seemed to had ran out of steam, however we did see a final frenzy rally for commodities till the middle of 2008. The ratio of emerging market index to the world index now stands at 0.60; a decline of 20% YTD. Emerging Market Index has declined 52% YTD against a decline of 37% for the world index. I believe this ratio will fall further; emerging markets would underperform the developed markets for some time to come. I wont be surprised if we see this ratio going down to 0.40 in the coming months. Long term mean of the ratio is at 0.48 with std dev of 0.16 and I am sure we are going to see one std.dev move on the downside. We shall all wait for the global liquidity to come back with a bang for emerging markets to do well in future.


(P.S. World Index does include a proportion of Emerging Market Index in its composition)

The big slide ...

For past few days, as every other analyst on the financial street, I am trying to figure out when this turmoil going to come to end .. or whether there is some steam left in the sell off's we have witnessed globally ..

Incidentally I pulled up the charts of S&P and Dow Jones since 1990 and tried to figure if one could draw any conclusions from these weekly charts ... .

So here's the chart for S&P 500. It has seen two major falls in the past 18 years ... one was when the S&P peaked in 1998 and we had the russian bond crisis and the crisis of asian currency. The fall had lasted for nearly 4 years ... obviously this peiod had 9/11 happening as well dampening the spirits in the market. Interestingly look at the recent fall on the extreme right you may see the the velocity of the fall has been far more striking .. in just one year (from July 2007 to Sept 2008) we have had a fall similar to 4 years during 1998 to 2002. S&P is now approaching a very important support level of 800 ... if this support gets taken out ... the double top suggest that we may fall another 700 points...

Similiar is the story for the dow jones index as . The index had a trend upwards since the begining of Dec 1993 till 1998 and then a consolidation during 1998 to 2002. A strong trend again from 2003 to 2007 before finally reversing in July of last year. I fear based on the chart that INDU may go down to 7300 levels and may be there's a big support waiting for us then ..
These two charts indicate that we are very close to important supports and if we break these ... may be thats gonna be the end of the finance world!!

Doom strikes ...

Last few days in office have not been less than sheer disaster and this day, 13th October 2008, I see one of the hedge funds being the scapegoted purely because of whats going on in the financial markets world-wide.

This incidentally is (was) the first fund (and only till date) that I created by myself. Right from deciding on the capital allocation to checking the custody agreements and blah blah was done by me when we had launched this fund in August 2007. Wasn't perfect timing; however, everything we could do to protect our capital was done....infact the fund outperforms its benchmark by more than 10% YTD.

Sometimes I wonder what financial sense is? .. is to redeem out of relatively better performing positions or is it staying away from the bad one's. Incidentally whats been happening off late is that investors are selling good positions to fund some of the bad one's. How is that logical... when the market is at peak every one wants to be a part of it and when it turns bad everyone wants to leave ... bizzaaare isn't it ... however that behavioral finance. It feels disgusting to the fund manager though when peer's lose more than you do and you are bashed because you were better than the rest .... I am always gonna keep this email from my boss which said that investors are redeeming all their money from our fund and we have to close it down.... and most f*$%king thing of all we had to prepare the proposal ourselves.

Sometimes when you get up in the morning you feel there is something not right .. this has clearly been a bad day ... right from 9AM (when I saw this mail) the mood's just been terrible ...

Just as I write this blog ..my boss walked into my office ... and I said ... 'what a dis-appointing day ... we are left with only one fund ... I fail my driving license final test ...' and my boss told me strikingly ...'atleast you have a job' (pun intended)

What a week!

I wasn't too surprised to see S&P end positive w-o-w last week. My previous experience was the week of August 6 2007. However in a week's time, it turns out of that 4 of the major investment banks get wiped off the street - Lehman which will be sold in parts, Merrill which got sold in whole and Goldman - Morgan which are now full banks and no longer just independent investment banks.

It also turns out that for the first time in American history a 700 billion dollar rescue package has been annouced. Paulson is undoubtedely going to be the biggest trader of all times. There is no doubt that if any one were to buy these subprime mortgages at 20 cents on a dollar; give a consumer the time he needs to fulfill his obligations; he would profit from the 80 cents he is going to earn. Even if this were to happen in the next 20 years, US treasury earns a 7% r-o-r on their invested capital. However, the only trader who could have bought this market was the US treasury.

Whether it means good or bad for the markets? - difficult question to answer! ... is Socialism the pivotal issue and Capitalism always secondary? or is Socialism always the last resort for all Capitalist wrong doings of the 20th and the 21st century? take a guess ... few men take risk, they get paid for that .. when their trade falls out to be wrong government raises its hand .. wrong doings are never punished for it means bigger harm to the larger society. Isn't that really good .. you may do whatever you want, there's no punishment ... you lose money .. you get more to lose. "Regulations" is an economic term used for Socialism and we will surely witness regulation play a bigger role in shaping financial future. If regulators drive away speculators, an important part of the markets will go missing. Indeed, speculators who failed need to be driven out. Bigger question though is why pull out swords on the successful one's.

