Monday, October 27, 2008

This Diwali It's The Economy....some verse

Stepping out of my house, I see the empty looks that these malls bore

Slowdown has hit the Indian shore

Till last year the Goddess Lakshmi shone

This year people wonder where has she gone

Or was it a dream from which we woke

And has the Midas touch gone and left people broke

Nothing to worry says an old sage

‘Greed and Fear’ this is how the market behaves

Every dusk precedes a dawn

This nation will move on

The pedestal is shifting from West to East

The cycle of millennia is getting complete

Till then let there be chaos before the pattern emerge

India will be stronger post this deluge

Friday, September 26, 2008

Religion and Economy....' Money is just a Medium of Exchange'

No I haven't turned socialist and neither has the feeling of greed for more money died down within me....The article is just about an interpretation of what I observed on my trip from Hardwar to Gaumukh. 

Here I enter into Hardwar and I observe the market economy at work to the fullest.....The product of the region..'Religion'....It's a city whose economy drives itself solely on the basis of religion...At every step you can find temple and dharmsalas each selling some USB to attract bakhts (customers), as you step into the ghats for watching the aarti you are appaled by the its untidiness and don't want to sit on the dirty floor (looks like the we had to do the long wait and watch the whole aarti standing) but wait the market economy comes to your find children selling paper sheets to put under your b**ts.....and as you settle in would come hoards of people selling you Diyas, milk and flowers to offer to the holy Ganges, so even if you never wanted to take it but when you find other people buying it you are tantalised to do the same...(the usual herd beaviour in the markets thus creating a market for a product out of nowhere)....

Next let's  cut short to Gangotri....almost 300 km from Hardwar....the need for money seems to have subsided here though not completely 3200 metres above sea level the food is a little expensive and you still need to tip the waiters...though the needs here are limited and so is the need for money...that brings me to the first major point in the article:

1) The need for money is driven by the increase in need and luxury..... Half a century ago a monthly salary of 500 rupees was thought to be good!!! simply because the articles costed much less as there was lesser cash in the world and there were not many funky gadzets. The worlds money supply grows at around 20% annually!!! and at this rate the amount of money the world would have had now would have grown by over 8000 times!!!, however even if someone's assets might have grown at this pace he would still have been the same of as he was some 50 years ago when it comes to luxury articles (articles not essential for survival and basic living) so if you want to become richer make sure that first of all you have a good asset base to start with which then grows at a rate faster than the money supply of the world and add to it the rate of growth of your needs (no idea how you can quantify it though!!!)......

Coming back to the story on the top of Gaumukh glacier with nothing around us but simply looses its value completely, well not really...we just realize that money practically had no value to start was and is just a medium of exchange and derived it's value mainly from because it can buy you the needs by being the easiest medium of exchange but here at 4250 metres above sea level this medium of exchange doesn't work...One of our fellow trekkers tried to offer some of this medium of exchange to a sadhvi on her way to Tapovan...she just laughed and went passed..probably she was clever to know this at the first place.........

Now back in Delhi...the value of money is back...(Thank GOD!!!)...probably that was a different planet but the lesson I learnt there can be encapsulated in one line:

"Money helps in making the market efficient however its value is derived from the inherent inefficiency in the market"......

In other words just because money is the most convenient medium of exchange it has a value, so its critical that for wealth creation only a small portion of your portfolio is in the form of cash the rest should always be invested in some asset or the other.........

Wednesday, September 10, 2008

The Secular Growth of the World - 'It's a Tangent' - Part 1

After a little pessimistic last article... let me get back to more optimistic talk.... In this article I would discuss the future shape of the global  economic development..........

In the century gone by the world saw tremendous economic growth... infact the kind of economic growth the world saw in the last century was never ever seen in the history of civilized mankind.... There are 2 main reasons for such an occurrence...

1) More areas joined the economic growth
2) But the most important reason why this happened is because of 'technology'.

The economic growth of the world can be expressed as Y= C + I + G-T+X-M, Now keeping every parameter as constant suppose we change investment I from I to I' then the economic growth of the world is (I'-I)/(1-i), where i is the 'marginal propensity to invest', similar marginal propensities could be defined for the rest of the variables. 

What technology does really is change this variable of marginal propensity by bringing about a structural change and let's see how. Earlier man used communicate through letters sent through post...a long drawn affair.... Let's say I post a letter from India to US for the signature of the CEO of my company for some contract the whole process would have taken around 10 days... now such a think happens within flip of a finger!!!, OK for calculations sake I put it at 1 day... but still its 10 times more efficient....I would not be discussing the mathematics of marginal propensity in this part but in part 2, however still let me put some ballpark numbers, let's say a 100 rupees were invested in the world before this invention of email and now the marginal propensity was .2 so the GDP of the world would be 125 rupees. Now with the email as things have become much faster so the marginal propensity changes to .5 and with the same 100 rupees invested the GDP goes to 200 rupees!!!, so without spending an extra penny the world sees a higher growth....So with technology this saying is apt... ' You can have your cake and eat it too' or 'there can indeed be free lunches in the economy'. Such structural changes can be observed in locomotion with the coming of planes, markets with online shopping and trading, better roads and highways, improved productivity in agriculture and industries. 

Take for example an ERP software in companies. First with a central storage and access system time is saved thus improving productivity and using them now the companies can better manage their inventories and sales thus improving their inventory if the inventory earlier was kept in warehouse for 60 days, this period because of the use of these systems have come down to 30 days...a 50% improvement in productivity transcending into similar amount of growth....

