Banking: The Next Crises & The Ignorance of the Economic Establishment

Rajib Handa

In over six decades post India’s independence from the British I never recall Repo rates dropping down to 2 per cent and peak rates on 5 year unsecured bank deposits to 7 per cent. Compared to a CPI of 12 per cent banks are now offering negative returns of 5 per cent per annum to depositors, while throwing money at near bankrupt Real Estate concerns at artificially induced low interest rates. The CAPM pricing theory propounded by Nobel laureates Muller and Modigliani professed that the only difference between debt and equity was the tax. So why do investors expect ROEs of 20 per cent on Equity but are willing to settle for 2 per cent income on deposits? If this is not laying the seeds of a gargantuan Real Estate Asset Bubble and everything else connected with it, then what else is it? The repercussions of easy money will be felt over a number of years, but the disaster will strike investors in many forms. So Brace yourself up. It’s easy to understand how loose monetary policy causes inflation and/or speculative bubbles. But the economic establishment in Washington, on Wall Street, and more or less all over the world refuses to acknowledge the cause and effect relationship! They insist on Keynesian theories of macro managing the economy mainly by monetary and fiscal policies, thereby rapidly increasing the government’s influence. Their models and theories totally missed the importance of the real estate bubble and its aftermath … the most severe crisis since the Great Depression. And they were incapable of forecasting the meltdown of the banking system. It should be clear that following the wrong models and theories leads to the wrong conclusions and wrong policies. And that’s exactly what’s going on today. The policy prescriptions since this crisis erupted are the very same that laid the foundation for the real estate bubble. So the toxin that caused the crisis is being given as the antidote! This has led to a postponement of the next stage of the current crisis. Yet if governments keep throwing trillions down these rat holes, we’ll end up with a financial and economic catastrophe much larger than the current one. So although I suggest you take a bullish medium-term view, you should remain very bearish about the long-term. Remember … Secular Bear Markets Consist of Cyclical Swings I believe that the stock market and the economy entered a secular bear market in 2000 when the technology bubble burst. The first recession took place in 2001, and the first cyclical stock bear market ran from 2000 until 2002/03. That’s when governments all over the world implemented extremely easy monetary and fiscal policies. Their strategy worked … the recession stopped in its tracks. But it came at a very high price … starting a real estate bubble. This artificial and unsound boom lasted until 2007. Then the bubble burst and all hell broke loose! And the second recession and the second cyclical stock bear market began. Again governments stepped in, but to a much larger degree than in 2001-2004. And, for now at least, they’ve rescued the banking system by bailing out nearly all big banks and initiated a medium-term uptrend in the world’s stock markets. The long-term analysis is simple and easy: With each round of counter crisis policy, governments are upping the ante. So each crisis is getting more expensive and more damaging than its predecessor. The severity of the 2007/08 crisis should make it clear what an even worse version could look like: The total collapse of the banking system and of the world’s dollar-based financial system, probably including the bankruptcy of some states. Even hyperinflation seems to be a probable outcome of these policies.

Why The Mad Urge To Own Patently Rigged Stocks Like Unitech, Anantraj et al…?

By Rajiv Handa

Those who have been long enough in the Indian Stock markets will never forget that post the Year 2000 collapse of TMT, those very tech stocks doubled and halved four times in the succeeding year before most of them disappeared from the radar screens of investors. Ofcourse some investors still nurse fond hopes for HFCL, Silverline, Pentamedia and Crest Communications. But they remain hope.

 

Something similar his happening to Real Estate stocks: Anantraj goes from Rs 30 to Rs 120 and comes back to Rs 90, Unitech from Rs 20 to 90 and comes back to Rs 63, DLF goes down to Rs 125 and then to Rs 375 and back to sub-Rs 300 and so on.

 

Why is this happening? Most of these corporates are going for QIPs, (an estimated 3.75 bn is to be raised by Realtors), and $ 2 bn has already been raised, hence the urge by interested groups to back their horses, even when houses are not selling. I said “houses” are not selling, not “horses”…but the “horses” are doing just fine.

 

The fact remains beyond interest rate cuts precious little on the price and inventory front has been achieved. A Rs 7 crore apartment does not become affordable at Rs 6.70 crore even if borrowing rates go down to 8.5 per cent teaser rates. The flip side of the argument is, that a person without job is still going to renege on mortgage payment even if interest rates go down to zero.

 

So do you still think, there is no solution to the ‘housing affordability crisis’?

