Archive for September, 2007

The rupee correlation

There’s a lot of talk about how a currency affects the stock market and the economy. There is even literature available on the dollar and its beneficial effect on the Dow. A strengthening dollar is considered good for Dow components. The top 30 companies of the world have operations around the world and receivables in dollar. Thus, a strengthening dollar is considered positive for Dow blue chips.

Not a very different story connects the rupee with the Sensex and the rupee with Indian tech sector. A stronger rupee hurts exports and a weaker rupee benefits. Now this is about perception and theory. A real correlation check on how strong these correlations are reveals a different picture. Dollar-Dow correlation oscillates from positive to negative and not surprisingly the correlation of the rupee with the Sensex or CNX IT is also weak. The reality, just like always, is different from perception.

This is another economic rule which markets trash. We talked about the spin effect on currency last time. The reality of rupee proved us right again as the rupee broke the 40-mark. The story should now be that foreigners want to assume currency risk as local currency is strengthening against the dollar. Being invested in Indian stocks is a haven as both the Sensex and the rupee go up. This is a double benefit. But unfortunately even foreigners are human and as a group go wrong. Their investment strategy was weaker in Jun 2006 (rupee at 46.5), but itʼs stronger now that we hit 39.

Correlations are make-believe, there is no clockwork here. They cannot tell you where the rupee is headed and where it will take the Sensex with it. The big surprise always happens when people least expect it. We don’t see the rupee appreciating beyond 38, it’s a turning point for us. And we are not far from a dollar surprise as it turns around for a multi-month of strengthening. And about the Sensex, the immediate price targets lie at the Fibonacci confluence of 18,000 points despite what the rupee does and without health care, FMCG, auto and IT, which still reel under or near May 2006 highs. The positive correlations of yesteryears of these four sectors with the Sensex are turning sour now.

Blind men and the elephant

Demand-supply dynamics are not only differentiating economics from finance but reshaping capital market research

At a farewell party last night, we found that five of us had the same birthday, which was quite a coincidence as the gathering was small. There, a friend from Lebanon who is a senior techie at a Fortune 500 infrastructure company asked me to explain how such recurring coincidences take place often. There was no traditional answer for his question. I told him that just like clustering of market prices was a cyclical reality, and such coincidences happen again and again with cyclical precision.

The age of confluence is full of many such coincidences and witnesses a mixture of cultures, thoughts, sciences, information and above all the human emotion, which continues to oscillate from one extreme to the other, changing the way we comprehend and see things. This is why time and again traditional or conventional research has come under fire. How accurate is it? How accountable and how relevant?

The Indian legend of the six blind men and the elephant fits the predicament well. The blind men are the traditionalists trying to understand what they can’t see. It’s not because they are blindfolded, but because the tools they use are archaic and only explains a part of the picture. Times have changed, as a neuroscientist, physicist, biologist, psychologist and historian are challenging the economist on his home turf.

The new age brings with it an overload of information and a host of parameters, which are humanly impossible to interpret and analyse. This is why what we have been doing for a long time, analysing and valuing markets based on available information and demand and supply gaps is futile. A recent paper suggests that we got it all wrong and there were certain subjects like economics and finance we should never have mixed in the first place. The new model of finance suggested by Robert Prechter and Wayne D Parker in the Journal of Behavioral Finance explains why our tools are ineffective and why fundamental analysis does not work in markets.

The fundamental analyst calculates an intrinsic fundamental value using a number of objective features, such as the company’s industry position, sales trends, profit margins and earnings, asset composition and liquidity, and its mix of financing. However, the market may not always reflect this value and may deviate owing to investors’ non-rational emotions. The analyst makes two assumptions here. One that the emotion is temporary and second, that the markets will revert to the mean after rationality returns. According to Stephen F LeRoy, economics professor at the University of California, Santa Barbara, “The only problem with fundamental analysis was that it appeared not to work.” And economist Alfred Cowles’s study showed that fundamental analysts’ forecasts actually yielded worse results than random choice. No wonder the world’s best research company had an accuracy of 34 per cent. The report was published by Bloomberg last year.

Stock price action over the past ten years has especially confounded fundamental analysts, who have watched share prices fluctuate wildly despite little change in traditional “fundamental value” (or in some cases despite no fundamental value at all). The data also suggests that the stock market is blissfully unaware of the dividend discount model and the earnings discount model. Financial market prices are not stable but dynamic, and they are not dependent upon but rather substantially independent of supposedly related “fundamental” values. And from the point of view of fundamental analysis, prices spend far more time deviating from the mean and the “fair value” than reflecting them.