Also now the more improvement one would find in the marginal propensity(Mp), higher would be the economic growth due to the base effect... For e.g. when Mp was .5 a 20% increase would have taken it to .6 so the GDP growth would have increased by 25%....Next with an Mp of .75 a 20% increase would take it to .9 and the GDP growth would shoot up by a whopping 150%!!!, the flip side though is that this would require a very big technology shift....

So now every big technology shift could take the economic growth of this world to a much higher orbit and so I say that we are likely to see growth rates never ever seen in the past....Based upon this let's contemplate on the technologies one can see in the future, this would also help in betting on the companies in the market.....

- The first technology that comes to mind is that of teleportation method of transport (transport at the speed of light... seems like a Star Trek fantasy!!!, I don't think so...I think this technology is quite realistic)

- Banking would totally shift from credit cards to mobile banking

- Nuclear Fusion reactors.....

- Faster computers with microprocessers not based on transistors but some other components at its core

- New agri and mining technologies that can help us cultivate in artificial environment and mine from asteroids and other planet surfaces

- Electric Storage cylinders

These are some that I can think of.... One thing is for sure though that we are in the most sweet spot of 'Wealth Creation'

Monday, September 8, 2008

Era of Wealth Destruction Begins............

I don't want to sound too pessimistic.. but this how any free market economy works, in cycles... what goes up comes down only to go higher at some later date, I for one firmly believe that the kind of economic growth the world is going to witness, it would have never seen before but let me put this article on hold for some other day; perhaps after this little pessimistic article it would be apt to put write in that article.... so with this optimistic note let me begin............

Oil has seen a sharp pullback of around 30% from its all time high.... now this could simply be a correction in a bull market...bull markets do correct by around 30% (remember 2006 Indian markets) or finally the bear market has set caught up with oil as well.... and with this happening the final piece of puzzle in the process of wealth destruction has been put in place as wit oil falling every asset class across the world is in the process of meltdown... this is what we call 'Wealth destruction', you are loosing wealth no matter what you do....

- If you keep cash, inflation erodes your wealth....
- Similar story with bonds
- Commodities and Equities are loosing their notional values so even your principal is getting eroded in these asset classes
- The new esoteric asset classes including art and sculptures... well let's not really talk about it because they may be asset classes today, but time changes and so does tastes of people...

Now the question that comes to mind is that if asset prices are a function of liquidity then with US (the main source of global liquidity) having interest rates that low, how can every asset meltdown... after all said and done people would invest the new money somewhere... Well the idea is right however asset prices are not just a function of current liquidity but also future liquidity or what we call growth....

Let's assume an economy with just two people A & B... A has a piece of land with him while B has 100 rupees with him... A sells the land to B for 100 rupees... now A goes nerd and throws the 100 rupee note in the river.. while B turns lazy and sleeps/hibernates for 6 months on the land he bought...What happens after 6 months when B tries to sell the land back to A... A has nothing to give him back...The price crashes to zilch..... 

However wait the story is not over yet....Seeing its pupil in distress, enter our angel - 'The Central Banker' ..... and distributes 200 rupees to A... now B sells the land to A for 200 (double of what he had bought!!! or is it)...any crop A produces on that land would automatically cost almost double of it had 6 months inflation rate of 100%!!!.... so the 200 rupees B got turns to be really worth 100 and worst still the 200 rupees borrowed by A has to be given back to the on earth would that happen when already inflation has eroded the wealth by again the price crashes to zilch............

Now the Central Bank accepts that there is a problem and only a structural change wherein in the A & B starts doing some productive work in the economy can bring the economy out of this hole and for that to happen the Central Bank is bold enough to take in a few periods of economic downturn...However it can do one other thing to prevent the asset prices from doing to keeps on printing will keep on inflating asset prices along with prices of consuming commodities leading to HyperInflation.....10000%, 100000%, 1000000%....just pick a number and that could be your inflation figure.....This has serious implication of eroding business confidence as with so much uncertainty no one wants to risk new capital in any business, currency looses its meaning and people switch to barter system which again ultimately means no appreciation of wealth in any asset class....

Unfortunately the Fed of US has taken on to this very last route... ofcourse structurally US economy is much more stronger than countries like Zimbabwe.. but it doesn't take long for the tide to turn... but now there are two routes in front of the Fed.... stop printing easy money and let the world take in some pain... or keep on doing what it has been doing and worse still print more money (reduce rates further) and take this world to a total disaster...... Either ways there is going to be wealth destruction for now... However in the first case there would be short term pain with long term gain... In the second yu might again see some asset classes (may be oil again) propping up.. However it just be the final spark before the total darkness that will engulf the World economy.. Hopefully good sense might prevail atleast this time........

Thursday, August 28, 2008

My Editorial Published in Economic Times, August 23 (Saturday)

Was not able to write anything for last over 1 month.....will surely add something new very soon..

Thursday, June 26, 2008

The RandomChalice Price

A few days back on CNBC Europe I saw some UBS analyst talking about who is going to win the Euro 2008, no it was not a fun banter; this man had actually constructed a mathematical model!!! to predict this………no wonder UBS is doing so terribly, I really don’t know what value this analyst community actually add……..

