Markets & Economy

Stocks have no reason to go higher

In the past five weeks, the US equities have rallied 8%-10%, as the earnings in the 2^nd quarter were better than expected. Obviously, layoffs, pay cuts and thereby productivity increases, have given a boost to the bottom line of many S&P companies. Another boost came from banks across the pond—EU banks have passed the well-negotiated “stress tests” without much difficulty. So, bulls have come out after the recent lull, and they are ready to give bright forecasts. Everything is going to be rosy again!

Not so fast. None of the problems this economy faces have disappeared. They are very much intact. However, there is a concerted effort by the governments and the central banks of the world, to delay the inevitable, in an effort to beat the dreaded “deflationary” forces in the economy. I have no desire to doubt their motives, but I really doubt whether “kicking the can down the road” will help solve this crisis.

Right now, we are witnessing a cyclical burst of activities in the economy, after a panic halt, in response to an economic Armageddon experienced in the wake of credit crunch. This, however, is only a short-term phenomenon. Excesses of the last two decades across the developed economies have finally come home to roost; it is going to need more than just two years to even get to the so-called “new normal.” Debt levels, both private and public, are quite high. Big banks carry plenty of toxic assets and there is no way to know how much they will have to write down if these assets don’t appreciate in value. So, these financial institutions are very reluctant to lend. If there is no new debt formation (I am not recommending that, in fact, de-leveraging is good), how are businesses and consumers, the engines of growth, going to drive this floundering economy higher?

Here are my reasons why I feel equities will go down:

• Consumers, after this cyclical revival in spending, will once again hibernate. Fear of losing jobs, loss of equity in their homes, higher taxes, reluctance to take on more debt (only if banks are willing to lend!) will be the factors driving this big change in American consumer.

• Despite the liquidity pumped into the system by the Feds, it is really not changing the credit dynamics for the small businesses and consumers. If new debt is not created in the economy, GDP will not grow. Aggregate demand is a function of changes in GDP and debt level. With all the de-leveraging in the economy and banks refusing to lend, aggregate demand will shrink. Right now, private debt is close to 3 times the GDP and a small percentage drop in the debt levels, will adversely affect the aggregate demand.

• I don’t think there will be another massive economic stimulus from this administration. That means one cannot hope for government to continue to spend. In 2010, the budget deficit is expected to be close to $1.5 trillion. Despite rosy forecasts, deficits will continue to rise (www.usgovernmentrevenue.com forecasts total tax revenues, states & federal, to be $5.4trillion by 2012, but expenditure will be $6.8trillion, hence a deficit of $828B; GDP will be $16 trillion and national debt will reach $19.5 trillion!). So, muted GDP growth, debt-to-GDP at 120%, higher taxes and higher interest rates (despite lack of economic growth, interest rates will rise, as our creditors will not be willing to lend us at lower rates anymore), struggling job market and stagnant housing sector…there are only headwinds. How can equities prosper under this scenario?

• European banks are headed down the path of Japanese banks. They will be more like “zombie” banks. The farce that was on display with the bank stress tests will only exacerbate the banking woes. What I hear is that, these big banks in the EU zone were not required to recognize losses on their sovereign debt portfolio, as they were allowed to “hold it to maturity”! Many of these nations whose debt these banks are holding in their balance sheets have huge debt-to-GDP levels. If the economies don’t grow due to austerity programs and assets don’t appreciate in value, plus, unemployment remains high, how will these nations come good on their service of debt? So, with the threat of “sovereign default” very probable, banks need to be very vigilant and will be forced to hoard cash. That’s how they become Zombie banks—idle cash that cannot create new debt because of the fear of existing debt going sour!

• The thing is, this is not one of those routine boom-bust cycles to expect a normal recovery. This is a consequence of two decades of excess leverage and asset bubbles. It will unravel slowly and will hamper growth globally. Despite the economic miracle in China, India and Latin American countries, if US, EU and Japan stagnate (US, EU zone and Japan account for a staggering 60% of the world GDP!) there will be negative consequences worldwide. Equities just cannot perform in such a scenario. And, this downtrend will be long lasting, as the psychology of the markets will suffer. In the absence of higher expected return projects or investment vehicles big investors will shy away from risking their capital. Preservation of capital will be the most followed strategy across the globe.

Markets are mostly driven by animal spirits. If market participants feel confident and upbeat, the markets will go higher. If more investors anticipate growth, then they are willing to part with their cash, as they see higher returns and creation of wealth. If not, they will try to remain liquid by hoarding cash. Liquidity is everything. The so-called “liquidity on the sidelines” will refuse to come into the market or economy, if the psychology is negative. As the sovereign debt crisis and the havoc it can cause in the financial world become more obvious to big investors, the liquidity will dry up. It is as simple as that. Consequently, economy will suffer. When most realize, that in this cycle of journey to the bottom, over-leveraged nations, businesses and consumers are not going to be back on their feet for a long time, even the most daring investors who kick-start the faltering economies (the real risk-takers with big bank balances) because they see value in distressed assets, will refuse to get into the game. That starts a self-sustaining death spiral to the bottom. This is one of those times. This is a “black swan event” as my favorite author Nassim Taleb would frame it. Many in the policy circles and big investment houses have still not figured it out. So, am I smarter than these brilliant minds on all these big places? Not really. However, my intuition alerts me that the possibility of a long drawn downward move is highly probable. When I see all the data, I don’t see anything that inspires confidence that all the bulls see. That doesn’t mean that I am pessimistic. I just feel it in my gut that one has to be prepared to face this period in which everything is going to be tough to come by. If my gut feel is wrong and this is just a temporary phenomenon, then I have nothing to worry, because in good times, things will work on their own; there will be lot more opportunities and those who are willing to take risks, I am sure, prosperity will be in the reckoning with fewer hurdles.

I hope my intuition is wrong, just this time.