Past week wasn't huge because 4 investment banks failed ... it was big because we saw a glimpse of time to come .. time where businesses will be guided by regulations, time where central banks would decide market actions and who know's time where free economy will go back to the books again ...

Few greedy men!

So there it is.... Lehman Brothers is history now. The stock trades at 21cents (closing 15th Sept 2008), down 94% over the previous day. The institution which ran for 158 years was finally brought down by greed of few traders who traded mortgages.

In a way I would say this is a good thing to have happened. Somehow the concept that Leverage mangifies losses was forgotten in the first decade of this 21st century and the financial market did require a sanity check. However, the magnitude of this lesson is certainly glorified by the write off's we have seen over the last one year in the subprime credit markets. Estimates suggests this figure to be somewhere around USD 600 Billion (FED's balance sheet size is USD 800 Billion) and may be there are more losses coming our way. Unfortunately this isn't just a US story any more. It is now going to be a global contagian, Europe has to follow next; no doubut on that. Chineese (Asian) real estate; god save 'em ... Middle East; I dont want to hear about it any more .... It is going to extremely hard to think of new money making opportunities in the next 2 years or so.

The crux of the problem is excessive liquidity. Dick Fuld - CEO of Lehman had mentioned in one of the meetings that ample liquidity is hiding a lot of evils. He was so true. Unfortunately, Investment Banks were the greedy men who gave markets excessive liquidity speaking purely of mortgages. As the velocity of money increases when you package CDO's / CMO's, it free's up capital to be re-invested and if you dont have enough deals to re-invest your money you have two options - one to sit on TIPS or second to make a bad deal look good. Everyone choses the second (after all its a question of pay and perks) :-)

Paradox of plenty...

Ever imagined a situation where having more money is bad?!! ... suddenly it reminds me of Uncle Scrooge (the cartoon character) who used to say 'More money is always good for health'

GCC countries are facing a peculiar problem called 'Paradox of plenty' ... yeah, having more and more oil revenues is actually proving to be a disaster for these economies nowadays. One doesnt have to be an economist to understand that more money you have the more you can spend it as well. Hmm ... however spending more money means that you artificially inflate the price of commodities which are avaliable cheaper and then comes into picture the inflation dragon. Sometimes inflation does play a 'Casper' however it is a ghost afterall.

So lets first understand where did inflation come from .... the answer is not as easy as one would think - its actually a combination of multiple things explained as: firstly, a USD peg when Mundell, MC Kinnon and Kenen's theory proves that Gulf economies and US are no more an "Optimum Common Currency Area"... a falling US dollar meant increasing import prices and since any of the Gulf countries hardly produce goods of basic neccessity the price was surely gonna go up! ... Secondly, as the prices went up the demand for short term funding in name of personal loans started to rise (leave aside an laready looming public debt amount drawn to finance asset price bubbles - specially in the UAE) adding more liquidity in the market. However, these two reasons didnt pose a major risk previously. This was because while the local government's were investing their petro dollar's outside the region, foreigner's were actually pooring in money into the Gulf economies anticipating removal of USD peg's by some of these economies. Due to this available liquidity the interest rates were low and financing inflation or an asset bubble was an easy option.

However, as the anticipation of removing peg's abated we saw the foreign money returning to its destination and a huge shoot up in the short term interest rates (as much as 40% in a month's time). This is a good thing to have, high interest should correct inflation over the long run, however, in the short run it creates tremendous squeeze for liquidity so much so that it affects corporate productivity for every business (the ROC is no longer greater than the COC). Also, if one was to look at the real growth equation: its a function of marginal change in employement and marginal change in productivity. And in the short run both employement and productivity suffer affecting the growth of the economy. GCC equity markets have been hammered (may be 'hammered' is a soft word to use) because the visibility on growth has dwindled. Banks are indeed facing a miny liquidity crisis ( no matter how much one denies), Real Estate: main driver of these economies is showing signs of weakness, government intervention is at its peak and all possible efforts to restore balance in the economy have been made.

Usually, the 'Paradox of Pleanty' is a self-correcting phenomenon and hopefully this correction should happen over the next year. However, governments in the Gulf countries have to re-think their strategies on USD peg, diversifying the growth base away from construction and real-estate, increasing credit standards to avoid piggybacks and most importantly have a regime to control inflation and increase the affordability of living in these countries for expats.