Let’s talk about the value of a stock. Frankly there is nothing called a ‘right value’ or a ‘fair value’ of the stock and all these valuation methods of DCF/FCFE etc though may sound very logical but are nothing more than B School lab rats, think about it…………If I ask you about the fair value of the apple in the market, ofcourse you can theoretically calculate it by constructing some exotic utility function and projecting some inflation figures but your answer would be as good or as bad as mine if I wake up early morning and in my half asleep stage just take a guess. So what really matters is ‘Relative Value’

Keeping this thing in mind how should I take a call of investing in a stock, Let’s take the example of ICICI bank, currently ICICI Bank is trading around 800 rupees however at the time of writing this article it was trading around 950 rupees. Now for argument sake let’s assume its earnings growth remains linear at 25% (though I have my reservations over the fact that this bank would be able to keep up with this earnings growth). The reasons:

A banks growth is dependent primarily on its financial capital and human capital. The return on financial capital is going to be very mediocre due to the state of capital markets and the bank itself is scaling down on its employee intake. So with both aspects of growth faltering the earnings momentum of this bank is surely going to take a hit.

The price (P) of any stock is composed of two components:

- Linear price (Lp)
- RandomChalice price (RCp)

═> RCp = P - Lp

When I invest my money in the stock I expect it to grow faster than the money in fixed deposit. Now the PE of ICICI bank in case of the market price of 950 is around 26. Now if I put my money in FD, I can get my principal back in about 8 years. At 20% growth rate any stock

═> P/E = ((1+g)n – 1)/g

So in case of ICICI bank n ≈ 10 yrs

So much longer, at n = 8 years my P/E = 16.5, this implies that this bank warrants a reduction of 36.5% in price, which implies its linear price if approximately equal to around 600 rupees. Any excess price above this is what I call the ‘RandomChalice price’. This is the price we pay for positive surprises in the stock or in other words it’s the price of unknown (this can be due to anything: structural change in business, new invention/discovery, oil find, acquisition, increase in earnings or any other unimaginable thing on the planet or in the universe). At 36.5% this price is too high for this relatively mature stock when many other stocks are available in the market with a very low randomchalice price.

I have taken the benchmark as the return from FD, however the returns from stock should certainly be greater than that of an FD due to the higher risk associated with them (ofcourse a number given to this risk can always be subjected to argument). This is just an example to show how exorbitantly high the price of ICICI bank is.

So essentially after adjusting for the risk any price over and above the linear price is the randomchalice price, if this price is negative then either the stock is too undervalued or the associated risk associated with the stock is too high and you need to adjust your risk adjusted return. This is how one should really judge a stock by its randomchalice price because this what ultimately leads to real wealth creation and through some predictable mathematical model……..

And O! yes by the way that UBS analyst had predict Germany to be beaten by Switzerland in the quarter final, unfortunately Switzerland is out in the very first round so much for the mathematical model……………

Tuesday, June 17, 2008

Oil touches an Intraday high of $139/bbl

Oil shot an intraday high of 139 yesterday. I was watching an interesting debate yesterday on CNBC Europe wherein one of the guests termed this phenomenon as a transfer of wealth. I am afraid this is a very myopic view towards international trade. Wealth is not just measured in monetary terms. In realty oil is an asset for the oil producing country. So we are essentially purchasing this asset and giving out cash in return. Here is how the transfer takes place:

Now the key here is that what really country I and E does after this transfer. For the importer nation oil purchased at $139/bbl should yield more value than the price paid for it and if that is the case it is not really a transfer of wealth, wealth is still created in country I though some may argue that the pace of wealth creation can certainly slowdown, but again my answer to this argument would again be – ‘it depends’.

Since the oil price spike has been fairly quick and sharp the economies of the oil exporting nations are still not mature enough to absorb such sudden inflows (remember the funds flow problem in India during October – December 2007) so they are then forced to invest abroad and hence ultimately a large part of money ends up coming back into the Importer country (provided its assets are attractive enough for investment), so if the oil utilization is prudent enough any slowdown in growth due to the oil price hike should be compensated with the capital inflows, ofcourse if import oil and just burn it without any productive outcome then it will always yield you into a problem. Let me also add that subsidies also contribute to the inefficiencies in the oil utilization, however the Indian subsidy bill especially on petrol is just a farce as thanks to the taxes on petrol we end up paying much more than warranted.

So here is summary of the article:

- The rise in oil prices does not really lead to a transfer of wealth.
- Any possible slowdown in the importer country is avoided due to the capital inflows from the oil exporting nations.
- However for this to happen the attractiveness of its assets has to be proportional to the possible slowdown as a result of oil price hike.
- This is only possible if the utilization of oil is prudent, subsidies hamper this process in a big way.

Saturday, June 14, 2008

The Economic Growth of Nations

Sorry for delaying my articles all this time.....I have been consistently writing articles on my notebook during my flights, just never got the time to post them on the blog....I will try to be more organised now going forward....So going forward I will post 3 articles that I have written, I which I would post today relates to the another small step in decoding the economic growth mystery, next would be talking about a critical concept on investment fundamentals and in the third article I would continue with options trading.....I would delay the China topic for sometime ( I hope I don't have to write that article prospectivelly...), so here goes the article for today.........

Sitting on my flight to New York, I can't help but think how far has India grown (well atleast some part of the population). People essentially become rich because of wealth effect. However it does not mean that the 'income effect' is insignificant. Infact it is the rise in the income level that ends up driving the wealth effect.

15 years back a plane ticket to US was twice more expensive than what it is today around Rs 120000, however back then a good salary for an Indian used to be around 5000 pm, 15 years down the road this has multiplied 12 folds while the expenses on such items in relative terms have come down significantly. This phenomena is visible in every field. Let's take the e.g. of a Maruti 800, I remember we buying this car some 20 years back for around 52000 rupees, today this car costs around 2,00,000. A rise of just about 4 folds and compare this to the rise in paychecks.........So things are becoming cheaper relatively....Therefore the fundamental key to invest in such growth economies is to invest in areas werein in the pattern is as follows:

(1-∆price(relative))*∆growth(product) > ∆ income growth of the topmost percentile of people. The funda for such an investment decision is as follows….