Why Things Are Not As Rosy as They Make Us Believe…

We know that past two years have been extremely distressing. With the meltdown of job market and the destruction of many sectors in the economy, ordinary Americans have struggled. But what’s not really hit home yet in the midst of a 70% stock market rally, is the real calamity that is slowly unfolding in so many municipalities and cities across the nation. It’s quite alarming. I don’t want to flash distressing data here, although, I must say that nearly 28 states are facing dire budget situations.  What I want you to see is the calamitous nature of the financial crisis and how it is destroying the very fabric of our communities. Look at the video below to get a sample. City of Newark is going bankrupt and what that means is fewer policemen and firefighters, drastic cuts in basic services that people take for granted in most of the first world countries.

 

While banks continue to reap profits by trading esoteric financial instruments, enabled by the largesse of Federal Reserve, and stocks march on with pumpers displaying disdain for those who dare talk about the ground realities of American economy, real people are suffering and will suffer more if more cities start crumbling the way we see here.

We are in a vicious downward spiral. It’s unfolding slowly, but it is gathering momentum. Trillions of taxpayer dollars came to the rescue of big banks, which were guilty of making big, bad bets with a complete disregard for inherent risks in them, yet, they are unwilling to lend and rescue the Joe Public now. Obviously, now they are worried about risks in lending to poorer consumers, businesses and cities, who got into this mess by the very institutions who spoiled them by lending too much in the first place. Of course, everyone was party to these excesses—banks,  consumers, businesses, city councils and so on—but the big guys always come out unscathed and the rest are asked to fend for themselves. Bankers made billions in bonuses even when millions were losing jobs and homes. May be bankers deserve it for their skills and the nature of work they do, but isn’t it the dharma of these institutions to put their capital into use where society needs the most, at least in times of such distress for millions? Banks have responsibility towards their investors, but aren’t they benefitting from taxpayer money? Couldn’t they minimize the bonuses or divert some of the zero interest capital they received from Feds for the greater good of the society? If capitalism embraces Darwinian rule of ‘survival of the fittest’ and expects ‘creative destruction’ to bring new species on the debris of the older,weaker ones, then banks had no right to be rescued by the government, risking taxpayer money. Yeah, but then banks are “too big to fail” for our own good! No arguing that point. After all, it is the hallmark of crony capitalism—“socialize losses and privatize profits".”

I am a capitalist, and I will continue to favor this economic system; but, I demand and hope that out of the debris of this financial crisis evolves a more humane, compassionate and far more equitable system. Let us hope that the new system embraces principles of dharma.

A Picture is Worth Thousand Words…

With all the chaos in the global markets in the past few days, one is constantly reminded of perils of complacency. There are way too many landmines, waiting to explode, if you don’t tread carefully. Couple of blogs ago, I had asked the question, “Is it time to short the markets?” The debt problems in the European Union (EU) seem to slowly unravel and there is a serious threat of this contagion spreading. So, finally, the time for a serious correction could be here. That doesn’t mean it is going to be a one-way rush to the downside. We could see intraday rallies, only to trend down until a substantial correction makes this market more in line with the prevailing fundamentals.

I am not going to regurgitate all the current macro issues that are plaguing the market, which I am sure are being repeatedly shown in every form of media out there. What I want to show you is a picture I found at www.financialarmageddon.com. The title of the picture:

Accident Waiting to happen

The BP “oil spill”, Massey’s “mine explosion”, the “riots” in Greece in the aftermath of Government’s announcement of austerity program…are the accidents we are currently witnessing. But , as the picture suggests there are bigger accidents waiting to happen, which are more problematic. Spain, Portugal, Ireland, UK…the list goes on. As I explained in that blog on shorting the markets, bad news have a way of coming in clusters and they suddenly look so ominous and magnified that market reacts in fear. That’s when stampede occurs. I don’t think the fear is still at that level and once again governments of the world may come together to provide a backstop, but irrational fear is a force that exerts itself at a time when most investors are asleep and complacent. That scares me, as all the good work by the authorities to bring this economy back from the brink may go waste in no time. And, that my friends, may take us to the much-talked about “double dip” in this fragile economy. If that happens, America, brace yourself for real tough times. Already jobs are not easy to come by, and one more leg down in the economy, spells real trouble for those who are already struggling.

My hope is, underneath all these chaos, a sound economy is emerging and no matter how difficult the situation is, people stop fearing an “end of the world” scenario.

Trust? Why Should Main Street Trust the Wall Street?

It is incredible how this financial crisis is throwing up the accumulated dirt in Wall Street. You can hear my own cries of anguish in some of the articles I have written in this blog. What always bothered me was the entrenched corruption and the blatant disregard for the well-being of the larger society exhibited by these very pillars of our capitalist society. Why am I writing this again? Because, just today, SEC decided to charge the mighty Goldman Sachs for committing fraud in their structuring of  Collaterlized Debt Obligations (CDOs) in at least one specific case. This, I feel, is only the beginning of what could be a long summer of more instances of clear violation of ethics by these famed institutions.

Without getting too technical about it, here is what happened (Read this for more): One of the CDO managers, working for Goldman Sachs (I believe a 31-yr old man who called himself “fabulous fab”), structured a CDO, (a derivative instrument made up of different tranches of residential mortgage-backed-securities (RMBSs) of various risk levels), wherein the securities were hand-picked by a hedge fund manager who in turn “shorted” them by purchasing credit default swaps (CDS, a form of insurance against the default of underlying bonds, in this case the securities within the CDO). So, while Goldman was selling the CDOs to all those customers who trusted their products, behind their backs Goldman was selecting rotten securities so that a hedge fund manager could short them. A serious violation of trust. There is nothing more to be said.

Now we know that John Paulson, made famous by WSJ’s Greg Zuckerman’s book “Greatest Trade Ever”, was the hedge fund manager behind this deal. Mr. Paulson made more than $2 billion in 2007 for himself and nearly $15 billion for his firm. I don’t think SEC has charged him. But, the point is, it looks like deals like this were quite commonplace in those days. Those who had the vision to short the subprime market made billions, but what is stunning here is, those who were creating these CDO products were aware of the “crumbling towers” they were building for their customers. Yet, they were driven by self-interest of the worst kind. There are more cases like this discussed in Michael Lewis’ book “The Big Short.” What is abominable is the fact that Goldman was making money on both ends—selling CDOs to the customers on one end and selling CDSs to the shorts on the other end. By the way, this is lot more complex than what I have described here. The worst part is, Goldman wasn’t even responsible for paying the CDS-holders in the event of CDO defaults, as they had investors on the other side of the CDS transactions who received the CDS premium while Goldman took a cut. Believe me, the kind of financial legerdemain evidenced here belongs to the world of Harry Houdini. Despite the complexity and conspicuous greed behind such esoteric products, there was nothing illegal about most of these actions, I think. This is a clear case of violation of trust.

