Archive for October, 2007

Cash and Crash CYCLES

Cash conservation becomes strategic, as the healthy disinflation era is challenged by rising food prices.

“We learn from history that we do not learn from history,” these famous words of George Bernard Shaw are a befitting reality for mankind. These people he talked about also dabble in stocks and commodities. And a majority of them are oblivious to these written words of fate. It’s the few who understand while the majority perishes owing to short sightedness. The rush of greed has historically overshadowed sanity. Personal skill and the power of state have always been overestimated. Great nations have failed along with revered geniuses in front of market cyclicality. And till the time humans last, our love for speculation and war, boom and busts, creation and destruction, celebration and vilification will continue. The great Manmohan of yester years is the weakest PM ever, says Advani. It is this cyclicality of mass psychology — cheerful today and depressed tomorrow — that pushes us to extreme behaviour where we don’t know how to stop and hence the violent pause, which econohistory quotes as crash.

The ideal time to study econohistory is when sanity matters most and greed busters are needed. We really need them today. And nothing busts greed better than a pinch of econohistory. Spirituality can, of course, do it better than econohistory, but then use of religion to bust greed, seems a tall shot in the age of speculation.

We will stick to econohistory, which exhibits very well how long the current boom will last. The subject relies a lot on cyclicality and makes some bold findings. It proves that every generation has its war. Every market has its crash, big and small. It also proves that economics cycles are driven by credit, which itself inflates and deflates cyclically. There is a shift from paper to hard assets and vice versa.

There are three stages linked with the credit cycle viz hyperinflation, disinflation and finally deflation. Disinflation is a period of low inflation and low prices for food and essential goods. This leads to economic growth. While there is little literature available on the chronology of events, disinflation is the one preferred most by investors and market participants. Disinflation is generally perceived as beneficial. However mass psychology extremes have been know to stretch the benefits to an extreme causing deflation. The most visible example of deflation is the 13-year slowdown of the Japanese economy. The deflation period is one of decrease in the general price level over a period of time. Deflation is the opposite of inflation. During deflation the purchasing power of money increases. Many still consider deflation as a problem of the modern economy because the phenomenon can spiral into a depression.

Hyperinflation on the other hand refers to a period when inflation goes “out of control,” as cash or currency rapidly loses its value. A monthly inflation rate of 20 per cent or more is hyperinflation time. Although there is a great deal of debate about the root causes of hyperinflation, it becomes visible when there is an unchecked increase in the money supply or drastic debasement of coinage, and is often associated with wars, economic depressions, and political or social upheavals.

The worst case of hyperinflation happened in erstwhile Yugoslavia where inflation doubled every 16 hours. Hyperinflation destroys real money. So the talk of hyperinflation in India or the US is a clear misinterpretation. There is a crisis of confidence in hyperinflation. China between 1939 and 1945 is a classic example of government printing money to pay civil war costs. By the end, the currency was flown in over the Himalaya to be destroyed. The chaos often ends with a civil conflict. And there are a lot of zeros in the currency and they keep adding. A majority of countries around the world have experienced this phenomenon. In recent times, itʼs happening in Zimbabwe. There is a crisis of confidence under Mugabe and the country is in a civil strife witnessing the biggest modern-day exodus.

So all our good times rest on how sustainable this current disinflation is, the good inflation. According to a research paper by Marc Hofstetter, Universidad de los Andes , very little is know about the sustainability of disinflations. The paper dispels misconceptions about disinflation and points food as the most essential sustainer of prosperous times. One cannot blame the low sustainability of disinflations during the seventies on rising oil prices as Yale professors Boschen and Weiss state that world food prices are a significant predictor of inflation in OECD nations. And food inflation plays a bigger role in undermining positive disinflation than oil prices. In fact, the significance of oil shocks turns out to be weak. The paper also comments on exchange rate regimes saying that an increase in exchange rate flexibility reduces the sustainability of disinflations.