Prechter and Parker also define economic and financial markets. The former catering to utilitarian goods and services, while the latter for investments and speculations. Demand and supply relationships differentiate economic from financial markets. In economic markets, demand generally rises as prices fall and vice versa. In financial markets, demand generally rises as prices rise and vice versa. This difference is essential because the behaviour of economic markets is compatible with the law of supply and demand, while the behaviour of financial markets is not.

Sensitivity to oil prices explains the economic behavior well, as people change transport habits to cut back on consumption. Higher the price, more sensitive and subdued the demand. On the other hand, in finance, prices do not influence behaviour in this manner. The volume of trading in the stock market goes up with price. Higher the price, higher the demand.

Prechter and Parker explains the new socionomic theory of finance that should replace the dysfunctional old Efficient Market model. Prices are driven by mood of the majority as they herd. Valuations are a direct measure of investor optimism or pessimism about the valuations they believe others will place on stock prices. What is new in socionomics is that social mood trends are unconsciously determined by endogenous dynamics, not consciously determined by the rational evaluation of external factors, and investors’ unconsciously regulated moods are the primary determinant of the direction of stock prices.

The paper rekindles the old debate of how we are using a wrong economic model for the financial markets. The traditional way to value markets and assets with demand-supply gaps is flawed. Global equity research model is dead. “From the Ashes of the Equity Research Model” was a report issued by the Tabb group in April 2006. The report claimed that the business model for research was broken and the death of the equity research model had really unfolded over the past 10 years as investors migrated toward passive investment strategies, lower transaction costs and self-directed electronic trading. And if economic models like Efficient Market Hypothesis were believed, it was impossible to outperform the market and that meant that investment research ultimately had no value. The big bucks were in large-cap research. And even this left a huge section of mid-cap and small-cap under researched and under serviced.

An alternative model of research is already thriving in the US, and it’s only a matter of time that it is accepted globally. The new capital market research model should be different from the old one and clarify some broad misconceptions of traditional research such as capital market research is free; it is linked with money management revenue; it is incapable of earning big bucks on its own; it needs domain knowledge ie to know about coffee plantations all over the world to forecast coffee prices; it means access to privileged information; it is extrapolation; it is resource intensive; it is not accurate and accountable; it cannot be global and local at the same time and it can never be a standalone business. Non-traditional research addresses all these misconceptions and a research revolution is already under way. What we need is a few more coincidences, a few more questions and an elephant to blow the blinds away.

Psychology of a loss

Humans are Loss averse. And the individual, corporate and society which understand it thrive despite odds.

“How did this stuff ever get published?” was what traditional economists asked when behavioural economists observed that human beings were loss averse. This aversion is at the heart of human psychology and asset pricing. And if professors are fighting over academic leadership over the subject you can understand why the only “loss” Google search can handle today is that of “weight”. The psychology of a weight loss is positive and motivational unlike the psychology of a monetary loss, which can be pretty depressing. But despite all negativity around the subject understanding loss aversion is at the heart of an investment strategy and even being a successful money manager.

Loss aversion can explain why a price “bid” on or off a trading screen is always lower than “ask” prices. It’s not just because sellers always ask for a higher price than what the buyers can pay but because people attach more pain with a loss of “x” than the pleasure they experience with a gain of “x”. In other words people place more value on giving up an item than on receiving it. Giving up is tougher, more valuable and hence a perceived loss.

So it is not the reality of loss that matters but the perception. And propensity to be loss averse is somewhere connected to a real loss. The more one tries to avoid it, the more it grips you. We have seen nations going to over-extended wars until miserable failures, owing to loss aversion. And loss aversion combined with inability to admit or learn from mistakes can only complicate investment decisions, delaying them till they are of no use, as in a capitulation.

The psychology of a loss works against market timing, and clearly explains why masses cycle from complacency to panic. It also explains why entrepreneurs are contrarians, why we are uncomfortable with geographical risks (Indians trading on the Pakistan stock exchange), why very few of us marry foreigners, why very few intra-day traders make profits consistently, why volatility as an index derives its strength from panic, why our over-trading is an extension of loss aversion and why volume rises when the market goes up and vice versa.