The fact is, there is. And it’s simple. Are you ready?

It goes something like this. You remove all the subsidies, taxes, and duties that distort house prices. And you leave it to a free market to decide what the price of a property should be.

It’s the simple, and it’s not hard to implement. The problem is it won’t happen because policy makers, banks and special interests are worried that it would cause a massive slump in property prices.

As for this idea of a “clear shortage of housing in India”, well, we hear that all the time. We hear that there is a shortage of 1 mn houses. But that doesn’t mean prices will always rise, or even stay the same.

As written before, supply and demand isn’t just about supply and demand, it’s about price as well. The argument over the shortage of housing seems to argue that because there is more demand than supply then prices can continue to rise without a crash.

This is blatantly incorrect. The very fact that government’s and spruikers like Rajiv Singh of DLF and Sanjay Chandra of Unitech have come up with so many hare-brained schemes is a clear admission by them that the property market is over-priced.

If further proof was needed, I’ll let you decide if this industry has any future whatsoever. First, most North Indian Realtors bought farmland at ridiculous prices, on which each and every project to be built will be unviable irrespective of where interest rates go to.

 

Secondly, with the GOI planning to raise massive sums of money to fund its deficit either interest rates will go up substantially from hereon, or the Rupee will be debased by monetising the deficit which in normal circumstances should imply inflation in just about every asset class.

The thing is, even before interest rates have risen significantly, more homeowners today are struggling to pay off the mortgage than were struggling when interest rates were at 12 per cent plus. They are no better at 8.5 per cent.

But don’t think that’s as bad as it will get. It will get much worse. And the mainstream media are happily cheering the property market all the way to the edge of the cliff.

Privately real estate purveyors are calling for a price fall of atleast 40 per cent from current prices and a multi-year bear market in Real Estate. To believe or not to believe…in a slightly distorted version of the famous quote from Hamlet, the choice lies with the investor.

Investing In Real Estate Can Possibly Destroy You

Make no mistake; as bad as the housing market gets, it will eventually stabilize and resume its upward trudge.

And when that happens, probably a few years from now, we’ll see a truly once-in-a-lifetime buying opportunity. Perhaps the best housing deals this country’s seen in over a century.

But even then, buyers will be facing an inordinate amount of hidden risk, in the form of massive amounts of real estate fraud.

That’s because incredibly huge bubble-sized profits gave mortgage brokers, bankers, builders, fraudsters and homeowners the incentive to rip people off…the incentive to “game the system” at the cost of honesty and fair play.

You might think this fraud is likely winding down…what with the death of the housing bubble and all. But in reality, the opposite is happening. With the housing bubble burst, go any legitimate bubble-sized profits…leaving just one alternative for fraudsters not wanting to face a rude awakening…

The New Generation of Fraudsters

Back just a few years ago, mortgage fraud felt like a black-tie affair. At least compared to what it’s become today…

Granted, the criminals have definitely changed.

It used to be a non-descript – often ex-convict – seller, and an equally non-descript straw buyer. Seller scoops up the house at an inflated price, turns around and sells it two weeks later, and he makes US$150,000 in fast, easy money. Talk about flipping a house.

Anyway, seller clears his mortgage and takes home the profits. He gives said straw buyer a cut, and the buyer disappears. At the end of the day, the bank has effectively inflated the money supply by a small degree to put money in the hands of a criminal. Just the kind of thing to make your skin crawl.

But today, it’s different.

It’s television ads, builder scams, and call rooms. It’s individuals within organizations, out for personal enrichment at the cost of an already fragile real estate market…and perhaps even your hard-earned savings.

In a sense, it’s to be expected following such a massive housing bubble. As a recent FBI report on mortgage fraud put it, “Industry employees sought to maintain the high standard of living they enjoyed during the boom years of the real estate market and overextended mortgage holders were often desperate to reduce or eliminate their bloated mortgage payments.”

So let’s look at a few of these scams, just to get a sense of what one might look like…

Scam #1 Bailout Money & Foreclosure Assistance ads

If you live in South Florida, it’s a cute young girl on television, telling you, “the Federal government has set aside special funds to help homeowners in need…” There are also mailers, cards, websites and Internet ads. Through deed transfers, payment of up-front fees, and other means, homeowners can allegedly escape foreclosure.

Naturally, it’s all forged documents and rude awakenings from there on. “In extreme instances,” says the FBI report, “perpetrators may sell the home or secure a second loan without the homeowners’ knowledge, stripping the property’s equity for personal enrichment.” Ice cold.

