The Great Crash is coming ...

Warning signs are all over ... but no-one is reading them..  Is it complacency ? Is it speculation ? Is it a false hope that somehow someone somewhere will bail out ...


Is it Greece ? No way.. Greece just needs $147 billion for a bailout. US can print that money in an hour .. 

Is it Spain ? How about the Italians ? Will they be the ones who will eventually cause the contagion that will bring the world economy down .. 

The biggest one is still out there. Moody's has just issued a warning that US credit rating may be downgraded. In my opinion the US debt rating should have already been downgraded.. 

US Debt to GDP Ratio is around 98%.

Federal Revenue:GDP ratio is around 30% and Federal Spending:GDP Ratio is 45%+ which means that every year the government continues to spend 50% more than it earns. Unless there are deep cuts in federal spending the debt burden is going to grow and grow and grow and grow.. 


The current US Debt Ceiling is about 14.3 trillion, and as per the Debt clock below, that limit is already reached. In simple words Uncle Sam has already borrowed to the maximum allowed limit. The congress has to agree till Aug 2, 2011 to raise the debt limit.

Under pressure from the rating agencies the congress will squabble and eventually agree to increase the Debt ceiling. Once that decision is reached and the market will temporarily rejoice. Time to sell.. 

However US debt is still attractive for foreign governments, most notable amongst them the Chinese, who depend on a strong dollar to sustain their trade with US. China is still growing at 9%+ and European debt is far worse than their US counterparts.

As per this article: "bought $38 billion in U.S. government debt in May(2011), increasing their holdings 0.6 percent to $4.51 trillion"

Chinese growth story and "There is no Alternative" factor may still sustain the US debt for some more time.. How long ??? 

Eventually the economic fundamentals have to catch up. Sooner or later the world appetite for consuming US debt is going to reduce, especially if US keeps spending at the current rate. 

To reduce the deficit the US government will eventually have to increase taxes and reduce spending. Tax rates are already quite high and increasing them further will only lead to a further slowdown in an economic recovery that is growing more because of availability of cheap credit rather than an improvement in the fundamentals. Reducing spending is the most practical and sustainable alternative. Unless US reduces it's spending significantly we are slowly and certainly looking for a major crash of confidence, crash of dollar and a prolonged economic recession..

However any US president in his first term in office would want to get elected for the second term and prefer to take populist decisions to keep funding wasteful expenditures like excessive medicare, social security benefits to the undeserving unemployed, and wars that are not needed.. Bush-Greenspan brought down the interest rates to near 0% and fueled the "sub prime" crisis by encouraging unqualified borrowers to buy overpriced houses with "zero down". I doubt if Obama can cut down spending for his core constituency.

Bottomline is that US debt ceiling will eventually be increased. The bubble and the monster of US deficit will become bigger and bigger. The more inflated the bubble the bigger the burst. Till such time the world considers US "Too big to Fail" and gobbles up US debt.. we can live in the illusion of growth and safety..


When the bubble bursts.. as it must ... many will remember God

The great Crash is coming... Are we prepared for it ?

Abstract Choices and Portfolio Selection

You are rated as a "Good Performer" in your company annual performance review

Decision Point 1
- Would you buy an insurance policy that provides for 12 months salary if you are laid-off ?

Most of us would say "No". After all you are rated a Good performer and it is highly unlikely that if such a thing happens you would not be the one at the receiving end of things.

Most of us think that they would be relatively better off in an uncertainty and fail to consider the rational alternatives in the event of an uncertain event and base our choices on predefined "heuristics" that are based on our emotional predisposition rather than an objective selection amongst alternatives.

As our decisions are based on emotional predisposition we end up making choices that are objectively incorrect. Just because an objectively incorrect decision turned out to be the right one does not make it the best decision.

Now to rephrase the above decision point if i ask the question..

Decision Point 2
-- "Would you buy an insurance policy that provides for 12 months salary if you are laid-off because the company did misreably due to the current economic recession OR because it got acquired"

Most of us would say "I'll think over it"..

