Russia to Play Catch Up

Bank of Russia was Hiking to Protect the Ruble When Everyone was Easing Policy...



...Not a Surprise that Russian Equities Lagged



I bought RSX eventhough it has rallied significantly from the lows. It is still cheap and will play catch up in the reflation theme. The ruble is now on firm ground and that should help the central bank to aid the recovery.

Cycle dominates Seasonals

No September Effect in 2003




No January Effect in 2008



A number of articles were floating around in August highlighting the negative seasonals for September. Looks like September 2009 will turn out just fine, just like 2003.

India's Water Crisis and the Stock that will Benefit

When the rains fail

Jain Irrigation is the stock I am betting on.

INR Looks Cheap on a Trade-Weighted Basis

INR: 36-Country Nominal Effective Exchange Rate




INR: 36-Country Real Effective Exchange Rate



My initial view was that the US recovers first. That is clearly not the case. In the initial phase of the recovery, both - rising risk appetite (equity rally) and interest rate differentials - should work against the US dollar. The rupee looks cheap and December 2009 forwards are pricing in rupee depreciation of about 1%. Both these factors should help if the dollar starts to strengthen.

Relative Value in Russian Equities

‘Dummy’ Day-Traders Whipsawing Russia Signals Buy

Completely agree. If this recovery is for real, Russian equities could deliver stellar returns.

Food for All Palates

Manufacturing ISM: Looks Like a "V"




Existing Home Sales: Looks Like a "U"



If you look enough, you will find data that supports your view. That is why my endeavour is to find "view neutral" investment ideas. There were plenty of these at the start of the year with several asset classes discounting Armageddon. The low lying picks are gone now.

SENSEX vs. USD/INR: NEGATIVE CORRELATION ALIVE AND KICKING

This negative correlation has been alive and kicking for a long time now. The mid-oughts' bull market in equities coincided with global dollar weakness. During the crisis, the ultimate safe haven status of US Treasuries provided a further boost to this inverse co-movement.

The big question is what happens to the US dollar as the global economy recovers. The answer to that depends on whether the world can decouple from the US. I remain sceptical of the decoupling argument, at least in the near-term.

Russian Equities Are Decidedly Cheap

The Exhibit shows the ratio of RTS (scaled by 1000) to nominal GDP. Clearly, Russia looks cheap. But cheap does not mean that it cannot get still cheaper. That is exactly what I discovered last year when I bought RSX around 19 and it fell like a stone to below 12. That said, after the global rally in equities, valuation still supports a case for upside in this market.

Even if one gets the short-term wrong, there is always the case for buying resource oriented equities for the longer-term.

Sector Performance Since the Correction Started

Oil and materials have driven markets lower. That is in line with reality. It is important to remember that the years 2003-2007 were about a synchronous global upturn and not just India and China growing at a breakneck pace. The global recession will certainly end sometime in the near future. Yet, a worldwide boom is nowhere in sight.

U.S. 5Y5Y BREAKEVENS BACK TO PRE-CRISIS LEVELS

Junk Bonds: A Great Year in Just Five Months ( Barron's)

"IN THE NEVER-ENDING STRUGGLE BETWEEN GREED and fear, greed has had the upper hand lately.

The market for risky high-yield, or junk, bonds has gone from ridiculously cheap to just cheap with remarkable speed. The Merrill Lynch U.S. High Yield Master II index has narrowed from a wide yield margin of 2,100-plus basis points over Treasuries with comparable maturities in February to 1,232 basis points through Thursday. Back in June 2007, the yield margin was a mere 241 basis points."

My Comments: I missed the fast furious equity rally, but certainly rode this one!

U.S. High-Yield Cheap Versus U.S. Equities

Benchmarking the Current Bear

Lessons from the Anatomy of the Bear by Russel Napier. I found the analysis interesting in context of the current state of the market.

Brief Summary

The author researches 4 equity bear market bottoms: 1921, 1932, 1949 and 1982. These years preceded spectacular stock returns. The author seeks to identify the factors that would have helped investors to identify the bottom and capitalize on the impending rebound.

Common factors present at all the bottoms: 

1. Presence of optimism and good news. Unlike the popular market belief that “it is darkest before dawn”, reasonable amount of good news and optimism existed as evidenced by WSJ articles around each of these episodes. Investors just chose to concentrate on the bad news.
2. The best valuation parameter for identifying extreme undervaluation of equities in each of these episodes proved to be the q-ratio. The P/E ratio did not appear useful given extreme uncertainty surrounding earnings around these turning points. 
3. Commodities bottomed first and the copper price upturn figured an important harbinger of subsequent stellar market performance. Surprisingly, this point held sway even in the 1982 episode when a rise in commodity prices could have un-nerved investors given Volker’s inflation fight.
4. The bond market led the recovery.  Corporate bonds rose first, followed by stocks.   
5. A final sell-off on low volume. This theme also works against the common belief that markets often bottom out with a final capitulation on high volume.
6. Liquidity analysis did not help in any of the cases. Broad money/credit trends did not make the task of calling the bottom any easier. If Fed rate reduction were taken as signals of easier liquidity, the market fell further from that point.