Due to a high base the change in price (which is going to be negative as discussed above) is going to be lower, the change in growth is going to be higher due to a lower base ( as still a very low number of people are consuming the goods), stock/sector following this pattern would certainly outperform.

Just saying that a product or service would grow in the country is not enough because its price would inevitably depriciate vis-a-vis the income levels. So keeping this equation in mind I would say that the best investment in any gowth economy is real estate (ofcourse the flip side to this is the fact that in a slowing economy the worst sector is also real estate)

The 'price' is always a barrier to ownership. The price has to be higher preferrably much higher compared to than the current than the current income levels of the topmost percentile population. This leaves a wide scope for the prices to come down and also gives a lot of time for the prices to come down, also the service has to be prefferably more of a necessity (if not now then atleast in few years from now) this would ensure a very high growth rate.

So whenever a company says that it is moving to the villages because it sees growth there, consider that the growth story of the company is over ---- ' Get out of that stock'..........

As I discussed above that to me price is nothing but a barrier to ownership which can be really due to some tigh regulations, so any sector where such regulations are released also provide enticing opportunities for investment.....

My plane is about to land at the JFK airport but before I end this article consider this, the real estate prices in this country (atleast in the NCR area) have grown 100 times in the last 20 years!!! ofcourse there has been a currency depreciation, even if we take this account an Indian has gained over a New Yorker and now even this currency trend is changing so the gap between an Indian and an American is narrowing faster than ever before. Ofcourse keeping this thing in mind we should not forget that almost 60% of our population lives on agriculture and we desist when wheat, rice gain in prices so think about this that while some part of India is ceratinly becoming richer it is these people who are becoming poorer everyday, so keep up the economic growth momentum of this country it is imperative that we reduce the gap between these two halves of India by moving people away from agriculture or improving prodcutivity or else it is a disaster waiting to happen, time to see New York, catch you soon................

Friday, April 11, 2008

The Swiss and American Growth Story

The last week was extremely busy so writing after a big pause. I would be leaving for New York on Sunday so before I do that let me elaborate the points on the reasons of growth in Switzerland (some points of the analysis holds for many European countries) and briefly discuss growth of US. I know I am unable to discuss about options trading and China story, probably my next article would be about them if something more interesting doesn't strike me. So here we go.........

Two countries that gained tremendously in the watershed event of WWII were US and Switzerland

America gained tremendously as result of influx of great minds from Europe, no amount of physical capital can match the influx of high influx of human capital, its simply invaluable (almost like a call option with limited downside and unlimited upside) , no one can tell the value of the idea or business venture started by some crazy nerd today whereas in case of pysical capital we know the number printed on the note!! So these great minds from Europe (particularly Jews) entered the US shores and made America , powerful and also changed the face of the planet. Einstein discovered general relativity, Goldman started an organisation that later came to be known as Goldman Sachs.

Back during the period of WWII, Switzerland chose to remain neutral in the global conflict. Unlike US it mainly gained from the influx of physical capital. Wealthy Jews and others kept their money in Swiss banks. Large part of money was never claimed as their owners lost their lives during the war. Now once you have large sums of money it has to go somewhere (to business and assets) and this leads to wealth multiplication over time. This is what has given rise to UBS, Credit Suisse. Don't fool yourself in believing that they are big because there are a lot of smart people in these organisations (smartness has no correlation with money making and oh! yes UBS just recently devalred losses worth USD 12 billion... smart people). Anyways a few such organisation can change the face the nation that has a population of not more than a millionWith almost 50% of them in active workforce these two organisations employ a very large chunk of population. Also with banks with such lare capital around it propels other internal businesses as well e.g. ABB. So with just a handful of entrepreneurs and large amount of wealth created this nation is a rich nation even though people don't work!!!, shops open at 9 a.m and close at 6 p.m, some restaurants open for not more than 3 hrs!!! well let them carry on this way other nations would surely catch up.

One more important point in development of Switzerland and many other European countries is culture. Well before jumping up and down just read..... I walk out of the airport and call for a taxi, two drivers come up one is an Indian driver and another one is an american, whom would I hire.... well the Indian driver....why? because I feel comfortable thats all, nothing against any country or race...its just a human fallacy. In a similar fashion these European countries have benefited from the influx of investment from global giants (mainly from US and UK) over other economies in aisa, simply because of this reason. All countries in south asia is still poor and so there is no surplus capital to invest. Atleast the countries in Asia Pacific, Taiwan and China have benefited from a rich Japan. So the next time you pick a taxi think about this point.........

Wednesday, April 2, 2008

The European View

Been very busy the day I stepped in Zurich and so ofcourse have been unable to write any new articles. I will continue the articles specifically on options trading and China once I return back to India. Anyways this article is a bit of digression but one important insight that I have gained from my visit.

I expected Zurich (financial capital of Switzerland) to be a very modern city, however it turned out to be just another town, totally shocking. The buildings are old, well maybe because Switzerland was a neutral country during WWII and so unlike most of Europe the city survived with its legacy. Anyways two important things that I observed here are:

- People are not very rich in the west, ofcourse Indians would find the place expensive but thats purely due to purchasing power parity ( which anyways would vanish in the next 30 years) though the people are not very poor unlike in India. So the GINI index (level of disparity) is smaller here compared to India. What is the reason behind this I am yet not sure. The government taxation and social security system might be one answer but certainly there must be some more important reason to ponder over.