Now the conditional probability of you getting laid off (which includes layoff due to recession or acquisition) is greater than you getting laid off because the company had a bad year.

However in the first choice you (most likely) evaluate the decision based on your assumption that the most likely reason for someone to get laid off are because they are a poor performer and hence on your confidence on your ability is the driving emotion behind the decison

In the second choice you are now anchoring your choice on the likelihood of the company doing bad.. emotionally our confidence in our abilities is greater than our confidence in others abilities.
So as there are "many idiots in top management"(a universal belief shared by even the employees of most successful companies) your confidence in the company's ability to do well is less than your confidence in your ability.

Now we further rephrase the above question..
Decision Point 1.1 (Assuming you said "No" to decision point 1)
- Would you buy an insurance policy that has annual premium 0.1% of your salary and that provides for 12 months salary if you are laid-off ?

In 30 years this premium would amount to 3% of your annual salary and now saying "No" would mean that you are almost 100% sure that you will never get laid off in your working career.

Yet i would not be surprised if many of us actually decline this decision point and stick to "No"..

The reasons are again emotive..

Based on our previous decision that we would not want this insurance policy we are closing our mind at rationally evaluating the new piece of information (0.1% premium rate) and building that into our decision making process.

This happens often when we brand someone as a "star performer" based on our (often) first impressions of someone's capability or quality of work.. Similarly those who have initially not got into the "good books" in terms of how their performance is perceived are unlikely to subsequently get career growth opportunities.

After all Humans are wired to think emotionally..

I'll summarize the discussion into 2 points..
A] We prefer the concrete over the abstract even though rationally the abstract may be more valuable than the concrete (As seen by the choice on insurance policies)

B] Once we decide on a choice the future decisions depend a lot on past choice and we do not objectively incorporate new information into the decision making process..

Now how does this influence our portfolio selection..

- Averaging down a bad stock and then
- Holding on to a loser after you have realized your mistake

==> I had a colleague at Sun Microsystems who had bought the stock at $100 when the .com bubble was at it's peak and Sun was what probably Apple is today..

Eventually the stock started coming down 100-70-40-17 and at each fall more was bought because "it could not go down more than that" and the fundamental belief that the company was good..

He bought more at 9-5-3 dollars and his "averaged down" price was something like $10. Other rational employees who incorporated the "new" information of the dwindling fundamentals "sold" the stock when it
went up a bit and got out. But not this person.. His choice was dependent on his past choice and not on rational and objective evaluation of current data.

I wonder how many Satyam employees are trying to "average down"

Eventually my colleague realized that the fundamentals had deteriorated and the stock should be sold. However he had too much invested (almost half his savings were in the stock) and getting out would mean huge losses. This meant holding on to the losing position with a risk of losing out further.. (i.e an investment with a potential for a downside is always a bad investment irrespective of whether you are profitable or at a loss)

Eventually the company went down and was sold for around $2.

Now assuming that our Human investor had $1000 in investment (at average $10 this is 100 stocks) and when the stock was at $5 he realized that the fundamentals were pointing to a downside risk.

A rational investor would book losses and take the remaining $500 and invest in something with a upside potential. Assuming the new investment is good his portfolio would be worth maybe $700. Holding on to the losers meant that his portfolio is now $200 and it would take some luck to get it to $700

It is possible that at times holding on to a loser (that you now believe would lose further) you would get lucky and recoup your investment. would it mean that you took the "right" decision to hold on to the loser.
I would say that your decision was still wrong and you were lucky. i.e a Lucky Fool

The preference for the concrete also leads us to choose from a limited subset of "known companies" I know many friends at Infosys whose portfolio consists of Infosys, Wipro and TCS stock (and now PERSISTENT).
When asked why they dont buy something like Sterlite.. the comment i often get back is "What does this company do?"