And it’s a shame too. Because for many of these distressed homeowners, the answer to their troubles is actually bloody simple. Let me explain…

Their gazillion-page mortgage was bundled with hundreds if not thousands of others, then sold to someone – a bank – who didn’t really care. Now I spent a little while in the consumer debt industry, and I can tell you that banks like paperwork about as much as the mafia does. They used to charge about twenty dollars just to bring you an account statement.

And with mortgages it’s an even bigger quagmire.

The Mortgage Electronic Registration System (MERS) scanned all the paperwork, so it’s all on computers somewhere. But most state laws require the original signed document as proof. And it’s your right to ask for it. Generally that can send them bumbling back to the woodshed. They’d rather stall than look through a few million stacks of original mortgage documentation.

So the ads could’ve just told the people to “ask for the original paperwork (proof),” and they wouldn’t even need to respond. But where’s the slimy profit in that?

Scam #2: The Builder Bailout Two-Step

You’re going to have a hard time disagreeing with this one, because it involves the banks getting ripped off.

And that’s not just because you probably hate the banks. But you think that by this point, they’d actually be focused on getting the job done. We’ve pumped trillions of dollars into some of these companies so they could do precisely that. But it still seems that if one really wants to rip a bank off, it’s not that hard…

Usually this one happens when developer’s having trouble unloading a property, don’t mind getting their hands dirty to do it. Using shifty tricks in the paperwork, they’ll confuse lenders on the terms of the deal. To quote the FBI, “In a common scenario, the builder has difficulty selling property and offers an incentive of a mortgage with no down payment. For example, a builder wishes to sell a property for $200,000. He inflates the value of the property to $240,000 and finds a buyer. The lender funds a mortgage loan of $200,000 believing that $40,000 was paid to the builder, thus creating home equity.”

Unfortunately, there’s no equity involved. And the bank gets caught giving a sizable loan on terms they never agreed to. Should the mortgage-holder default, the bank is stuck with all the expenses.

But one of the only ways this could affect you personally – assuming you’re not a banker – is if you find yourself in possession of mortgage-backed paper with these kinds of “equity included” deals underlying your investment.

Scam #3: The Outright Ponzi

It sounds brazen, yes, but for a bold few…like the guys at AFG Financial Group, it worked. For a while at least.

AFG, a ring of 25 lawyers, mortgage brokers, appraisers and bankers was recently charged with $100 million in outright mortgage fraud. Back in the heat of the bubble, these guys used inflated appraisals, forged documentation and fake deals to bilk some major players out of huge amounts of cash.

New Century Financial, Countrywide, and Washington Mutual can be counted among their victims. Add in a heap of straw buyers who often weren’t aware they were straw buyers, and you have the makings of a great crime novel. Good thing they’ll have plenty of time to write.

But as much as you may think these ponzi-style schemes of outright fraud are a thing of the past – a relic of the real estate bubble – think again. As investors start to sift through the depths of paperwork behind the U.S. mortgage market, these scams will likely keep coming to light. So keep them in mind if you ever find yourself bottom-fishing real estate debt (an extremely profitable enterprise if timed and carried out correctly).

Scam #4: Short-Sale Fraud

And with this, the last of our scams up for review, we come full circle. Or at least close to it.

This kind of scam is favorable for our “old school” fraudster, the kind who works with straw buyers. Except he can double up; by purchasing a short-sale property from another straw buyer.

Essentially, the first buyer goes into default. And because our fraudster’s in touch with him, he knows all about the timing. So before the foreclosure sale, he approaches the bank and makes an offer. If he makes the right offer, the bank accepts, and he gets a discount – without having to compete at auction – and no one even suspects fraud.

He can then turn around and flip the house – as in the example above – and make fraudulent profits two times around!

I know what you’re thinking. The banks loaning him the money…aren’t these the guys we’re currently bailing out? And weren’t these mortgages averaging over US$200,000…and much higher in some places? So it’s possible we’re bailing out over a million in toxic mortgage debt; just because of a single incident of fraud?

The answer on all accounts is – of course – yes.

Caveat Emptor

Warren Buffet is famously quoted as saying, “Only when the tide runs out do you see who’s been swimming naked.” And Bernie Madoff’s arrest and sentencing over the last few months seem to suggest Warren’s right.