- Also one thing to think over is how such a small country with negligible natural resources became developed. Well the answer to this question is relatively easier. One reason is that the surrounding countries were richer so it automatically boosts the economy of your country as labour and trade arbitrage processes are quicker and this transfers and creates wealth in that country (switzerland in this case). The second reason is that during the WWII many of rich jews and other people kept their money in the swiss banks ( this is what made UBS and Credit Suisse) and most of that money was never claimed as their owners lost their lives during the war. This money in turn got channeled into the Swiss economy and created the growth momentum..............

Sunday, March 30, 2008

Decoding the relation between Money Supply, Inflation and Growth

The cutting of interest rates by the Fed has raised the inflation and inflation expectation of people. This has prevented other Central Banks particularly that of the Euro zone, Bank of England and the RBI to resist in cutting of interest rates. While I have given my views on this topic in the previous article, over here I am going to discuss one fundamental dilemma in economics that of money supply on Inflation and growth. Are they truly antagonistic and if not in what scenario.

Assume a small slow growing economy Torts from tortoise having just 3 players A B C each having 1 kg of wheat. Let’s put a monetary cost to their produce at Rs. 10/- . In such a scenario the economy would remain stagnant and the growth of the economy is going to be 0%. Now seeing this perilous scenario an angel descends on their world with the name ‘The Party Pooper Bank of Torts’ – PPBT. The bank says that it is prepared to lend Rs. 5/- to anyone for 1 year but wants Rs. 5.5/- in return. A is the entrepreneurial type of guy. He comes forward and takes the offer. Now at the end of year one the following 3 scenarios can occur:

First of all in all the 3 cases let’s convert their wheat stock to Rs. 10/- per kg unless otherwise mentioned. A toils his land and produces rice. Now he can sell his rice at any price between Rs. 0-10, let’s take 2 cutoffs of 5.5 or less and more than 5.5, in the scenario where A is able to sell his rice at more than Rs 5.5, he is able to make a profit on his venture. Let’s say A is able to sell his rice at Rs. 10 so the GDP grows at 33.33%.

Let me add that this scenario also answers one of the basic questions in economics: ‘Why do economies grow’. This economy grew because of 3 factors:

Capital (Money from PPBT)
Land (Asset which is natural resource in this case)
Labour (The effort put in by A)
Entrepreneurial spirit (As shown by A)

A would have equivalent of Rs 20/- , B would have equivalent of Rs. 10/- and C would have equivalent of Rs. 10/-. Now A can buy some of the goods from C at Rs 10 or more. If A knows that B has just Rs 10 with him then he would buy the goods at Rs lets say at 10.05, so the inflation in the economy stands at 0.5%. However in a normal scenario there is ‘information asymmetry’ in the market and so A may jack up the price to as high as Rs 14.5/- for the product of C causing inflation to shoot up to 45% !!!. So its important to understand that the culprit here is not the monetary policy but information asymmetry.

In the next scenario wherein A gets Rs 5.5 or less A makes no profit however the economy still grows at 18.33%, any surplus liquidity is absorbed and so inflation menace doesn’t raises its head. Well this looks like the perfect scenario which has no excesses, the only problem is that if this scenario continues for long it will generate 2 problems. A would loose any interest in investing in the venture and also A would have no surplus capital of his own to invest.
In the last scenario A takes the 10 rupees and jacks up the price of the product of C to Rs 20. This causes the inflation to rise at 100% and GDP growth is 0%. Later on in order to repay the loan when A tries to sell back the product whose value is supposedly Rs 20/- but only C has the capacity to buy, however there is no reason for C to buy back the product he sold a little earlier (Velocity of money comes into picture) the value of the product crashes. This might lead to cutback in supply leading to negative GDP growth.

One question that can come to mind is why on earth would A behave in such a manner. The reason can be mainly two fold:

- The inflation is very high and so he feels that he needs money just to consume
- The inflation expectation is very high and he wants to buy products today expecting a rise in prices in the future

So it’s important to understand that printing money in itself is not inflationary. Inflation happens because there exists an information asymmetry and high inflation expectation. Printing more money in such scenario could be disastrous.

In countries like Zimbabwe which is suffering from hyperinflation is clear case in this regard. The supply crunch led to inflation and higher expected inflation, to top it all the government printed more money thus creating hyperinflation and causing the nation to go in a tailspin.

I conclude this article with two points that must be amply clear while taking the decision of printing more money and thus making sure that this money results to higher growth rather than inflation:

- Information Assymetry should be minimal
- Extra money to be used in capital assets and not in consumption.

If inflation expectations are high then the money supply would go into consumption instead of creating assets and hence leading to further inflation at the cost of growth (as players would first be concerned with consuming goods to survive and then think about creating capital assets). …………………..

Thursday, March 27, 2008

Options Trading - The Trading Ways

The beauty of options trading is the whole array of trades that are made possible by options with varying risk profiles. One more thing I would like to add here is that unless specified I would be refering to equity options. Ofcourse after sometime I would be moving towards options on other asset classes as well. Using options one can get into the directional trades on equity prices, perform volatility trades, trade on skewness and kurtosis. I would be covering each of these class of trades, this would including various trading strategies and arbitrage trades for some. Each trade would include the risk and returns possible. Right now derivatives products are limited in Indian equity markets and those that are available have limited volumes specially in stock puts. However unless you are a very big player the lack of volumes should not bother you. However new products are being introduced now in our markets. This include long term options and the volatility index to come very soon, so things are going to specially become quite interesting.

So I would start with directional trade on equity prices using options the next I write on this topic...............