Secondly we tend to value a stock on its absolute price and the price in relation to past price rather than do some valuation in terms of market capitalization. If a certain stock goes down from $15 to $11 we will think
that its a good time to buy it at $11 WITHOUT analyzing if it has gone down because it was fundamentally overvalued and the movement from 14 to 11 is a correction or if the fundamentals are intact and this move presents a buying opportunity. Similarly folks who sold something at $11 will repent if the stuff went from $11 to $15 WITHOUT analyzing if their selling decision was based on their fundamentals and if so then it was the right decision at the time. Similarly if they now believe that new information warrants that the fundamentals have improved and there is an upside even at $15 then they should actually BUY at $15 (irrespective if they have sold it at $11)

Lastly rational decisions may not turn out to be the right decisions in terms of favourability of the outcome. N N Taleb has an interesting anaology of the Russion Roulette (a revolver has 6 slots one of which has a bullet) The trigger is pulled, you either win a $1million dollars or become a part of history.

You and your friend are given the option. You opt out, fearing for your life. Your friend opts in and wins !!! Would you then say that "i wish it was me who got the million.." A favourable outcome based on irrational choice is still a bad decision.

Talking about the markets i see much more probability of a downside than a significant upside from the 18000 levels. Euro debt crisis is not over, China bubble is heating up, India growth story is strong but that has already been built into the price.. Rationality dictated that one should sell off and sit on the sidelines. There is a possibility that FIIs may pump more money and take the index to 20000 but that does not mean that the decision is wrong because it was based on objective rationality..

It's not over yet !!! Worse may be yet to come..

New home sales in US have dropped around 32% to around 300000, the lowest since 1963. This comes on the back of expiry of the federal homebuyer credit.

Quite likely many buyers preponed their purchases before the expiry of the tax credit but 32% fall was much steeper than expected.

http://www.snl.com/interactivex/article.aspx?CDID=A-11371151-13622


Again the US government may well extend the tax credit leading to some improvement in the home sales, but then that is not the point here. Extension of tax credit will just shift the burden to an already excessive fiscal deficit and unless it triggers a real improvement in the economic indicators that is just putting money from your left pocket to your right and hoping that things will improve.

It is just indicative that despite the "worst is behind us" consensus in the markets the fundamentals of the economy have still not improved enough. There are other potential "waiting to happen crisis" like the EURO debt contagion spreading to other countries and this will surely serve as a deterrent for Bernanke against letting the US Fiscal deficit get larger by way of tax credits and bailouts. I think that the federal reserve has already exhausted its ability to prop up the economy by artificially lower interest rates and tax credits.

So we may well be staring at another recessionary period.. this time there will be no bailouts. Surprisingly FIIs seem to think that Indian markets are immune to the global economy and pumping in money into the bourses. That "logic" is only driven by the presumption that India is still growing so if there is any money to be made it's here.

However as a result many scrips are now trading way above their fundamentals. While fear looms large on the world scene our markets are going up in greed. This is a time to book your profits and keep out till a clear direction emerges on the Euro or US scenes. Atleast diversification of the portfolio from US/Euro dependent companies like IT to companies that are growth enablers in India(Infra) will be a prudent thing to do.

Foreign Education Providers Bill : Unlocking economic prosperity through innovation

How many Nobel Laureates (in Science and Economics) has India produced since Independence ?

None

How many Nobel Laureates (in Science and Economics) has India produced till date ?

One. The great CV Raman

How many Nobel Laureates were on the academic staff of Columbia University before or at the time when they got the award ?

57 [Reference]

As a country with more than 15% of the total world population and one that takes pride in learning sciences, isn't it a surprise that none of our universities have been able to come up with fundamental research that has been recognized by what is arguably the gold standard in excellence in sciences and economics.

If not fundamental research what about applied research. After all aren't the Intel's, Microsoft and Oracles of the world staffed with Indians ?

While our track record is slightly better here, none of them can be said to be because of our universities. Most of the successful "Indian" stories have had contributions from western learning and applying that in the Indian context. A speech by Narayan Murthy is definately worth reading here.

http://www.icbs.com/iit/learn-from-west-narayan-murthy.htm

In contrast to this if you look at the applied innovation in silicon valley and just take a few products that have come out of a single university (Stanford) the difference is striking.