That is why there is so much cynicism in the Main street when it comes to Wall Street. Of course, most of the employees of these big institutions are honest workers who work very hard to earn their above average rewards. However, it is the greed, dishonesty and incompetence of few who really hold the levers of power who are responsible for this huge crisis that has destroyed the trust of people in these institutions.

I am sure Goldman will fight these charges to safeguard its reputation. And, despite all the bad news there may be no consequences except few bad players getting thrown out of the game for good. Longer term, if this culture of greed and excesses is not changed, it is inevitable that we will be faced with another crisis. Through all this, ordinary, hard working people will suffer for no fault of theirs. Financial crisis invariably results in economic crisis and that in turn impacts people of all walks of life. It hurts them as they lose jobs, lose equity in their homes, their nest eggs deplete, children’s education suffers…the list is very big and depressing. Entire humanity pays a huge price for the action of few. What bothers me is, despite such irresponsible behavior, the central bank has allowed these big banks to have access to easy money (at the expense of tax payers), so that these banks can make billions by trading (it’s like a casino!) esoteric products and pump up the equity markets and at the end of the day have a party and giveaway huge bonuses while people in the main street continue to suffer the consequences of the actions of these big banks.

I have nothing against these institutions. I know that they play an important role in this economy. Being a finance guy myself, I have lot of respect for those who run these institutions. But somewhere, especially, in those areas where the actions of these institutions impact the larger society, things do need to change.  In order to win the trust of the main street the Wall Street has to shed greedy excesses; they have to identify the bad apples early. Instead of waiting for government regulations, they should resort to self-regulation. Greedy behavior has to be checked by creating a better incentive system. While fierce competition among these Wall Street firms require them to play the game everybody plays, any evidence of ethics violation by one firm need not be a de facto industry standard or a license for everyone to do the same. Instead, such actions should be immediately brought to the attention of regulators as opposed to waiting for the regulators to catch the thief. One honest action will lead to another and will become the reason for saving the entire system.

I guess, I am naive. Yet, is it too much to expect honest and able leadership from at least some of the leaders who head these institutions? Don’t they feel like questioning the system when there is obvious wrongs being committed that have larger implications? I certainly hope so.

Is It Time to Short the Equity Markets?

Being an active participant in the equity markets, I follow the US and global markets quite closely. What has stunned most market observers, including me, is the one-way market that keeps going higher and higher completely ignoring scary fundamentals—sovereign debt crisis in key European nations, continued softness in  US housing market, deleveraging of the US consumers, high unemployment rate and so on and on. Pundits call this slow march to new 52-wk highs as “melt-up.” I see it as Fed-enabled, liquidity-driven market where bears have simply lost the mojo to short this market. Every small dip has been seen as a “bear trap”, which is a Wall Street jargon for drawing the bears out of their hide-outs with a dip in the market only for the bulls to come in full force, reversing the trend and forcing the bears to cover their short positions.

Well, there are great many commentaries all over the web and on print media as to why the market is going higher or why it should be going down or why it will continue to go higher and so on. So, I will not dwell on it. What I wish to do is share with you some key data that depicts the tremendous run-up in the US and global markets and various individual sectors. It is simply astounding. Table below shows the ETFs that track major stock indexes of key developed and emerging nations:

World Market ETFs (as of 4/09/2010)

Symbol	Price	Change	52-wk
USA (SPY)	119.55	0.66%	+41.53%
Canada (EWC)	28.62	0.56%	+61.11%
Russia (TRF)	21.07	0.81%	+75.58%
India (IFN)	32.83	0.74%	+67.33%
Israel (ISL)	16.85	0.30%	+95.25%
Japan (EWJ)	10.64	0.28%	+27.29%
Singapore (EWS)	11.88	0.68%	+75.67%
Taiwan (EWT)	13.01	0.62%	+48.49%
S. Korea (EWY)	52.05	-0.04%	+60.57%
S. Africa (EZA)	62.19	0.34%	+64.51%
China (FXI)	44.59	1.87%	+41.99%
Lat.America (ILF)	49.78	0.69%	+70.00%

 

Except Japan, every other market has seen more than 40% rise in the last 52 weeks and stand at the above closing prices as shown, as of April 09, 2010 (“Change” column shows the weekly change in these ETFs). Israel ETF is up by a whopping 95%! This is incredible growth in the face of all the issues that continue to linger in the aftermath of global financial crisis.

Here is another Table that shows the individual sector performance in the US equity markets:

Sector ETFs (as of 4/09/2010):

Symbol	Price	Change	52-wk
Oil Service (OIH)	126.31	0.03%	+54.35%
Big Pharma (PPH)	66.01	0.33%	+30.21%
Internet (HHH)	62.69	0.21%	+63.40%
Semis (PSI)	14.15	0.57%	+40.75%
Utilities (XLU)	30.24	0.73%	+19.94%
Defence (PPA)	18.84	0.77%	+49.34%
Nanotech (PXN)	10.38	-0.19%	+35.63%
Alt. Energy (PBW)	10.08	-0.69%	+17.89%
Water (PHO)	17.81	0.34%	+36.72%
Insuarance (PIC)	15.54	-0.38%	+31.57%
Biotech (PBE)	19.7	0.20%	+53.67%
Retail (PMR)	18.5	0.49%	+31.73%
Software (PSJ)	22.39	0.86%	+49.37%
Big Tech (QQQQ)	49.03	0.59%	+49.60%
Construction (PKB)	13.01	1.17%	+27.60%
Media (PBS)	13.56	1.19%	+79.91%
Consumer Svcs (IYC)	62.74	0.64%	+48.71%
Financials (IYF)	59.16	0.51%	+53.94%
Health Care (IYH)	66.31	0.39%	+36.82%
Industrials (IYJ)	59.53	0.69%	+56.59%
Basic Mat (IYM)	66.08	0.32%	+71.58%
Real Estate (IYR)	51.79	1.58%	+77.63%
Transportation (IYT)	81.25	1.08%	+54.99%
Telecom (IYZ)	20.48	0.59%	+24.06%

(data source: www.growthstockwire.com)

Every sector has seen incredible moves to the upside. Basic Materials (IYM) is up by 71% while Real Estate (IYR) is up by 77%!

