Thursday, November 27, 2008

The Global Financial Crisis: Part 3 - A Guide to Self Preservation

(Published in DNA Navi Mumbai - 27/11/2008)

There are some inescapable ironies in the way the above drama has played out and in what is still happening out there in the markets. 

Contrary to what happens in all stories, the bad guys have not been punished.  They are being “bailed out”.  The rationale is that they are “too big to fail”.  If you are small you will be punished when the time for reckoning arrives.  If you are big, and if you have succeeded in creating a deadly contagion, and spreading it across to others in such a way that your collapse could cause the system incalculable harm, you are likely to be granted immunity.  You are also likely to be rewarded handsomely for your culpability.

There is huge systemic incentive for people who take these decisions to take a lot of risk with other people’s money.  This must stem from the fact that the people who do this make a lot of money on the upside but lose nothing on the downside.  If this were the middle ages, the perpetrators would perhaps have lost their heads, in the literal sense.  What is galling is that it is our money they are playing with.

While the system conspires to move in a particular direction, it is very difficult for an individual player (except individuals who are acting on their own behalf) managing funds to move in the opposite direction.  The herd mentality tends to prevail, magnifying events both on the upside and on the downside.

Contrary to what popular theories of diversification are based on, there seems to no true diversification among asset classes any more.  All asset classes have moved in the same direction in the recent past.  This is due to the huge inter-linkages in the financial systems.

Volatility has increased and is here to stay.  Those with weak hearts should not participate in the markets. It used to be thought that this was true for individual investors; investing money through funds would ensure peace of mind.  Unfortunately, no one in the financial system is immune from volatility.  Probably we need to train our kids for this new reality to prepare them for the real world.  I propose to start with roller coasters and then work them up to financial markets.

Commonly held notions like “debt funds are safe” are now under review.  Several debt funds who have lent to companies in the real estate and financial sectors are now facing defaults, not considering those funds which have already lost enough money “marking to market” all their CDO investments.  Money market funds across the world are in danger of “breaking the buck”, a situation where their NAV drops below the principal.

Capitalism and free markets, much touted as the best economic systems,  holy cows of the modern age, are now coming under cloud.  Unbridled free markets with minimal regulations seem to have unleashed the forces of human greed, allowing entire systems to be corrupted by market manipulators operating under the cover of perfect legality.  This is not to say that any other system is necessarily better.  Modern economic growth in the first place may not have been possible without these institutions and constructs. 

Insulating oneself from the world is not an option in this day and age.  The Indian market deluded itself for some time believing that we are “integrated” with the rest of the world when it comes to taking advantage of global business growth, but are “decoupled” when it comes to stock markets.  In the last few months, the co-relation between the Dow and the Sensex, as well as the Sensex with other world stock indices has been so high as to lay permanently to rest the myth of decoupling.  The exchange rate movements that we see now are also a result of cross-border cash flows reacting to global events.

How do the decision makers, the politicians and central bankers of the world, plan to address this?  With more regulation, naturally.  There is a clamor for regulations to be tightened.  How, in what fashion, and to guard against whom, does not seem to be very clear.  I have no doubt the system will arrive at a list of culprits and causes by consensus, and move to take certain steps to contain “such” excesses in future.  The only problem being that any excesses in future will be of a different nature.  The system will soon enough find a way to work around the regulations; it will possibly use them to advantage.  The current round of liquidity being infused into the markets is just the beginning for such a cycle to start again.  We can be sure there will be another set of scams a few years from now; that a few hundred individuals will benefit hugely; and a few million lay people will again have to bear the consequences. 

What can the individual investor, i.e., you or I do to safeguard our money given the above somber conclusions?  It is impossible to predict how the markets will move over the short term, and how economic indicators like inflation, interest rates, or exchange rates will behave over any defined span of time.  What we can attempt to do is to draw some general conclusions from what has been happening in the markets, and keep tabs on certain trends that are likely to emerge in the near future.  We can draw up a plan of action based on this; and keep checking our assumptions and correcting our strategy and direction from time to time.  It is no doubt going to be painful process, one where we will have to correct our course as we go along.

Some of the fundamental truths of investing still hold good.  You need to invest regularly and for the long term.  You need to diversify over different asset classes by using asset allocation strategies.  You need to understand the risk, return and liquidity profile of every asset class that you are investing in.  You can hand over your money to someone else to manage it for you, but you need to be knowledgeable enough to know where and how your money is being deployed. 

We need to add some more fundamentals in light of recent happenings.  You need to be reasonably aware of economic cycles and how to take advantage of the ups and downs.  The recent meltdown may have been too severe for most people to have taken timely corrective action; however, it is likely that not all future swings will be this dramatic, and with enough vigilance you might be able to act in time to avoid potentially nasty situations.  You need to be aware of global economic trends at least in a broad general sense; it may not be prudent to be completely oblivious of what is happening in the rest of the world.

As to some concrete steps for the immediate future, you could consider the following.  Equity markets are at  artificially low levels right now, more so in India.  You should start entering the market by buying in small lots.  The index is likely to swing wildly for the next few months – my guess is between 8000 and 11000 levels.  While the prices are at such low levels, it would be a good strategy to invest.  However, you should only commit funds that you don’t need for the next three to five years.  While the market will surely rise, we can’t really say when.  If I were to take a guess, I would say that we will see the year 2009 end at 13000 levels, and 2010 to end at 16000-17000 levels of the Sensex.  If the markets reach those levels in a sudden spurt over a very short time period, you could even consider selling at that point if you expect a correction to happen.

For those of you who invest in equities via the mutual funds route, invest in large diversified funds or index funds.  Avoid midcap funds for now.  For those of you who like to invest directly in the market, do not jump into real estate, financial services, or commodity stocks for a while.  Pharma and FMCG are good options currently.  IT and IT Services are a bit more difficult to predict due to factors that are both positive and negative – watch the sector closely and try to take a call at the right time.  Avoid hotels, travel and entertainment.  The global economic slowdown is not likely to reverse direction at least till mid-2009 at the earliest.  Tight liquidity conditions and shrinking debt markets are likely to persist for some time. The Indian elections are likely in early 2009, which would paralyze fresh policy initiatives and spending till the new government is up and running in mid-2009. All these factors point to this strategy likely to being effective for the next six months at least.

Some part of your portfolio always needs to be in cash.  The best option for cash is to open Fixed Deposits with large banks.  The interest rates are currently  around 10% for FD’s of one to three years’ duration; it might make sense to lock in at these rates since the rates are expected to drop in 2009.

If you are willing to take some amount of risk with your debt investments, you could look at investing in long-term gilt funds.  You could benefit from the increase in NAV when interest rates drop.

Invest in real estate.  That is something that will always stand the test of time.  However, currently real estate prices are expected to drop further.  You should wait for a few months; it is expected that there will be major drop in real estate prices by the first quarter of 2009.

Invest at least 10% of your total investible surplus in gold.  This is a strategy you could adopt for the long term.  When it comes to gold, only ETF’s and gold biscuits (or coins) qualify as investments; ornaments do not.

Keep re-evaluating your strategies in light of developments.  If you think you have to exit any investments, do not hesitate to book losses.  Do not indulge in derivatives of any kind.  Commodities (except gold and silver) are also avoidable.

Remember that it is not possible to make money unless you take risks.  For an opportunistic investor every downturn presents an opportunity; currently, the opportunity is big.

Happy Investing!

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