Cisco Systems, Google, Hewlett-Packard, Sun Microsystems and Yahoo! all had their beginnings in Stanford and were result of academic research in Stanford being monetized as commercial applications. Today these companies together command at-least $200 billion in market capitalization.

Bottomline: Innovation and especially one coming out of academic research is crucial to a country's economic prosperity. The universities play not just a supporting but a enabling role in creating the innovations and the ecosystem around them.

If we look at the university landscape in India today, we "produce" undergraduates by the truck loads, post graduates in engineering : not many and genuine PhDs hardly.. Arguably this is because most of the educational institutes are still hostage to the "licence-permit" era in which incompetent governing bodies like AICTE dole out "approvals" for running production factories for engineers.

The result is that most of these approvals are then cornered by the "Education Mafia's" with political blessings, the standard of education falls and research is the biggest casualty.

There are almost 40 odd engineering colleges in Pune alone, yet none of them can boast of a PhD program of international repute.

Professor TT Ram Mohan argues in his blog that..
"The secret of the success of IITs and IIMs is that they attract the very best- and they do so because they are affordable"

I disagree. I also disagree that IIT, IIM or COEP for that matter impart top quality education. The secret success of IITs or IIMs is that in a populous country not short on talent the entry criteria of these institutions is so stringent that they attract the best. And since they attract the best they succeed whereever they go and bring repute to the institution. They attract the best because the "second" best institutes are those owned and managed by the "Education Mafia". Also due to the reputation of the Alumni the new entrants are guaranteed success just by association. This guarantee of future opportunities and not affordability is what attracts the aspirants to these institutions.

However as successful these institutions have been in creating successful individuals who have "succeeded elsewhere", these institutions (as compared to their repute) have failed in succeeding at fundamental or applied research.

This can change by competition. And the Foreign Education Providers Bill definately holds the potential to add competition to an industry which has been content in churning out semi-literate (and i count myself to be one of them) graduates. Now competition does not mean that it's the "foreigners" that will succeed.. it may well be the local universities.
The argument is not about the cost or the affordability but of innovation. If the "indian arm" of Stanford can undertake a research project funded by Google at a fraction of the cost and with the same quality that it takes in Silicon Valley, then the funding will come to "Stanford India".. If MIT(Maharashtra Institute of Technology) can demonstrate that it can more effectively utilize funds than the Indian branch of MIT (Massachucets Institute of Technology).. then so be it..

The bottom line is that the current "licence-permit raj" based education system will be replaced by a competition and merit based education system. Premium will be paid and demanded for quality of education and quality of research and people will pay for premium.

Isn't this the same reason why our private schools have succeeded. I am willing to pay Rs30000 per year as the fee for kindergarten not because it is cheap but because it is quality. Swaminomics has this interesting piece in which he has statistics on how as the income levels rise for the poor they are actually prefering to send their children to private and not government schools. http://www.swaminomics.org/articles/20080615.htm

Hope that this bill introduces competition in higher education and that competition in turn brings the quality. The moment india based universities (be they domestic or foreign) excel generating fundamental or applied research it's not far fetched to imagine the next Google or Cisco from the Sahyadri rather than Silicon Valley

Once that happens our economy will take a path of quantum and not incremental growth..

Who's deficit is it anyway ? Why bombing Iraq keeps the deficit going and the dollar strong

Do these two news make economic sense ?

US Fiscal Deficit to touch a record 1.6 Trillion (that's Trillion with a T) in 2010

Dollar Strengthens as sentiment shifts towards safety.

Common sense would dictate otherwise. Would you invest your money with someone who is neck deep in debt and is borrowing as if there is no tomorrow. Would you loan a pauper and consider your money to be "safe".. and apparently "Risk Averse" investors are shifting their investments back into dollar.

Yet why are folks doing it ??

Behavioral economics (branch of economics that studies economic events as a consequence of human behavior) could probably have explained irrational behavior (had it been done by a few investors) but here we are talking about the entirety of collective humanity.

Why is the dollar not crashing through the roof. Why do investors(and we are talking about the reserve banks of almost all the countries here and not the "retail" types of investors) still consider US a "safe bet" ?