But as you can see from the examples above, naked swimming is alive and well even as we approach low tide. At the turn of every corner, the fraudsters still have a leg up on bankers, homeowners and investors. By comparison, the feds and the banks look like dopey, lumbering buffoons. Sure they might “crack down” on one kind of fraud, but that just drives the criminals elsewhere.

So make no mistake; apparently the “real estate fraud” bubble is lagging housing. Because even though the real estate market has already peaked out, fraud still seems to be growing.

DON’T file your tax returns just yet!

The devil, they say, lies in the detail. And here’s one that threatens
to derail the income tax return filing process. Individuals now need
to mention a unique transaction number (UTN) against every tax
deducted at source entry.

The problem, though, is that infrastructure to generate UTNs is still
not in place, leaving income tax assessees in a lurch as July 31,
2009, the last date to file returns for the financial year 2008-09,
fast approaches. “Nobody can say whether the returns will be valid if
filed without UTN,” says Sandeep Shanbhag, a chartered accountant and
director, investment and tax advisory, Wonderland Consultants.

In a circular dated May 21, 2009, Munesh Kumar, secretary, Central
Board of Direct Taxes, said, “The credit for any TDS…claim will be
allowed…if the assessee quotes the relevant UTN for every TDS.”
Simply put, if a UTN is not mentioned against a TDS transaction then
the tax already paid by the individual will be considered unpaid.

It then becomes necessary that companies, who deduct tax every month
against salaries, provide employees with UTNs against these
deductions. This UTN then needs to be mentioned in the Indian Income
Tax Return form that is used for filing tax returns.

“You won’t get the tax credit unless the UTN is quoted. If they go
ahead with the regulation, the person will have to pay the tax all
over again along with the interest and penalty,” says Shanbhag.

This logic will also hold for any TDS that a bank might have cut on
interest earned on fixed deposit. Like employers, even banks will need
to provide a UTN.

As per the May 21 circular, the National Securities Depository Ltd is
supposed to issue UTNs to the deductor of TDS (companies, banks) who,
in turn, has to pass on the UTN to the deductee.

That, clearly, isn’t happening anytime soon primarily because the
change was introduced on May 21, 2009, nearly two months after the
last financial year came to an end.

“We don’t issue certificates in the middle of the year and the UTN
number will be given only by May 2010,” says KVS Manian, group head -
retail liabilities & branch banking, Kotak Mahindra Bank.

None of the form 16s received from salaried clients has any mention of
UTNs, say chartered accountants. “UTN is to be provided for the
accounting year 2008-09.Everybody – banks, employers etc – has issued
TDS certificates and form 16 as per the old law,” says Ameet Patel,
partner at chartered accountancy firm Sudit K Parekh & Co.

Aware of the problem, the CBDT is in the process of amending this
rule. Shishir Jha, CBDT spokesperson, says, “Action is being taken to
ensure that assessees do not face any difficulty. Individuals are
requested to wait a week for clarifications.”

Given the uncertainty, it is advisable to wait for a week or two
before filing your IT-return, says Shanbhag. “We have 40 more days to
go till July 31. So, when there is such a big issue involved, one
should wait,” he says.

—————————————————————————————
Since I cannot increase the content of life by increasing its duration,
I will increase it by increasing its intensity…Art, Music, Poetry,
and everything else that I do have this one purpose—increasing the
intensity of my consciousness and life.
HOMI BHABHA (1934)