So, as my title suggests, is it time to short this market? Other than the fact that there is still a lot of cash on the sidelines and Q1 earnings are expected to be great, year-over year (YOY, easy comparisons with Q1 of 2009), we still have many of the headwinds I mentioned earlier, intact. The fact that there is the possibility of yields on the long-terms bonds (10-yr bond yields briefly touched 4.00% after a long time this week) going higher, forewarns us the threat of higher cost of capital for both the US government and the US businesses. While the US companies boast superior balance sheets with more than a trillion dollars in cash, the gains over cost-cutting has reached its peak at then end of Q4 of 2009. So, further EPS growth has to come from top line growth and that depends on growth in exports and US consumers stepping back into the game. I feel, and many markets experts concur, that rising USD may have an adverse impact on US exports, while debt-laden US consumer, faced with a weak job market, may only show up briefly (the proverbial “pent-up demand”) before withdrawing into his shell.

So, I feel the market is ripe for a 20% correction. Why such a huge correction? Once the profit-taking starts in the midst of this “great” earnings season (market has already discounted this improved YOY earnings), many of the aforementioned problems will look much larger and the herd behavior, the fear of losing the accumulated profits, will lead to a self-sustaining downward spiral. And, most of the positives that have helped sustain this rally in the form of  improving economic data (lot of it is built on the back of government stimulus and Fed easy money) will plateau. Add to that, the end to Fed’s MBS (mortgage-backed-securities) purchase coupled with rising long-term rates will stall any improvement in housing market.

So, there are strong headwinds. Therefore, I feel the market will head lower from third week of April. There will be a broad market decline with every one of the sector ETFs shown above becoming a prime candidate for shorting. Of course, this is not for the faint hearted. If the majority of the companies provide great guidance for quarters ahead and job market improves dramatically (200k – 300k jobs added every month), then the stock market will propel upward. Either way, there will be a strong inflection point in the near future. We will take a look at these ETFs at the end of the second quarter and grade this market call then.

Aftermath of Financial Crisis, Michael Lewis’ Big Short and My Struggles after MBA

The greedy who ruled the world of high finance are sitting pretty. Yes, Madoff was caught and has been rightly put behind bars for the rest of his life. How about those who wronged all of us, yet cannot be held responsible in the eyes of law?

As each day passes by, I read more stories about the shenanigans from Wall Street, who left no stone unturned, in their drive to profit from “innovative” financial products that were so complex that the only way to unwind the craziness was a certain meltdown of credit markets and therefore, the general economy. Here is one such story of how big banks looted ordinary Americans; while bank executives made millions, ordinary Americans lost jobs and contemplated suicide. I am certainly one of the casualties of this crisis and at times feel extremely angered by the irresponsibility and the greed of some, which destroyed the future of many talented people who just aspired to live a productive life. While I completely take responsibility for all my actions and decisions past, I cannot help but think that the magnitude of today’s problems are solely the creation of few powerful people who blatantly discarded all their morals and responsibility toward the society. It was a meltdown of capitalist’s dharma.

You see, I was passionate about finance. So, I left engineering in pursuit of a career in finance and economics. I read financial history, economics, business cycles, financial theories and tools, and everything connected to the capital markets with great intensity and passion. I was fascinated by the way the markets evolved over the past one hundred years. There is this amazing story of Louis Bachelier, a French mathematician whose “theory of speculation” became the foundation for the concept of stochastic processes, random movements observed in statistical variables such as stock price. I fervently studied the works of William Sharpe, Harry Markowitz, Eugene Fama, kenneth French, Ben Graham, Myron Scholes, Fisscher Black, Bob Merton and so many other brilliant academicians and strategists whose theories and models became pillars of what is being taught in the business schools and practiced by investors and traders alike in their quest to understand and conquer this dynamic organism called financial markets. I read more and more about the history of capital markets, magnificent bull runs and devastating market collapses, rogue traders and the psychology behind their irrational behavior, 1987 crash, the demise of LTCM, which boasted the Nobel laureates and the “dream team” put together by the legendary John Meriwether. Boy! did I really work hard! I did a great job in MBA where I single-mindedly pursued financial topics—advanced corporate finance, international finance, risk management & Derivatives, investment & portfolio management—and finished at the top of these finance classes. I worked hard and was certain that at some point I could be one of the most valuable contributors in managing risk in the world of finance. I promised myself that I would work very hard, shun greed and work with great ethics and morals. In essence, I wanted to truly embody the true dharma of a capitalist.

The financial crisis destroyed everything I believed in. With each passing day, while I look for a job, I am troubled by the entrenched corruption at every level of our financial system. The system is incapable of eliminating the corrupt minds and incompetent, yet powerful people who were at the very heart of this crisis. Those who can make a difference are summarily dismissed as “misfits.” The mantra is still, “ profit at any cost.” Big banks, with all that “free money” from the Feds, is trading merrily and raking in big profits. The bonuses are going ever higher. But what about the real businesses, the bloodline of our economy? Feds’ easy money doesn’t translate to easy credit for these businesses. What is the strategy here? Those who screwed up the system and brought the entire global economy to its knees should be revived so that we get our confidence back? When these bankers and their brilliant, Ivy-educated traders make millions, we, the ordinary citizens should feel everything is back to normal and go about our lives? It’s an illusion. What is wrong with these central bankers? While I agree that in free market society those who have the ability need to be rewarded, I am disgusted by the fact that these traders in these big banks, with every advantage to turn the markets in their favor by the sheer weight of their big presence, are called “brilliant” and deserving. I think a high school kid with zero interest capital and the might of Goldman Sachs behind him can make millions! I have no doubt.