The answer i believe lies in a combination of economics, psychology and history (what has history to do with economics)

A] Economics
==> Too big to Fail. Collective faith that the dollar is too big to fail and so putting money back there is the safest bet.

==> The TINA factor. There is no alternative. If not the Euro and not Gold where would you go to keep your money. After all isn't the known devil is better than the unknown angel.

B] Psychology
==> The fear of "what if"
What if the dollar crashes ? That fear in the collective hearts of the reserve banks is sufficient to drive strategies designed to make sure that nothing radically goes wrong.

While both Economics and Psychology do play a role. I feel that the real answer to this lies in lessons from history. "Might is Right" or so they say..

A lesson in history:
The Soviet Union was successful in proping up their currency, not due to the strength of their economy but by the strength of their military. Arguably "Star Wars" program during the Reagan years was not aimed at missiles in space but at "spending USSR to the ground". Soviet defence budget increased to 27% of their GDP however the currency was still strong (artificially) and India still continued to buy Soviet Arms at artificially high currency conversions.

What sunk the soviet union was not just the imbalance in finances but the openness that the "Glasnost" years brought. That led to the loss of "fear factor" that the Soviet Union once had and hence the "fear premium" on Soviet Union vanished. This led to the economic fundamentals (and not the military firepower) dictating the value of the soviet currency. Hyperinflation set in and the rest is history...

Similar parallels can be drawn with current US might, especially the strength of the dollar in face of continuing weakening of the US Economic fundamentals. The dollar is not propped up by "Risk Aversion" but by "Fear Aversion". The fear premium is asserted by occupying oil rich countries like IRAQ for no good reason and propping up unpopular monarchies in many others.

I have a hunch that Obama may be to US what Gorbachev was to the USSR. A new era of peace loving US that pulls out from occupying foreign lands may soon reduce the "Fear Premium" that props up the currency and hence the economy. When that happens only time will tell but happen it will.

Dollar::Oil::Gold

How many times have we wondered on the between Oil , Gold and Dollar prices and how each is influenced by the other. What are the drivers that are responsible for the price fluctuations.

In the past 2 years Crude Oil has fluctuated between $40 to a record of $148 per barrel, that's almost 4 times the lowest price. Gold has touched record highs..

Let's examine the issue, first by understanding the economic value of each and then examining the correlation between them

Gold

Fundamental Economic Theory and Common Sense give us 2 principles..

1. In times of turbulence choose certainty and safety over uncertainty
2. Make sure that your savings don't lose purchasing power with Inflation

If you leave aside the last 60 years and delve into history, humanity has been subject to wars, rebellions, coups and what not.... In such times could you have trusted your savings in some bank deposits or in a currency that can depreciate or disappear anytime ?

Naturally the primary mode of savings was something that will not lose REAL value over time, have a universal appeal and have a relatively low cost of maintenance. Gold fits the bill perfectly and over time not just individuals but central banks of most major countries held some of their reserves in Gold.

Post World War II as the world became by and large peaceful.. trust in the "system" grew. The focus was no longer as much on preserving real value of savings but growth. The mode of savings shifted to avenues that provided the opportunity to get real growth. Stocks and Bonds became popular modes of investment. Gold lost some sheen but the fundamental economics (preservation of real value) meant that it was still relevant more as a safety net rather than a growth vehicle.

Oil

Growth in demand fueled by energy hungry and rapidly growing world economy, scarce and depleting reserves coupled with in elasticity in supply meant that this scarce resources was in great demand. To add fuel to the fire most of the large reserves were in countries that were in the unstable mid-east.

All these factors meant that this commodity was in great demand and also the price was not just fluctuating with demand but also the geo-political climate of countries which sat on the bulk of the reserves.

Dollar

The rise and rise of global trade meant that most countries needed a highly liquid currency that had universal appeal and could readily be used as the currency of choice for international trading. The rise of trade coupled with the rise of US as the dominant world economy meant that the US dollar came to be widely accepted as the global currency.