Disinflations that bring inflation down to low rates of 5 per cent or lower (like we have today) are more likely to succeed in keeping those gains in place. Rogoff (2003) and Razin (2004) add the idea that globalisation played an important role in the recent worldwide disinflation. Since the early nineties, an increasing number of developed and developing countries have adopted inflation targeting regimes to conduct monetary policy, which is ineffective in determining sustainability of disinflation. Politics also seemed to have little effect. The most interesting aspect was the linkage of whether US inflation had something to do with worldwide prosperity since the nineties. Boschen and Weiss found strong evidence that US inflation plays an important role in triggering inflation abroad and US monetary shocks have important consequences abroad ie a higher US inflation reduces the sustainability of disinflations abroad.

What all this means is that if food prices donʼt stop going up, the good times will come to an end. And there is nothing the central banker or the politician can do to sustain it. Grains are up and so are other agro products and this is just the beginning. We are looking at multi-year rises on food prices. We are not bears at Orpheus. And it was here in this column we talked about energy outperformance and software underperformance in Jan 2007. It happened. We also gave you sectoral winners like Reliance Energy which moved up 300 per cent since it appeared in The Smart Investor on June 25, 2007. We highlighted many other outperformers like Reliance Natural Resources and underperformers like Hindustan Zinc which we suggested exiting near Rs 1,000. But unfortunately we see a lot of unsustainable greed at current levels. And highlighting the importance of cash before the crash cycle can never be overstated.

Coffee on a high

Time magazine recently wrote a story on the human addiction. And out of the many addictions, to alcohol, sex and gambling, the write-up also mentioned coffee. And how there are withdrawal symptoms if you stop having your morning cuppa. I would have laughed about this addiction to coffee five years back, but today I don’t. I am a believer, of the coffee cult and the coffee revolution.

The bean has acquired a mega status. Coming from a tea-drinking nation the changeover was not easy. Barista and Cafe Coffee Day did bring a change in me, but it was moving to Europe which did the rest. A daily Espresso was unthinkable five years back, but it’s a part of waking up now. Coffee has got us addicted to such a stage that having Illy coffee and a 1000-dollar coffee maker for home and office are not stupid ideas.

Then there is this revolution which has just begun. You might not have heard of it in your morning newspaper. But the news is that coffee internationally has moved to a new eight-year high. And this is just the beginning. We will not be surprised if the next nine months see the bean moving up at least 50 per cent from here.

Technically, we have a classic rounding bottom pattern which projects targets near $180, up 100 per cent from recent lows at sub-$100. Even MCX Coffee Robusta Spot is at a six-month high above Rs 8000. We consider this a low-risk entry point. Your coffee cup should never be the same again. We are early believers so we ordered our stock on the breakout. You should get yours too.

Diffusion and Sentiment

Information paralysis can be resolved by sentiment indicators which can not only predict but also time market turns.

These two generic sounding terms—diffusion and sentiment—are going to redefine the forecasting business in times ahead. Diffusion might sound familiar to economists as it’s also an econometric technique. But omnipresent sentiment measurement or sentiment indices are not only unpopular but also under-researched. In emerging markets like India and China, they don’t even exist. Internationally, there is not a single book available on the subject. And a web search on sentiment will take you to poetry.

This reminds me of the scene from Asimov’s screen adaptation I, Robot where Del Spooner (Will Smith) asks Dr Alfred Lanning’s (James Cromwell) hologram, “What do I see here?” Lanning’s hologram says, “My responses are limited; you have to ask the right question.” So even if you have the right question, the available answer may be insufficient. It is this insufficiency researchers are struggling with to come with the right forecast.

Information in itself has failed us, as stock prices react to so many factors that even regional fundamental analysts have started looking at the movement of the Dow Jones to gauge market trends. Not very many can disengage from international events and talk about markets or assets on a standalone basis. It’s a clear case of information paralysis. Less is not enough and more is overwhelming. And web searches really don’t help further the search of what really works or how to see through this clutter. Web search is a clutter where ‘loss’ is about weight not about finance, history is not about economics as in econohistory, valuations are about data not about fractals. The search engine’s responses are limited.