Incompetence and greed are a lethal combination. I would recommend everyone to read the brilliant book by the talented Michael Lewis. The book is "Big Short.” It’s the story of few courageous and brilliant skeptic investors/traders who made big money by betting against the US housing market and all those esoteric debt instruments concocted by the Wall Street bankers. Michael Lewis, a former bond salesman at Solomon Brothers, was a reluctant participant in the opaque world of high finance during his early days in Wall Street (he later quit and became a journalist and authored  many popular books such as, Liar’s Poker, Moneyball, Blindside etc.) and he was shocked to find that many Wall Street firms employed highly incompetent people who knew nothing about many of the financial products they were selling, yet received tremendous amount of money for their incompetence. In the Big Short, Lewis talks about Joe Cassano, the head of the now infamous division of AIG, the AIG FP, who was instrumental in the creation of all those high-risk Credit Default Swaps (CDS) on mortgage-backed-securities (MBS) that were sold to every investor/trader who was short on the rotten subprime loans. This Joe Cassano was a powerful, arrogant man who had no understanding of the esoteric financial products AIG FP was insuring, according to Lewis’s book. Moreover, the book says that he was a man who refused to listen to anyone who raised concerns about these products during their daily meetings. How can a company like AIG have such an egotistical, incompetent man at the helm? The great business writer, Jim Collins writes about the primary reason why mighty companies start declining from their peak,  in his new book, How the Mighty Fall, and he says it is the hubris that decides their fate. In the case of AIG, it was the hubris and the incompetence of Joe Cassano, and the stupidity of AIG’s leadership who failed to recognize that.

Before I conclude, I would recommend you to read the story of this unknown “moral crusader” of the Wall Street who finds himself as the central figure in Lewis’ book, Big Short—Steve Eisman. Steve was disgusted with the financial legerdemain that was all pervasive in  Wall Street. He found the recklessness of these organizations and its leaders morally reprehensible. Steve was also the man who trained the now famous financial analyst, Meredith Whitney of Oppenheimer.

My struggles are nothing compared to the millions who have lost homes, jobs and, more importantly, the hopes of better life. Somehow, moral hazard seem to only apply to ordinary Americans who made some bad decisions and not the big banks who threw all caution to the wind and played recklessly with other people’s money. I am troubled by this job market, which is going through a structural change. Many will never find the jobs they did all their lives. It’s been a devastating couple of years. I get a bad feeling that things will get really worse before they get better. While I keep upgrading my financial skills and try to be an active participant in the market actions, the realist in me says that dramatic upside in this economy is a mere mirage. So, I have to live by the teachings of Bhagwad Gita, “focus on the process and the result will take care of itself.” Easier said than done. I read a lot about the struggles of many successful people who defied all odds and made a mockery of conventional wisdom when it comes to building a successful life. Thinking about babies and how they learn to walk—they fall and fall and fall for a long time, but they keep getting up until they walk for good—is a great lesson. They are unencumbered by their failures; they don’t care what others think about their lack of success in the beginning; they just keep doing what they seek to achieve. It is a great motivator, that baby thing, but I am intrigued how as adults we forget that lesson we learned in our own lifetime. May be it has got to do with our own arrogance of what we know as we grow, our inflated measure of who we are and how we need to be seen in the society, how we let others define our own success, how conscious we are about what others think about our job, our assets, our family life, our material possessions…Life in the grand scheme of things should be all about where we started and how we make our journey till we bow out of this world. At the end of the day, poor or rich, we need to stick to our values defined by dharma and perform our actions that are positive in some small way to the society we live in.

Good luck and good life to all!

 

 

 

Traders and Spiderman

The way the global stock markets are behaving these days remind me of one of the most fascinating superheroes of our time—Spiderman. Why do I say that? Because, the only way traders can stay in this market and sleep at night is if they can emulate the agility of our web-weaving superhero.

By the way, those who idolize Warren Buffet and still subscribe to this agonizing “buy-and-hold” strategy, need to rethink; and, do so really quickly! I am a big fan of the Oracle of Omaha, but am also a realist. If you don’t have the kind of money Warren has, then forget this strategy. He can wait and wait for a long time; moreover, he can move a stock price just by buying it. Some years ago, when he purchased the convertible bonds of this much-hyped technology company, level 3 technology (NYSE:LVLT), the stock price shot up (yes, the fundamentals remained the same but Warren’s confidence in the company was enough for investors to jump in). Isn’t that a beauty? You buy these bonds at a low price and stir the market, get the prices to go up, and then  convert these bonds to stocks, and sell. Great! Once you are really successful, it doesn’t matter whether you make a wise or a dumb decision; you still make money and everything is hailed as a “touch down.” Nothing succeeds like success!

Enough written about Warren; let’s go back to our discussion on traders and Spiderman. Since the market hit the March 2009 lows, the major indices have rallied almost 60%-70%. Even though, the sovereign debt troubles were lurking in the background, thanks to the printing presses of central banks around the world, markets kept hitting new highs. This year, though, it has been a different story. Every day, with every new headline, the market has swung both ways. China’s steps to curb lax lending and Greece’s potential default issues (the bulging sovereign debt CDS spread has been well-documented by several bloggers and financial sites, ex: www.zerohedge.com) have scared the investors/traders to take cover. On the other hand, every dip in the market has been used as buying opportunities by some big investors—institutional and hedge funds—scaring-off the shorts who like to take the market further down. In the midst of all these up and down swings, there are serious claims by many Wall Street  insiders that some of the big financial institutions with proprietary trading disks have been happily manipulating the markets, with complete disregard for the fundamentals, and raking in huge profits. As a trader, I can see that possibility. Just when you think the market is downbeat, around 3:30 PM, the market takes a dramatic turn to the upside. This kind of manipulation is even seen in systematic pump-up of S&P futures before the market open. In my observation what I have found is, even when the news is fundamentally bad (I am talking about equities in general) and the global markets are reflecting that pessimism, US stock futures slowly rise, from their deep lows, as the pre-market hours progress toward market opening. I have never understood why?

So, since President Obama came out with his declaration of “Volcker Rule” in 3rd week of January, financial markets have whipsawed with every news headline and economic data. Traders have been forced to buy when the markets went higher and sell or short when the markets went lower. Traders have done well if they have kept their Spiderman instincts and acrobatic skills highly sharpened. Those who wait for the markets to go in one direction, up or down, have been left waiting, because at the end of the day, they have been left with nothing to show. The mantra has been, “take your profits when you have them, and cut your losses when things go in the other direction.”