Funds shuffle scrips as Nifty floats

The shift in S&P CNX Nifty, the favourite index of numerous investment schemes both at home and abroad, to a new system of computation is likely to get the fund managers busy this week.
The index, which is a benchmark for at least 73 equity diversified schemes of Indian mutual funds, is going for a major change in its composition.
The National Stock Exchange’s flagship index will shift to free-float capitalisation method from June 26.
Under the method, the weightage of each of the 50 component stocks in the index will be proportionate to the amount of free float.
Free float is the number of shares of a company in public hands — stock that is “floating free”, that which is not with the promoters.
Globally, most indices are moving to this system as it is perceived to be more representative of market action.
Experts say, with the new system coming into vogue, funds would need to adjust their portfolios accordingly.
“Managers who are tracking the Nifty closely, may have to make allocation changes. People who are mirroring the index should make bigger changes,” said Deepak Mohoni, MD, www.trendwatchindia.com.
Benchmark indices are important to two broad kinds of investment schemes: ones that track market indexes (index funds) and funds whose managers choose securities to buy and sell (actively managed funds).
While index funds mirror the index components, active funds operate on a relative return basis, wherein performance of the fund is judged by comparing it to the performance of the benchmark.
Some of the action is already visible in the prices. Stocks which are bound to lose weightage post this reorganisation, especially the PSUs, are out of favour.
“A significant portion of the adjustment has already played out and one can see the result of that in the fall of NTPC and ONGC and the outperformance of L&T and private banks,” said Anand Shah, head of equities at Canara Robeco MF.
While Reliance Industries will retain its position as the top-weighted stock due to its high free-float component (50%), ONGC and NTPC are likely to lose weightage.
Oil and Natural Gas Corporation (ONGC) has the second-highest weightage (8% )in the Nifty under the Total M-cap regime. This is bound to come down to 3.5%.
Similarly, the index weight of National Thermal Power Corporation will drop from 6% to 1.9%.
The reverse will also be true as some stocks such as Infosys will have a high free-float gain at the expense of these.
The weightage of Infosys, currently at 3.77% in the Nifty, will increase to 7%. So an index fund will appropriately double its holding of Infy shares.
ICICI Bank will increase its weightage from 2.96% to 6.45%, while Larsen & Toubro goes from 3.27% to 6.41%.
Some absolute-return products based on the index and long-term players like insurance companies who tend to mirror the index would go for shuffling of portfolios, said fund managers.
“Arbitrage funds and structured products, which track the Nifty, would also see some changes made. The majority of the action would take place on June 26 for index funds,” said Gopal Agarwal, head of equity at Mirae Asset Global Investments.
Jayesh Shroff, fund manager at SBI Mutual Fund, said, insurance companies and the funds managed by them are more likely to be affected by such a change.
“As far as they are concerned, it would already have started,” said Shroff.
The effect on the broader will be very short-term, feel experts.
A Balasubramanian, CIO of Birla Sun Life Mutual Fund, said there might be some minor changes in the portfolios of schemes. “A fund manager will change his scheme’s holdings on the basis of valuation rather than events such as these,” Balasubramanian believes.

Hedge-Fund Gate Bashing to start now

It may be time for investors to storm the hedge-fund gates.

During the market’s crisis last year, more than 15% of all hedge funds imposed restrictions on the withdrawal of money by investors. The explanation from managers: Illiquid markets for some assets meant that selling would destroy value for their clients.

But one furious rally later, only a handful of funds have disclosed concrete plans to hand back money, raising questions about whether some are actually resisting the move, perhaps to keep their firms alive.

There remain assets, such as some convertible bonds and insurance products, with limited trading. But some traders suspect that a number of hedge funds have placed improper values on some of their investments, and if they sold positions, it would force them to lower their returns.

Investors need to levy pressure on funds to sell positions and hand back cash. If not, they risk being caught in a cynical game where funds cling to positions. By not complaining, funds of funds, for example, can pretend an investment still commands a high valuation and continue to charge high management fees by telling their own clients they can’t get the money back.

There are rumblings that investors are beginning to fight back and push for liquidations. For example, Carl Icahn and other investors tried to stop Warren Lichtenstein’s Steel Partners II fund from converting into a listed investment company, demanding a liquidation of the fund instead.

It may cause some short-term pain, but as the hedge-fund industry tries to recover from a year of broken promises, dropping gates is a vital component for regaining investors’ trust.

Small is beautiful… but can be risky too

Be it the world of cars or the stock market, “small” appears to be in vogue. In the equity rally that began early March this year, stocks in the mid- and small-cap space have delivered returns that trounce those of their large-cap competitors.

Wondering what makes these stocks so attractive? Well, it is their high-risk and high-return positioning that charms the most, though their low valuation also appeals to certain investors. Read on to understand why small- and mid-cap stocks, believed to be multi-baggers in the making, come bundled with higher risks.

Market capitalisation, an indicator of the value placed on a company by the market at that day’s price, is a product of its market price and outstanding number of shares.

While there’s no clear-cut demarcation to differentiate the stocks based on their market capitalisation, given the dynamism of the equity markets, it can be assumed that stocks with market cap less than Rs 2,000 crore fall in the small-cap category, while those above Rs 7,500 crore are of the large-cap genre. The ones that fall in the middle zone are the mid-caps.