As a natural extension to this US was the dominant trading partner for most other nations and those who had trading surplus again "invested" their surplus with the dominant trading partner. So US Dollar became the popular currency for countries to maintain their foreign exchange reserves. Growth in US economy fueled growth in trade and growth in US economy also meant a stronger dollar. So "investment" in the dollar was rewarded by strengthening of the dollar and as a result it became the more popular choice over keeping reserves in Gold.


Understanding the reasons behind the price of each of Gold, Oil and Dollar now makes understanding the correlation between them much easier.

A] Deceleration in US Economy will lead to fall in dollar and rise in Gold

As the US Economy slows down and the US Government borrows through the nose to pay for the ballooning fiscal deficit it is logical that the need for the dollar (for trade with US) will reduce, the dollar will depreciate which will mean that the anyone who "invests" their surpluses in the dollar will run into losses. Both these factors combine to put downward pressures on the dollar and the dollar will depreciate.

As a natural consequence of the fall in dollar is that the reserves will now have to be "invested" in alternatives which at least preserve the real purchasing power and for that there is nothing better than Gold.

So the capital will move away from demanding dollar to demanding Gold. So a fall in the dollar is accompanied by a rise in the price of Gold.

As the biggest economy and one with the largest influence on mid-east geo-political situation any real or perceived fall in demand from the worlds largest economy is sure to send the Oil prices falling.

B] Rise in uncertainty puts a premium on safety

Common sense isn't it. As the fear that the stock markets may crash, fear of war, lack of confidence on the economy or any uncertainty of any kind puts a premium on safety. Wouldn't many prefer a decent pay and safe job than one which pays well but constantly has the uncertainty of getting laid off ? Similarly rise in uncertainty puts premium on "safe" investments like Gold and hence a premium on their prices.

Surprisingly even the dollar is considered to be a "safe" investment and hence if uncertainty is the dominant emotion in the market, the capital will move away from riskier investments like Stocks into Dollar and Gold. In which case both will rise while the stock market crashes.

Similarly rise in uncertainty of a financial deceleration will mean that oil futures fall as fewer investors are willing to pay the premium on oil futures. Usually a real fall in demand is counter productive to the Oil cartel so in times of uncertainty the spot price of the oil also falls ensuring that higher oil prices are not a causal factor that lead to economic deceleration and eventual fall in real demand

C] Rise of BRIC [Brazil, Russia, India and China]

This has not been a dominant factor in the past but my prediction is that this is what will primarily influence the prices of dollar, gold and oil in the not too distant future.

Rise of these economies has meant that the relative importance of these countries as trade partners will increase. naturally the countries who are trade partners for BRIC will want to maintain an (increasing) part of their forex reserves/investments in the currencies of BRIC. This will reduce the importance/demand of the dollar as the currency of choice and thereby put downward pressure on its price.

Similarly increasing demand for Gold and Oil from BRIC will combine to flare up Oil prices and put demand driven inflationary pressure on Gold


To summarize, while there is no perfect correlation between Gold, Oil and Dollar the prevailing economic circumstances dictate how these commodities move in relation with each other

- Recessionary US : Dollar Weakens, Gold Strengthens and Oil Weakens
- Uncertainty : Dollar Strengthens, Gold Strengthens and Oil Weakens
- Rise of BRIC : Dollar Weakens Gold Strengthens and Oil Strengthens

Naturally the prevailing circumstances will be a combination of these factors and in most cases the predominant factor will influence how the three move in relation to each other.

Irrespective of what happens it appears that Gold is destined to go higher and the dollar will weaken. So a short dollar long gold investment strategy is definitely likely to yield handsome returns.

Getting started...

After about 20 collective years in the industry .... We have floated a new research and education firm, Finsai Consulting that will aim to provide research and education focused on Financial, Economic and related disciplines.

We truly believe that "Knowledge is for Everyone" and aim to provide unbiased research and analysis that is widely available and simple to understand.

Our blog will touch diverse issues in the global and Indian economy, personal wealth management, stock market analysis amongst others..