This can be really stressful. Yet, traders can survive these market swings before a long-term trend is put in place. One has to be disciplined and show great agility to move with the markets and profits can be made in this market. Unfortunately, for those investors who keep dollar-cost-averaging (ex:401k) if the eventual secular long-term trend is bearish, then another “lost decade” could be devastating. Market and economic forecasts from some of the big names (likes of Nouriel Roubini, Harry Dent, Md El-Erian) in the industry have been nothing but lower normal to bleak. After 20 years of expansion and the excesses, some pundits believe that we will be reverting to an historic mean, which in plain speak, means lower markets, lower returns and lower living standards.

I hope long-term investors would still end up earning good returns; but a careful consideration of investment “time horizon” is a must. I know that for most people who are in the stock market, it is simply impossible to move with the market gyrations (it’s not just about the stress, people just don’t have the skill or the time or interest to follow the markets). But those who trade and religiously follow Mr. Market, may do well to learn from Spiderman.

Timing is everything. Good luck to all!

The New Normal

One of my favorite market commentators is PIMCO’s CEO Mohamed El-Erian. He has this remarkable gift of making pithy statements about the prevailing market conditions that really make sense. Without delving into his market credentials, let me simply state that the man is too good in taking a measure of the macro fundamentals and policy effects and explaining it to his audience.

El-Erian has been very vocal about the massive changes in the way the markets would evolve in the aftermath of the financial crisis. In his words, we will be living in a world defined by a “new normal.” I have been thinking about this new normal. While it may sound too alarming to some, I would like to ask this question: “Is this (new normal) what Karl Marx famously wrote about in his 1880 magnum opus, ‘Das Kapital’?” Marx predicted the end of capitalism and the rise of communism. While I am confident that such a dramatic shift in our economic system is too far fetched, it is probably worth our time to understand what Marx was thinking. Robert Heilbroner, in “The Worldy Philosophers” writes this about Marxian predictions:

"Why did it (capitalism) breakdown? Partly because it developed the instability Marx said it would. A succession of worsening crises, compounded by a plague of wars, destroyed the faith of the lower and middle classes in the system."

“The Marxist prediction of decay was founded on a conception of capitalism in which it was politically impossible for a government to set the system’s wrongs aright; ideologically, even emotionally impossible. The cure for capitalism’s failings would require that a government would have to rise above the interests of one class alone—and that was to assume that men could free themselves from the shackles of their immediate economic self-interest. Marx’s analysis made
that doubtful.”

And here we are, plagued by two wars with no end in sight and an economic crisis with a devastating impact on the middle class. This economy continues to lose jobs when it should be creating 150,000 jobs per month, just to keep the new entrants into the job market, employed. Although, Case-Shiller Index is showing some stability in home prices, it could be just a temporary calm before another huge dip. This is very much a possibility, if the middle class continues to get squeezed with no relief in the job market. On top of it, soaring deficits and national debt is not making it easy for those who are constantly worried about the future. Debt may not be a problem, provided we have the capacity to grow. But that notion of sustained economic growth and productivity increase are things of the past. If history is any indication, the debt level and the flood of fiat currency, thanks to the Fed, will eventually lead to inflation and higher interest rates. There are counterarguments to that notion, especially, with forecast of tepid consumer demand and contained labor cost due to prolonged high unemployment, that instead of inflation we may see Japan-like prolonged deflation. But, if demand for the US debt tapers for obvious reasons, especially among foreigners, the yields on the long-term bonds will rise thereby increasing the prospects of higher cost of capital. That will certainly dampen the recovery of housing sector and strangle business investment. How do we grow then? Lack of sustainable growth (not the growth that creates excesses) means that the country has to embrace new austerities, otherwise face a daunting possibility of nation’s inability to service the sovereign debt!

In the midst of all these economic upheavals, those who rely on jobs to sustain their living and building a nest egg will find things really difficult. Global competition in the labor market will ensure slow income growth while fight for resources among the nations will certainly impact the commodity and energy prices. And, the continued military expenses will distract the US from diverting all the precious capital on education, healthcare, economic growth and the funding of social security and Medicare. Is that the Marxian breaking point? I am sure, the American willpower and the ability to fight against all odds may save the day, but that does not change the prospects of a new paradigm of living for ordinary Americans.

This new normal, is, in a way good for this young nation. In the long run, new austerities and focus away from material excesses will be beneficial for this country. As long as people believe in the system and its fairness in most occasions, they are ready to ignore some of the imbalances and the acts of few corrupt people while striving to adjust to the new realities. In the short term, the process of adjustment to these new realities will engender pain and anger. That can be managed if our leadership forgoes the partisan politics and starts governing with a promise of better future.

The more I think about the aftereffects of the current crisis, more I am convinced that this extreme notion of “growth at any cost” will lead to highly asymmetrical societies, which essentially, what the Marxian ideologues wish to see. Although, asymmetry is a fact of capitalist society, as those who are able and somewhat lucky, hardworking and opportunistic, can quickly climb the economic ladder while the rest would have to be content with what’s left in the middle and the bottom. Economic inequality is an unavoidable fact of the system we live in. Yet, so far, this system has proven to be just, creating opportunities for all and instilling a belief that if one is ready to work hard, one can reap the fruits of that hard work.

However, the kind of economic asymmetry that helps create conditions, which could potentially throw us back to the days of feudalism, is at the heart of this discussion. At this point in our history, we can recognize that egalitarian society is a utopian concept; however, if the growth mechanisms we put in place create conditions that enable the common man to make progress, provided he is making the right choices, then the system will do well and sustain itself. That system, undoubtedly will be under threat, if those conditions enable only the rich and the powerful to stretch its fabric, to such an extent, in an effort to amass filthy riches, that the general well being of the common man is completely disregarded.