 

Large caps – few surprises

 

 

Large-cap stocks enjoy a large scale of operations; have established business model and hence have lower uncertainty in business. Besides, analysts, fund managers and investors alike, closely monitor these stocks. So, while the risks associated with investing in large-cap stocks are known, their likely returns aren’t unknown either.

This makes large-cap investing safer and more suitable for investors who have little stomach to relish uncertainties in investing. This is also why large-cap stocks are most sought after during periods of uncertainty in the markets. But on the other hand, investing in small and mid-cap stocks comes with higher risks, given their lower scales of operation.

While some of the companies in this cadre are still far from establishing their businesses, others are relatively new in their sector — which makes predicting their future revenues tougher. But it is precisely this heightened business risk that sweetens their return potential significantly.

History has it that multi-baggers in most equity rallies are, more often than not, stocks from the mid- and small-cap category only. It is then no surprise that the current rally too saw the small- and mid-cap stocks return higher.

When benchmarked on their year-to-date returns, the mid- and small cap stocks have scored a stellar 80 per cent and 85 per cent returns, while the BSE Sensex gained by 60 per cent.

High risk, high return

 

 

The desire to invest in smaller companies comes, from their ability to return higher. Sidelined by analysts and investors and weighed down by the higher degree of earnings risk, these stocks do not command the valuations that larger companies usually do in the stock markets.

For instance, while a large diversified company such as L&T commands a consolidated valuation of about 25 times currently, smaller ones such as McNally Bharat or Shriram EPC, which are in similar lines of business, enjoy a lower value. Why? While L&T has a wider business presence, large clientele and stable earnings outlook, the smaller ones compare less favourably with it on almost all these counts.

However, with the economy beginning to revive and credit availability easing up, investing in smaller companies may hold higher returns potential, with the advantage of a low base.

Not only do these companies hold the potential to grow at a higher pace; their earnings growth cannot also be easily replicated by their large cap peers either.

For instance, while net profits of Yes Bank have grown at a compounded rate of 53 per cent over the last three years, that of ICICI Bank has grown at about 10 per cent only.

It is this ability to scale high earnings growth that fuelled the recent rally in the mid- and small-cap space, once it became clear that the economy was beginning to get back into shape. For instance, between the cement major ACC and its smaller peers Dalmia Cements and Shree Cements, the stock performance of the latter two was way better in the run-up since January. While ACC delivered 68 per cent returns, the other two stocks registered 82 per cent and 131 per cent returns, respectively.

The trend was similar among stocks in other sectors such as FMCG and IT too. Infosys’ 38 per cent return since January appeared trifle when compared with the triple-digit gains recorded by mid-caps MindTree (117 per cent) and Hexaware (149 per cent).

Earnings trap

 

 

But if investing in small- and mid-cap stocks appears exciting, don’t turn a blind eye towards their earnings. While it is natural to get carried away by the seemingly low valuations, remember that they do so for a reason.

If the probability of these stocks to more than double their earnings is high, the probability of their non-performance is also equally high. Since their businesses are at a nascent stage, their earnings are highly vulnerable to a downturn. In 2008, a year mired with recessionary trends, the BSE Sensex declined by 53 per cent. But the mid-cap and the small-cap indices declined more, by over 67 per cent and 72 per cent, respectively.

This may explain why ACC trades at 13 times, while Dalmia Cements or Shree Cements trades lower at eight times and seven times. Here again, while the mid-caps are somewhat better off, it is their still smaller peers that become unpredictable during uncertain times.

Besides earnings risk, investing in small-cap stocks also bundles with it liquidity risk and higher impact costs. And since most small stocks sport a high promoter holding, the promoters’ credibility also becomes pivotal in determining the fate of your investments.

A Long Way to Inflation

Most of the media seem to have interpreted today’s lower-than-expected increase in the producer price index as good news. I’m not so sure. If you were worried that 5% inflation was just around the corner, then naturally you will have felt relief. Personally, I was more worried about deflation, and I still am. The inflation risk, if it exists at all, is in the distant future, and you could even argue that deflation in the short run increases the risk of high inflation in the long run. It’s hard for me to see how falling prices today are good news at all. And prices – excluding food and energy – did fall in May according to the PPI.

You might worry about energy and commodity prices feeding through to the broader price level. I’m worried about that too, but not in the way you might think. Undoubtedly some of that feed-through is already happening, and it hasn’t been enough to keep core producer price growth on the positive side of zero. I’m worried about what happens when commodity prices (1) stop rising (which they must do eventually) and/or (2) start falling again (which they may well do if the recent increases have been driven largely by unsustainable forces such as stockpiling by China). If core prices are already falling, and only energy prices are keeping the overall PPI inflation rate positive, what happens when energy prices stop rising?