Wednesday, March 26, 2008

The China Story

I know its a story told to death... But whatever articles I have read have either been in complete awe of the Chinese growth story or have been completely cynical... From now on I have decided to write something on this article and the options trading article. Ofcourse I would try to fill up in between with some ideas that strike me from time to time. I may be travelling to Zurich next week so not sure how frequently I would be able to write next week. Anyways before I start this China story from my next article I should tell you what my position is...............

I beleive China is a disaster waiting to happen. I sincerely hope it doesn't happen because an economically vibrant China is good for the entire world as I also believe that the global boom that we are seeing this decade is mainly due to China. However the way they are progressing is similar to over leverage trading. You are the king on every day till the day of reckoning. So in just one day you loose all what you made your entire life. The West is ofcourse crazy for China especially the American fund managers.... Now what can I say for them, people who loose billions of dollars ( for record some of the topmost I-Banks and the famous commercial bank supposedly composed of best talent have lost more than what they have made in a decade)......To be fair even I am awed by Chinese growth but I can't loose the sight of the structural deficiencies in its growth and system making it a disaster waiting to happen. I would try to analyse various aspects of Chinese growth to put the puzzle together..........

Tuesday, March 25, 2008

Options Trading (Basics 2)

In continuation with the earlier article written on March 19, 2008...........
Call option and Put option are also known as option to buy and option to sell respectivelly from a buyers perspective at a certain predesignated price called the 'Strike Price'.
Now let's intutively try to understand what factors would influence the price of the options. So basically how much is the just price that A should charge B. Well ofcourse market forces can determine the price and ultimately that is what govern options prices in reality (no fourmlas!!!) but in this case our market is limited to just two people so the market forces may not work prudently. So let's think about the variables governing the option price.
- The first factor that straightaway comes to mind is the goal difference on which the option is bought. For eg. if the B buys from A a call option on the victory of Italy by two goals or more the option value would be lesser when compared to the scenario wherein B buys from A a call option on the victory of Italy by any number of goals as chances of the first scenario happening is lesser than the second.
-The second factor is time. Let's consider two scenarios wherein in the first scenario the bet is made at the start of the match and in the other scenario the bet is made in the injury time of the second half (both teams stuck at 0-0). Obviously the chances of B winning the bet is far less in scenario B as compared to scenario A and hence the value of option is greater for first scenario vis as vis second.
So to sum it up this option can be valued on the basis of goal difference (distance from the current price in generic form) and time before expiry. These two are predictable components. What makes the option trading fun is the third and most critical component 'chance' or in mathematical form probability. Though the underlying distribution of this probablity is unknown (don't assume normal and ruin the real fun of options!!!). The probability is governed by the distance, time and to a very limited extent past track record. However let me add that it is this notorious unpredicatable probability component that can make or break fortunes in option trading...............

Monday, March 24, 2008

The New Economic Growth

Since the end of World War 2, thw world has seen a structural change in economic growth. This structural change has accelerated since the dawn of 21st century. Till about 1900 the trend grwoth per capita has been 1% or less. Moreover only a small portion of the planet participated in the then new economic order. However I would say that since the World War 2 that world did change dramatically (atleast in terms of economic growth). I would say that 3 main factors are responsible for this dramatic change in growth:
1. Technological progress contributing to very high productivity
2. Larger part of the planet participating in economic growth (earlier Japan, now India & China)
3. Better understanding of how economy works leading to improved management of economies
Now you must be wondering why am I writing this article. This is because I just now read a book, 'Bull' by Maggie Mahar. It spoke about for how long the Dow stuck to levels of 1000 and how dramatically it has broken levels of 10000 in so little time indicating as though it is some sort of very big bubble. Well bubbles will be formed in the financial markets, this is their nature as prices sometimes get ahead of themselves. However the reason why Dow got stuck to levels of 1000 for so long and now has broken those levels can easily be explained by the 3 factors explained earlier. The growth dramatically increasing in large parts of the world leading to much higher corporate profits specially to global companies, dramatic changes in productivity again contributing to higher profits and the Central bank and government intervention at right moments preventing system from complete collapse (ofcourse will this last factor always playout is a question mark). So I would like to say that the world has changed in the last 50 years and this is reflected in the stocks, ofcourse the markets can collapse back in case we undo much of the good our previous generation has done, let's hope it doesn't happen and I am positive that if the growth in India and China continue one would see not just newer market levels, but much higher standard of living across the world and newer economic theories shall come into the fore trying to explain this phenomena.