It was to see through this chaos that sentiment and diffusion indicators were first designed in 1960s. Are questions on diffusion and sentiment indicators the right ones? This question was partially answered by a client of ours, a national bridge champion, “This 80-20 theory is perfect-if most of the people do one thing, you do the opposite.” Conventional logic might make you laugh at this, but the champion is an intermediate term investor. He is always looking around for sentiment cues from newspapers, big bank securities’ company recommendations, local economic news, international updates etc. After that he gauges the sentiment, which side is heavier, the positive or the negative side. I don’t know how he measures it in his mind, but he surprises us with his uncanny sentiment indicator. It works. He is a good pattern recogniser, a contrarian and this he mixes with a sentiment study.

Diffusion indices are built in the same way. These are survey indicators. Talk to 100 experts and take their opinion for the day. If 80 per cent are on the positive side, we have reached a top and vice versa. Technical expert Martin Pring says, “Sentiment observations are as valid for intermediate term (multi-week) peaks and troughs as they are for primary ones (multi months).” The difference is normally of degree. At an intermediate term low, for example, significant problems are perceived, but at a primary market low, the problems often seem insurmountable. In some respects, Pring adds, “The worse the problem, the more significant the bottom.” He even clarifies that though sentiment indicators work well, it is best to monitor several sentiment indicators simultaneously.

The Advisors’ Sentiment Report has been one of the leading sentiment indicators constructed by Investors Intelligence since 1963. The indicator has a consistent record for predicting the major market turning points. The report studies over a hundred independent market newsletters and assesses each author’s current stance on the market: bullish, bearish or correction. Current readings are put into context against historic precedents. Signals generally arrive when you need them, near important market tops and bottoms.

Conventionally, the best time thought to be long on the market is when most advisors were bullish. This has proved to be far from the case; a majority of advisors and commentators were almost always wrong at market turning points. Quite simply, professional advisors are just as susceptible to market emotions as individual investors. They become far too greedy at the top of trends and far too fearful near the bottom. The contrary indicator only works at extremes. A large part of the time the Advisor’s Sentiment report readings remain neutral ie 45 per cent bulls, 35 per cent bears and 20 per cent neutral. Advisors are only wrong when you get too many of them to start thinking the same thing. Back in October 2002, there were many more bearish than bullish advisors. Historically, this has always been a good time to start thinking about buying the market. Investors would clearly find it more profitable, then, to take a position contrary to the advisory service industry. But then as we said earlier, advisors as a group invariably go wrong.

There are other sentiment reports published in the US like the Bullish Consensus newsletter by Market Vane, which has been around since 1964, well before contrarianism was really written about. There are a host of other indicators like specialist/public ratio ie smart money against not so smart money. Then there is the short interest ratio, inside sell/buy ratio, mutual fund cash/asset ratio, margin debt trends, put/call ratios, inverted dividend yield momentum and volatility indicators.

So, on one side we have sentiment readings and survey findings and on the other hand, experts who fight about lack of information or its excess. Very few of them ask, “Why do you need information anyway?” Studying sentiment is fun. It teaches you about social behaviour, mass psychology, error-prone humans, overestimation of skills, biases, overconfidence and above all herding.

“This time it’s different,” gets a large number of search results. We keep fighting for intellectual supremacy while the market needs a simple study of sentiment to see through the chaos and layers of leverage, which can end your investment life. Investors come and go. Some never came after the 2000 crash and some got burnt in small dips in May 2006 and July 2007. Nobody looks for them and writes about them. And they never come back to the market; not because the market is not a great place to be, but because to survive the market till you die and pass the art of investment to the next generation needs more than information access. It needs the ability to understand market sentiment and ask the right question.