What worries me particularly is that about 70% of the costs of production go to labor, and the forces of deflation work very slowly in the labor market. The data that are coming out today are only the tip of the iceberg. We’re already seeing evidence of the loss of upward inertia in compensation. Wage growth is decelerating, and, based on all historical experience, the deceleration is likely to continue – in this case, to continue to the point where it becomes deflationary.

I’m not talking about what will happen in the next 6 months; I’m talking about what will happen over the next 5 years. “Green shoots” – however green they may be – do not presage an imminent end to deflationary wage pressure. And they certainly don’t presage the beginning of inflationary wage pressure. Consider everything that has to happen before the wage pressure reverses and becomes inflationary:

1. Output must stabilize.
2. Output must start growing.
3. Output must grow faster than trend productivity.
4. Firms must slow layoffs to the normal rate.
5. Firms must remobilize slack full-time employees (workers who are still on the full-time payroll but aren’t being asked to produce much, because businesses have been trying to reduce inventories).
6. Firms must bring part-time employees back to full time. (This recession in particular has been characterized by the tendency to reduce hours rather than laying off employees.)
7. Hiring (which has been falling rapidly) must stabilize.
8. Hiring must rise to the point where it equals the normal rate of layoffs, to get total employment to start rising.
9. Hiring must become rapid enough that employment starts to grow faster than the population.
10. Hiring must become rapid enough that employment growth is faster than the sum of the population growth & labor force re-entry. In other words, net hiring has to be fast enough to absorb all the workers who will start looking for jobs again once there are more jobs around to look for.
11. The unemployment rate must start declining.
12. The unemployment rate must decline by 4 or more percentage points, which, by historical experience, will take a matter of years.
13. Firms must start competing for labor.
14. Firms must start raising wages.
15. Firms must raise wages faster than trend productivity growth.

Maybe – just maybe – we have already reached step 1. Step 2 may be just around the corner. There is no evidence thus far that we are approaching step 3. As for steps 4, 5, 6, 7, 8, 9, 10, 11, 12, 13, 14, and 15……that show may come to town eventually, but…I don’t see much need to start reserving tickets in advance.

Will Suzlon Lose All The Gains Of The Last Three Months?

By Maverick

Do investors have any bubbles left in them? How About Wind Energy?

  

You Bet. It is Alternate Energy…take away tax benefits off Wind Farms and what you leave behind are Steel Pillars adorned with Steel Blades, rotors and turbines waiting for the next gust of wind to come..to produce unstable, non peak load and the most expensive energy on Earth. This is the Bubble that investors have to be the most cautious about, and naturally the best short is Suzlon.

In the days of free and easy money, under the leadership of Federal Reserve chief Alan Greenspan (once dubbed the ‘Maestro’, though strangely enough, not any more), investment became a big game of ‘spot the next bubble’.

With hindsight, investing was easy. You just had to ignore things like fundamentals and rationality, and buy whatever everyone else was buying. Trouble was, you also had to avoid being the ‘greatest fool’, and bail out before the bubble popped. Lots of people didn’t, hence the current pain being caused by the property slump.

Losing money in bubbles is painful and teaches a hard lesson. We’ve had two in less than a decade – the tech bubble and then the property bubble. Surely it would be difficult to take investors for a ride again?

Certainly it would be difficult. But not impossible…

 

Investors do learn from bubbles…

James Montier at Societe Generale is a specialist in ‘behavioural finance’. This basically takes psychology and applies it to the field of investment and economics.

As someone who’s studied psychology in the past, I’d be the first to admit that it’s a pretty ‘soft’ science compared to something like physics, for example. But compared to the pseudo-science that passes for economics, it’s positively respectable.

And given that markets are anything but rational (even the Chartered Financial Analyst Institute admits that most of its members have lost faith in the ‘efficient markets hypothesis’), it makes a lot of sense to take investors’ all-too-human characteristics into account when trying to figure out what markets might do next.

In a recent research note, Montier took a look at the psychology of bubbles. As suggested earlier, you’d think that investors would learn. If they’d seen one bubble, they’d be more careful in future.

And in fact, they do learn. An experiment conducted by joint Nobel prize winner Vernon Smith used an investment game where investors could trade a dividend-paying equity under four different random economic conditions, each of which would result in a different dividend payout.