Sunday, March 23, 2008

The valuation conundrum and stock market dynamics 2

Continuing with this topic let me add the third variable which we termed as X. The condition was that no exchange was allowed. Well let's just allow such an exhange between gold and bread. Let's say that in this economy there are 10 people, 10 loaves of bread and 10 gold coins. What happens now. As one can see bread is the most precious commodity for people right now, so we would observe that the value of gold would come down dramatically and people would become vary of taking gold as a medium of exchange.
So doesn't this happen in markets. The liquidity dries up, the marignal utility of players shift from investment demand to consumption demand and the there is collapse in valuation of investment related products (the more illiquid the product the faster its fall) leading to a friction in asset markets as various players would tend to resist from accepting such securities as collaterals. This is how basically a market functions, the valuations etc are secondary, however important specially for an investor.
You don't have to go into complex calculations while buying a stock, remember you the real return from the stock comes out of random events, this is what make fortunes. The only research that you have to do is how is the company (because chances of positive random events striking a good company are far greater), don't try to buy stocks that you think are cheap in valuation terms (simply because chances are you would not be able to find very many stocks of this type and even if you do find them the returns would be very limited as they are predictable). However it's important that you also don't buy very expensive stocks. To decide if a stock is expensive or not decide upon your payback period (the period within which you want your investment back) this can depend upon the company, sector, its period of existence etc. Once you decide that take the expected growth rate of the company and see if the investment break evens in the expected time by adding profits of the company for the forward years.
For example lets say a company grows at 20% yoy, adding the various expected earnings for next 7 years would give you a PE multiple of 16.5 [((1+g)^8-1)/g], g is growth rate. Now let's say the current PE multiple is around 16.5 as well. Now you can decide wheter to invest in the stock or not the payback period, the linear growth rate assumed (20%) and component of unpredictibility.
Just remember one thing investing in markets is also like a business (the only difference being that you generally have a negligible or no control) and like in any business getting your investment back is critical, the same holds true in the markets. Ofcourse I am not saying that if calculations say that this stock cannot payback your investment in next 7 years don't invest in it, as you can see there is the assumed component of growth which can vary dramatically due to random events like the comapny entering a new line of business or geography, expanding its capacity much more than expected, getting a very big order etc., all I am saying is that if let's say the PE of the stock is 20 and your calculations gave you 16.5 and you decide to invest in this stock, you are investing on the positive bias of randomness which generally would be the case for most investors. So basically while investing you must know what are you betting on and how much are you paying for the stock's predictibility and how much for the stocks unpredictibility component............

Friday, March 21, 2008

Why we need communists

When I started writing this blog the idea was to put forward philosophical ideas (creative and fresh) in the area of economics & finance (mainly) but sometimes even other areas of social sciences like politics and to touch some aspects of my favourite area, physics. Apart from this I wanted to share my views on current issues that would come up from time to time. Some of my friends after reading the last couple of articles have said that I am getting too much into explaining valuations, options which really one can find anywhere and I am really loosing out on the objective for which I really started writing. Well i believe that that they are partly correct and wrong. I want to address through this blog to readers who are interested in ideas and philosophy as well as to people who want to know about trading and investment from scratch in a language by which they can easily connect. Hence I have decided that for every technical article I would follow it up by a philosophical article wherein I would place ideas and arguments.

So here we go for today. We need communists. If there is one class of people I have hated in my life they are communists, however inspite of this in a very strange way I believe we need them. You must be wondering whats the reason for this dichotomy. Well look around (in this world I mean) you would find that most of the countries that have adopted a single religion and don't have appreciation for people of other religion have become totalitarion nations, fundamentalists and fanatics in their way of thinking. I believe that by driving the communists out of this country we would become 'Eco Communalists'. Listening to ideas that the are poles apart from our way of thinking broadens our outlook and gives us a sense of appreciation towards others. Also I believe that no idea is completely right or completely wrong either. So that's why I beleive that no matter how much we despise communists we still need them. Why would like to end this article by this line that I thought of describing the stark contrast between Capitalism and Communism.

'Communism begins with an order that leads to chaos
Capitalism begins with chaos that leads to order'
However remember with the ideas of Karl Marx there would have been no labour standards, perhaps even no environmental standards, no corporate social responsiblity and without these the whole notion of capitalism would have collapsed at its infancy. So preserving communism is essential for the longeivity of free markets themselves.

Thursday, March 20, 2008

The valuation conundrum and stock market dynamics

These days as market takes a nosdive suddenly I see a lot of people talking about value, valuations and multiple of sub 14 times etc. and term this as irrational fall. The same arguments of value were also given when the BSE sensex was at 21000+ with a minor difference wherein we talked about valuations and embeded vauations and then tried to justify the rise as a rational rise. I to be honest never understood this kind of thinking and branding stocks in some closet of multiple. Sure valuations are important but the most important thing in any market are three variables liquidity and let's rename the other two variables as X and Y, stock market is no different.

Let's have an economy in which there is one supplier of gold and copper and these are the only two tangible products produced in this economy and the rest of the population has lots of money with them (also let me add exchange of commodities is not allowed: I will explain later how this condition comes to play even in real life for now this condition is our variable X), due to this the copper sells for rupees x and gold sells for rupees 100x. However one fine day all the money is gone. Then it's irrelevant to talk that gold is more valuable than copper they both attract negligible value as there is no liquidity.

Let's slightly tweak this example, so now we replace copper with bread. Whats more valuable after 7 days of hunger 'gold or bread'. So another factor that is extremely important in markets is 'marginal utility': The satisfaction a person recieves from one addtional unit of the good. This is our variable X.

If I have lot's of money in my pocket I would buy 'luxury brands', essentially the same quality of cloth from an expensive showroom with some fuzzy symbol on it. The same happens to stocks, in periods of high liquidity various popular names skyrocket.

Now when a person becomes cash strapped he becomes economical in his spending. The same happens in market he buys businesses that have real cash flows, he starts thinking about PE multiples. So really if one thinks about it, its liquidity that determines the performance of the stocks by controlling the marginal utility the players. I shall continue this article next time by explaining more about the variable X and hence completing the market dynamics.......

Wednesday, March 19, 2008

Options Trading (Basics)

From this post I introduce you all to the magical world of 'options'. I would try to limit the use of mathematics because frankly to be a successful options trader intutive understanding of options is what is needed rather than complex pricing formulas.