Here I want to digress a bit. Being an active market participant, I watch lot of financial news. And, what has bothered me in the recent years is the presence of plenty of reckless enablers who in the name of “free market capitalism” glorify excessive risky behavior. I call them “enablers” because they are precisely the kind of people who refuse to talk about “inclusive” capitalism. They do not understand the true dharma of capitalism. They are the ideologues on the other end of the spectrum who drum up the rhetoric of “growth is good” even when the growth is built on unsustainable leverage in the system; these are the same people who are unapologetic in their quest for resources of this planet and instant use of these resources lest their miracle growth could escape them in their lifetime. They don’t even spare a thought for the future generations or the long-term sustainability of mankind. They are ubiquitous in times of asset bubbles. Unfortunately, their voice is heard and they somehow find success in reducing the masses into “intellectual parasites”, as they go about attacking those who publicly criticize their crony capitalist ethos. The good news is, as the system reverts to a more meaningful mean, these folks will find it hard to survive.

Coming back to my new normal theme, I think it is apt to remind the readers about the economic philosophy of the great Indian leader, Mahatma Gandhi. He rightly rejected the welfare state as an assault on the dignity of individuals’s ability to be responsible for themselves. He wanted an economic system that required people to be self-reliant. Yet, he was also against “rapid” industrialization. He felt that the ideal of endless economic growth could be inhuman and destructive. That is not a stance against capitalism or the idea of economic growth that brings prosperity to most. Nonetheless, his economic philosophy cautions the policy makers to approach growth without losing sight of long-term societal harmony.

I don’t think, we capitalists, rue the possibility of an economic bust after a significant period of healthy growth. We are accustomed to the cyclical nature of business. No business lasts forever and no industry enjoys infinite growth. Joseph Schumpeter, an Austrian economist, described these cycles of innovation, obsolescence and the emergence of new industries as “gales of creative destruction.” That’s how nature works; transformational cycles exist in every aspect of our universe. The fact that we have seen such prosperity in this part of the world for so many years while billions of people have languished in relative poverty is probably a sign that a transformation in economic balance around the globe is in order. The excesses in the financial world and the flow of capital away from real economies (where it could have improved the lives of millions) into esoteric financial instruments and the subsequent destruction of wealth are harbingers of this transformation. This is the phase where those who have lost some of their riches due to their own excessive behavior need to introspect and rebuild the system with much lower expectations while those who were deprived for long use the new opportunities to improve their lives. New normal is being established everywhere.

Here in the US and in the developed world in general, the standard of living will be affected because of all that has happened in the past two decades. I think the days of 20% return on investments are few, as policy makers rethink the growth strategies and focus more on fruits of economic growth impacting all sections of society. That is critical to keep the system from becoming unstable again. New financial regulatory framework will curb excessive speculation and risk-taking. If there are financial instruments that are meant for hedging purposes, the new changes will make sure that they are used for only those purposes and not for speculative trades. New tax policy and higher transaction costs will further discourage people from taking massive risks. I don’t think people will be able to use their homes as piggy banks. That would put an end to home equity being used for funding all kinds of spending programs and what will ensue is a more meaningful allocation of capital to meet the most important needs. World is changing fast and the emergence of new economies will redistribute capital in a way we have never seen before. New normal in our economy will need us to do more with less. In the final analysis, that’s not bad at all.

Geopolitics

Will the US rediscover its role of a responsible capitalist power after the twin wars and devastating financial crisis?

In this very probing article from http://www.oilprice.com/, author Gregory R. Copley, discusses the fallouts of the latest financial crisis and the military adventures, in terms of the weakening status of the US as a super power. Is the US the modern Roman Empire? Can wealth and military power forever maintain the superpower structure? Author has some interesting conclusions where he lays out the much-needed strategic mindset to navigate in this post-crisis, transformed world.

Author asks this question:

“The question is whether this current process through which the US is going must inevitably be played to a conclusion which sees the US itself — as the Roman and Hellenic and Mongol and British and Netherlands and Soviet empires once were — broken apart or reduced to modesty among the ruins of grandeur? It is not. Nothing is written which cannot be re-written.”

What changed the communist bloc in the aftermath of the cold war? How did the defeat transform PRC and Russia? Copley has an interesting explanation:

“The Russian Federation’s grand strategic growth began only with its recognition that it was forced, with the death of the Union of Soviet Socialist Republics (USSR) in 1990-91, to put aside the pretensions that it had been a superpower. The defeat of the USSR-led bloc by the US-led bloc, which determined the end of the Cold War, engendered in Moscow the deep reflections and reorganizations, which only defeat can bring. Russia, with this realization, was able to revive the strategic momentum, which had been thwarted by the 1917 Revolution.

The West, and particularly the United States after the end of the Cold War, wallowed in a condition even worse than defeat. It wallowed in victory.

With defeat comes the ability — indeed, the license, mandate, and demand — to sweep out failed or obsolete institutions; to scour out the sclerotic accumulation of laws and bureaucratic procedures; and to purge the perpetuation of the kind of strategic insensitivities which had led to defeat. With victory, no such license is granted, and the presumption of superiority reinforces and compounds ancient structures. It does, however, reinforce the thinking and architecture, which had led to victory. Further, victory it leads to the excesses of those who ride to power on the exhausted backs of those who, in fact, had created the victory.”

…

“Thus, in relative terms, post-Cold War, Russia and — in a different fashion — the People’s Republic of China (PRC) learned, re-organized, and began the process of rebuilding their societies, less hampered by the earlier constraints of state structures. They prepared for a new world, and acted accordingly. They learned from history, ancient and recent. The West — but again, particularly the US — engaged in no such introspection; did not bow to the humbling workload of reconstruction; and was left hidebound by institutions which had acquired the towering and massive strength of fortifications built for a war long past.”

And what is west suffering from? Copley says, “the Saudi disease”

“Wealth and identity, while being built, demand absolute self-awareness, discipline, and a constant understanding of context. Wealth, when it is being spent, is blind to everything but self-gratification. I once called this “the Saudi disease”: I am wealthy, therefore I am smart. It is now the Western disease. And the West will continue its decline until it has sunk so low, spent so much, that it is forced and humiliated into self-review. Even alcoholics — those who admit their condition — are aware of this phenomenon.”

Excellent observation combined with analysis, Copley points out the potential alliances that may be forged between US and India, power structures in the Atlantic, Pacific and Indian Ocean.