In the first game, investors at first undervalue the equity, then massively overvalue it, creating a bubble which then deflates. Smith then got the same people back to play the game again. What happened? Well, says Montier, “far from learning from their experience in the first round, participants generally go on to create yet another bubble!” And when they were asked why, “the most common response was they thought they could get out before the top this time!”

However, when Smith asked the same players to play a third time, this time they’d learned. “You end up with a much tighter correlation between the market price and fundamental value,” says Montier.

So twice bitten, thrice shy, it seems. And you might therefore expect the current generation of investors to have learned from the two big bubbles of the past decade.

…but they can get sucked into creating them

But that’s not the end of the story. Smith found that there was a way to get experienced investors back into bubble mentality. How?

 

He cut the amount of stock available in half, and doubled the amount of cash in the game, “effectively creating what might be termed a massive liquidity surge.” This time around, even the experienced investors were sucked back into creating another bubble, although it peaked earlier than the previous ones.

“A massive liquidity surge” is exactly what the world’s central banks are trying to create just now. Montier says he has no idea if it will be large enough to “reignite a bubble (and of course another crash afterwards).” But as US fund manager Jeremy Grantham of GMO has pointed out previously, we’re currently seeing “the greatest monetary and fiscal stimulus by far in US history”. So if that doesn’t do it, arguably nothing will.

The next big investment bubble

We’re not sure that investors have another bubble in them just yet. But with all that money floating around, it’s eventually going to go somewhere.

 

And one area stands out as a prime candidate – alternative and renewable energy.

The sector has the heavy backing of the government. It has some great stories behind it – solar towers, wave farms and electric cars – all linked together by smart grids, already being hyped as “the energy internet”.

There’s also a genuine infrastructure problem to solve. The laying of internet cables and railway lines bankrupted many people and companies. But those bubbles created the infrastructure necessary to improve our lives and increase productivity and efficiency.

 

Alternative energy has a similar driving force behind it. Regardless of your take on the greenhouse effect, you can’t deny that it would be useful to reduce our dependence on oil.

So the conditions are ripe in the alternative energy sector for a bubble.

Entry load waiver: Investors get to bargain-hunt

Investors can look forward to lower costs on their mutual fund purchases and greater bargaining power with their advisors, after SEBI’s Thursday move to do away with entry loads charged by fund houses for their open-end schemes.

MFs currently levy a uniform 2.5 per cent entry load (on the prevailing NAV) on all equity funds sold to retail investors.

This entry load is usually passed on by the fund house, almost in its entirety, to the distributor who marketed the fund, be it an individual financial planner, distribution house, online portal or brokerage house. The entry load effectively reduces the initial investment a person makes in a fund.

For every Rs 100 invested, only Rs.97.5 would actually be deployed, with the rest pocketed by the distributor.

More choice

 

 

With no entry loads, it will now be up to the distributor to levy a separate (and transparent) commission for the services he renders to his clients.

Distributors will be free to compete with each other, offering lower commissions to lure investors into their fold.

An investor will have greater choice — either hunt for a bargain if he doesn’t need advice, or pay a higher commission if he values the quality of advice given.

Currently, neither of the parties had this flexibility, as entry loads of 2.5 per cent are “bundled” into every equity fund (debt funds usually charge no entry loads) bought through an agent.

Competition may trim costs

 

 

Having said this, will the entry load waiver actually reduce costs for investors, given that a commission still has to be paid? Much will depend on how intermediaries actually react to this move. If all of them decide to retain commissions at 2.5 per cent for every equity fund purchase, investors may not have much of a choice in the matter.

However, two factors may actually help in bringing down costs for investors over the medium-term. One, the mutual fund distribution industry is fragmented and made up of many participants — ranging from banks and financial services firms (such as Bajaj Capital and Birla Sun Life Distribution), to the many individual financial advisors. Online stock trading portals also offer facilities for transacting in mutual fund units. Given this backdrop, there is healthy competition between participants to ramp up volumes; that makes it quite likely that one or more of the participants will eventually offer lower fees, as a key differentiator.

The deep cuts in brokerage charged on stock market transactions over the past three years, is evidence enough of this. Two, as SEBI has already waived entry loads for direct walk-ins and purchases by investors in mutual fund schemes last year, investors do have the choice of completely circumventing the distributor to purchase MF units. That too may keep up pressure on distributor commissions, trimming costs for investors.