So what's essentially an option, well an option is essentially a bet. Let's say two people A & B while watching a football match of Italy vs France enter into a bet that if Italy beats France A pays B 1000 rupees else B pays A 1000 rupees. This if I translate it into options would actually constitue into an options trading strategy which I would address sometime later. For now to explain the most basic structure of option let's just extend our example a little bit----------

A fine evening in India in a B school campus to students (A & B) were worried about the derivatives exam tommorrow. To relieve the stress they start watching a friendly match between Italy and France. The match was turning out to be a big dissapointment 30 minutes gone and still no goals!! To heat things up they enter into a bet. A tells B that he pays him 500 rupees upfront. Now if France beats Italy he should forget his money and go back to his books, however if Italy beats france then A would pay B an amount equivalent to 250*(goal difference by which Italy beats France). This is what we know as a 'call option on the victory of Italy'.

B buys from A a call option on the victory of Italy. The payment he gives to A upfront is called the premium (the price of this option). A is known as the option writer, his maximum profit would be 500 rupees in the scenario where France beats Italy. However his loss potential is infinite and will start loosing if Italy beats France by a margin of more than 2 goals.

The same option can be termed as a 'put option on the defeat of France'. So basically the call and put options are the same thing, its just a function of your position.

In trading buying call is part of the bullish strategy --- You are bullish on Italy. While buying put is part of the bearish strategy --- You are bearish on France.

The rest of the article I would continue later..........

Tuesday, March 18, 2008

The Fed finally does what's needed

Atlast the Fed took the right bit of action. Expressing concern about inflation while not getting carried away by the market demand of a full monty cut. Also I believe the most critical action and in my opinion the correct action was the deftness it showed on the Bear Sterns issue, Fantastic!!! and adding onto this action is the fact that the Fed has opened its lending doors to Brokerage houses. This is what is really needed, the liquidity needs to go where it is needed and just blind rate cuts were never going to help. This action should have been taken long ago. Anyways as is true for everyone of us, it takes real adversity to tkae drastic actions.

However I still feel the Fed and more importantly the US government has to do more. I ultimately has to buy this mess (The mortgage backed securities). Hey I know the arguments against it and stop talking about moral hazzard, tax payers money and saving the rich. Let me give you a simple example----

You are driving on a Highway athigh speed and suddenly see some moron coming from a wrong direction. What would you do, sure that guy is an idiot and you feel like hitting him hard (Road Rage !!!) but would you do that, ofcourse not because it will hurt you aswell, so you just crib about it and give him way to get out. The same principle can be applied to the Fed and later on possibly the US govenment bailout. As for the tax payers money, well there would not be much left if this thing goes for long.

What required after these bailout packages and clearing the system is change in laws, increased vigilance. Like in our Higway example, had there been more vigilance the car would not have been allowed to enter the wrong way on the highway. The companies entering into any kind of derivatives transaction have to commit wafer thin margins. That has to change or if not change atleast it has to be made mandatory for the companies to report there equity against the derivatives position they are taking and the worst case scenario loss on equity (Not the Var crap, no more 95 percent confidence of this loss that loss etc. Keep these things limited to the MBA classes), The worst case scenario loss simple. No more fancy statistics just report how much maximum you can loose based upon there derivatives trade and then its upto the shareholders to decide whether to invest in such companies or not..........

Saturday, March 15, 2008

Well It has been a long time since I last wrote on this blog. Since my last blog lot of events have happened. The raging bull market has suddenly seem to become inverted. The same analysts (One of the most dumb & useless post in market) who not long back were tomtoying the great Indian bull story and taking this index into 30000 in next two months are now talking of four figures on sensex. Ofcourse this is market and anything can happen but my point is that no one no matter how succesful he or she has been in this market is better or worse than any guy on the street in predicting the future, if it sounds surprising just believe it.

Well this fall in the index has made my job slightly easier, as I wrote in my last post about explaining the market bubble; well I don't have to do it now so basically saved of some gruelling work in preparing excel sheets.

Now what I think about the months ahead well even I am looking forward for the drama to unfold but one thing is clear and since I started writing this blog I have been shouting this--- Sack the Fed Committee. Look what has happened now and these morons still have the tenacity to say that the inflation expectations of the people are intact. Well in that case either these people are completely stupid, are in a state of self denial, or bigtime liars. Well all is still not lost and the situation can still be salvaged in my opinion by going for one of the three ways:

1. The Fed must stop cutting rates. I know the markets across the globe would tumble for a couple of days but they would recover. More importantly the bubble in commodity markets would burst. I am sure that as you have the seen some hostoric rises in oil and bullion prices similarly you would also see the biggest ever fall recorded to date in these prices. But I doubt the Fed would have the teeth for this. Ideally in my opinion this is the best option.

2. The EU and BOE must cut rates. Today the most preferred trade is go short on dollar and long on oil or gold. With ECB and BOE cutting rates the expectation of dollar weaking would reduce and this trade would fall apart. Ofcourse with more excess liquidity there is a likelihood of bubble reforming in Emerging markets and again in commodities. However as a temprory measure this option can be utilised. I must also add the position the ECB chairman is taking is too textbookish. Economics is not Physics. Everyone knows what Fed cutting interest rates would do to the dollar. So this commodity inflation will not aggravate because of ECB or BOE rate cuts as this inflation id because of a hedge against weak dollar. The key in economics is to be creative and not do things which are written in textbooks as everyone is well aware so such scenarios and hence these things get discounted in markets.

3. A coordinated effort by main Central Banks of the world US, UK, Europe and Japan is needed to strenghten the dollar. This would break the back of speculators in the forex and commodity markets.

Out of the 3 options discussed the third one seems to be the most likely, I hope its excersised soon enough before its too late. We are living in uncertain ( well life is always uncertain) and interesting times. Hope this time would write soon and let's see how things pan out.........