Read the article at:

http://www.oilprice.com/article-the-us-finds-its-superpower-structure-and-capital-are-insufficient-to-cope-with-a-transformed-world.html

Guest Posts

Those of you, who feel like contributing to my blog, please do send your articles to the following email: dharmacapitalism@gmail.com

I will review it and post it, so that we can have more participation in good, constructive discussions.

Starting Point

Capitalist's Dharma

Couple of years ago, when I was still in my MBA program, I had an interesting exchange of thoughts through a series of emails, with a member of my project team. The topic was the economic systems of the world. I believe he had somewhat a libertarian streak in him. He was in support of laissez-faire market economy whenever US policies were in question, yet had some reservation toward free trade. Our debate lingered on for few days mostly him trying to stubbornly defend the virtues of capitalism in its current form, and me trying to profess the beauty of combining the best from all possible ideas instead of rigid adherence to an ideological viewpoint. Somehow, I had a feeling that he thought I was a socialist.

It is sad that good, intelligent people become so intellectually rigid, that they hide behind labels, which prohibits them from seeing the benefits of middle ground. It also makes them dumb enough not to grasp the importance of certain thoughts, theories and ideas within the context of the times in which they are profoundly relevant. What I mean by that, is, while we don’t need to adhere to Keynesian economics in every situation, it could have its relevance in certain times, as the best solutions to the prevailing problems could emerge from Keynes’ economic theories. But wait, isn’t giving credence to Keynes is like embracing socialist policies, as government is invariably “messing” with free markets? The problem is, we are in a world where free market proponents are always suspecting government motives and actions to uplift the powerless in the society while on the other end of the spectrum, the so-called staunch socialists who see nothing but satanic soul in every capitalist. Does anybody care that we humans are incapable of transcending the dualities that exist in every facet of our lives? Why do we have to always emphasize the difference, instead of joyfully experiencing the beauty of unitive nature notwithstanding such dualities? Dharma is simply rediscovering that essential nature we were born with, which will help us to transcend the dualities we struggle with. It is gratifying to know that we have examples of highly successful capitalists amongst us who have lived by this dharma, created wealth, improved the lives of thousands around them and all by exemplary set of actions without a tinge of greed. Narayan Murthy, the founder of IT giant Infosys, is one such luminary.

Let me make one thing clear. I have nothing against free market economic system. In fact, I am fascinated by the way markets regulate themselves. Free markets provide the best possible conditions to achieve material progress. I think wonderful things have happened in this great nation of ours exactly because of the unleashing of human entrepreneurial potential. Capitalism has worked here to such an extent that the countries around the world have bought into the idea of liberalizing their economies and done away with socialist agenda; China and India are prime examples. But my worrying mind is troubled by the huge economic imbalances created by this very system, which promises to lift millions out of the grip of poverty. Many believe that the economic divide between the rich and the poor in the US has reached scandalous proportions. Can this imperfect system, tarnished by its capacity to wreak havoc as evidenced by the financial crisis, sustain itself with its emphasis on self-interest? Is my MBA friend who fiercely argued for an Ayn Randian kind of system, where only those with superior abilities and their self-interests should triumph and rest should suffer (he didn’t say that, I inferred) as if they were social parasites worthy of elimination from the system, correct? Is Darwinian model the right one for humans with such great capacity for compassion?

This debate took place when the US economy was still buzzing in a Kudlowesque “Goldilocks” economy. While I had read enough by that time to expect a major financial crisis of global proportions, my friend was still stuck on the greatness of this unbridled capitalist system, which allowed those who were in positions of power to indiscriminately take risks with other people’s money to rake in millions of bonus money. Yes, self-interest, at its best! So, even though, economy was doing fine, the leveraged world of financial markets was writing a nasty script that included millions of ordinary, hardworking Americans losing jobs in panic firing by corporate America! Is that “creative destruction?” Can capitalism sustain itself if some within this system get richer and powerful with every tiny effort while rest get crushed despite their gargantuan efforts to stay afloat and sustain their livelihood?

I believe in capitalism, but one that is humane and accommodative. Capitalists have to perform their functions with a clear understanding of human dharma—dharma that brings to fore the essence of what makes humans a superior life form. While self-interest drives people to action, every capitalist should measure the success of his action by the positive impact on society. Wealth accumulation should be a by-product of one’s honest hard work—Warren Buffet style—and, not the result of the ruin of many others, a la Madoff. But, unfortunately, crony capitalism leads to monsters like Madoff to game the system and sustain their lavish lifestyle for a long time. In the meantime those of us who struggle to get good education, work hard to realize some of our dreams, live by the rules that only apply to the powerless in the society, and nurse a reasonable dream of dignified life, face a potential life-altering failure with one crisis precipitated by these greedy crooks. Ordinary people, despite all their good intentions, by the sheer burden of such failures, experience “experimental neurosis”—a state of inertia experienced by laboratory animals when they are faced with a sudden new environment, which renders them unresponsive to stimuli. A system that renders the majority of its productive population into such state of inertia can degenerate into economic chaos and destabilize everything. Our capitalist system is reaching that dreadful stage where things can quickly reach an inflection point and destroy all the great things that are part of a capitalist society, in no time.

So, my solution is, it is time to rebuild capitalist society with a different emphasis. While self-interest could still be a reason for one’s action, it should be enveloped by a motive that seeks greater good of the society and not its misery. This is not all that idealistic, actually. One has to let human dharma to guide one’s actions, control one’s greed, and evaluate consequences, and then follow-through by weighing the outcomes of one’s actions. When we are mindful of these principles, we will be socially responsible. We will not be less competitive or shy of employing all our God-given abilities to create wealth by adhering to these principles; in fact, we will thrive because rest of the world will benefit from our actions.

Yeah, I know, this still sounds very idealistic. But, being hopeful of a better world for its entire inhabitants is one that I don’t mind writing about.

One last thing, I am sure, that friend of mine from MBA, has changed his mind and his rigid views about capitalism after watching the economic devastation in the wake of global financial crisis.

Should every economic cycle bring such suffering to so many? Can we limit the swing of the pendulum to an inch to the right and an inch to the left?