Eric J Johnson, Simon Gächter and Andreas Herrmann, professors at University of Nottingham found some interesting patterns linking loss aversion with various parameters like, age, income gender, education etc. Age seems to be an important moderator of loss aversion. The older we get the more loss averse we are. Gender is an insignificant predictor for loss aversion. So being a woman trader or investor has no intrinsic disadvantage. The study concluded that loss aversion is not a constant. Rather a substantial amount of loss aversion can be explained by the decision maker’s knowledge of the attribute and the attribute’s importance to the decision-maker.

Antonia Bernardo, professor at University of California, Los Angeles, talks about how irrational overconfident behaviour can persist. Information aggregation is poor in groups in which most individuals herd. Shinichi Hirota of Waseda University and Shyam Sunder of Yale talk about how investor decision horizons influence the formation of stock prices. In long-horizon sessions, where investors collect dividends till maturity, prices converge to the fundamental levels derived from dividends through backward induction. In short-horizon sessions, where investors exit the market by receiving the price (not dividends), price levels become indeterminate as they lose dividend anchors. It’s in this case that investors tend to form their expectations of future prices by future expectations. These reasons are important contributors to the emergence of price bubbles. No wonder aggregate markets look for dividends at bottoms and forget them at market tops.

Building on loss aversion, Ravi Dhar (Yale) and Alok Kumar (University of Texas at Austin) analysed the impact of price trends on trading decisions of more than 40,000 households with accounts at a major discount brokerage house and found that buying and selling decisions of investors in the sample were influenced by short-term (less than three months) price trends. They classified investor heterogeneity in trading based on prior returns into momentum buy, momentum sell, contrarian buy or contrarian sell category. The trading behaviour of all the groups exhibited systematic differences in expectations and behaviour. The study could find support to the commonly held belief that relatively more sophisticated investors exhibit contrarian trading behaviour. And, the contrarian investor segment had the best overall performance and their portfolios exhibit better characteristics in comparison to the momentum investor segment.

It’s easy to be a momentum buyer or seller. There’s nothing easier than riding a trend down or up. Unfortunately, riding a roller coaster has its risks and it is not consistent and healthy for a long-term portfolio. There’s more burn effect. A majority of the economic society does not understand this link in profits, markets, psychology and economics. But a few corporate understand and are already strategizing to be ahead. Merck, for example understands this loss aversion and is rewarding scientists for failure. Inability to admit failure leads to inefficiencies in the industry. Despite the Vioxx failure, Merck’s new speed at developing drugs has surprised competitors. Companies are also questioning the fake shareholder power connected with momentum investors with average time durations of ownership barely a few months. They push companies to beat estimates unmindful of the company’s long-term strategy.

The observations and questions we have raised here have a bearing on where we will head tomorrow. When a society becomes loss averse, it looks for a fast buck, looks for more credit driven speculation than real investments, ownership horizons keep getting shorter and loss aversion reaches contagion extremes, as majority sits on the edge ready to exit with the gain. It’s when we reach there, its time for a painful restructuring. Developed markets may still get you 33 cents per dollar claimed after you sue your broker. But developing markets where legislation itself is weak, we are eons away from suing any Dalal Street broker. And both the pain and loss is for us to keep. The faster we understand the psychology of a loss, the better it is for us and for the market.

The Rupee Spin

Spin is an art and an important socioeconomic activity for politics, show biz, marketing and capital markets. Its capital market spinning which invariably falls on its head again and again. And only short public memory lets it thrive.

Let’s take the rupee. We have been tracking the rupee in this column since December 2006 from Rs 44.6 levels with anticipated targets near Rs 40 to the dollar. Our last column was in the thick of action as the currency made an eight-year high and strengthening spin was all over the place. While the spin was looking at strengthening citing GDP, forex inflows, Federal Reserve action, Asian currencies, IPOs and a host of other reasons, we said, “The psychological or wave impulse down seems incomplete. We will be surprised if any bounce back on the rupee crosses the 42 levels. We see this as a coiling continuing action. The main trend still seems down to near Rs 38 or lower,” on June 11, 2007.

After almost three months of price action, the rupee is still there coiling between 40 and 41.6. We still consider this as a counter trend move which should invariably resolve lower back to 40 and lower. Even month ending signals for August do not augur well for a bounce above 42. Between September and October, we should see a potential seasonal low for the currency as it attempts to retest 40 yet again. And with intermediate (multi-week) momentum continuing to be weak and the market-wide spin a bit muddled about the direction of the rupee, the currency might be ready to come out of a three-month long consolidation range and start trending again to get stronger vs the dollar.