 

Tata Motors: Who is Right?

China Led Markets?

U.S. Adds to the Global Savings Glut

Personal saving as a percentage of disposable personal income was 5.0 percent in January, compared with 3.9 percent in December.

My Comments: The sharply rising U.S. savings rate makes me more cautious than I was earlier. This is great news for the U.S. dollar as the current account deficit will continue to contract, but a very bad development for the global economy. Government dis-saving  is the only way out of this quagmire.

Citi = State Bank of America

U.S. Eyes Large Stake in Citi (WSJ)

My Comments: Carnage in financial stocks will continue. I think the November market lows will be conclusively broken in the times ahead. The market is not going to believe anything bank CEOs will say about capital adequacy. I maintain that nationalization is a good thing for the short-term.

DOW Broke November Lows: I Am Buying S&P Hedged for Financials

Source: Wall Street Journal

My Comments: Bank stocks are weighing on indexes. XLF fell 5% today(Citi: -14% to $2.51, BAC: -14% to $3.93). The nationalization theme is playing on markets. Ruling out the case where the government injects capital by buying bad assets at above current market values, severe equity dilution seems a certainty. Markets are adjusting to that eventuality. I think S&P will also break its November lows at some stage. But minus financial stocks, nationalization makes me optimistic. In the long-term, political interference will certainly not be a good thing for allocative efficiency. For now, however, government ownership will inspire confidence and is good news for the rest of the economy. I am now inclined to buy SPX hedged for financial sector stocks. I am also selling December S&P@1000 calls.

Distribution of Consumer Debt Burdens

2004 Survey of Consumer Finances

Mean Values of Net worth and Debt in Thousands of Dollars

Percentiles of income
**********NW*Debt
INC<20 * 72.6 * 24.6
20-39.9 * 121.5 * 41.9
40-59.9 * 194.6 * 69.9
60-79.9 * 340.8 * 108.9
80-89.9 * 487.4 * 156.4
90-100 * 2,534.6 * 296.5

Percentiles of net worth
**********NW*Debt
NW<25 * -1.4 * 32.0
25-49.9 * 47.1 * 66.3
50-74.9 * 185.4 * 111.4
75-89.9 * 526.7 * 137.5
90-100 * 3,114.2 * 293.9

Source:http://www.federalreserve.gov/PUBS/oss/oss2/2004/scf2004home_modify.html

My Comments: This data is dated. The latest survey results are not out yet. A lot of analysis is needed to arrive at solid conclusions. How income,debt and ownership of earning assets are distributed is key. Without that most of these aggregate numbers do not mean much to me.

Debt Service/Personal Disposable Income Does Not Look Alarming, But Averages Are Deceptive

Source: Barron's, Bridgewater Associates

My Comments: Household debt service at about 15% of personal disposable income does not strike me as particularly alarming. I mean is paying $750/month out of $5000 that burdensome? But then averages are deceptive. Obviously, the distribution of both income and debt incidence is important.

Baltic Dry Index: Showing Signs of Life

Source: Bloomberg

My Comments: I am now looking for signs of recovery or for indications that things are getting materially worse. A pretty bad global recession is already in the price. The big game now is guessing whether we are headed for a depression or the bottoming process for the economy has started.

The More You Pay, the More You Owe!

The Debt Deflation Theory of Great Depressions by Irving Fisher

In a state of over-indebtedness, there would be a tendency for liquidation:

1. Debt liquidation leads to distressed selling
2. Contraction of deposit currency as loans are paid off which leads to falling velocity of circulation
3. Fall in level of prices leading to swelling of the dollar and that this fall in prices is not interfered by reflation
4. A still greater fall in worth of businesses leading to bank bankruptcies
5. A like fall in profit
6. A reduction in output, trade and employment
7. Pessimism and loss of confidence
8. Hoarding and further slowing of the velocity of circulation
9. Complicated disturbances in the rate of interest rate, fall in nominal rates but a rise in real rates

The more you pay, the more you owe!

Solution: Create Inflation! How?

"The fact that immediate reversal of deflation is achieved by the use, or even the prospect of the use, of appropriate instrumentalities has just been demonstrated President Roosevelt."

My Comments: If Prof. Fisher is correct, given the steps that authorities have taken, we should escape the debt-deflation spiral.

Rout in Long Bonds: U.S. 30-year Treasury Yield

Source: Wall Street Journal

Gloomy Data from Asia Continues

South Korea’s January Exports Decline by Record 32.8%(Bloomberg)

"South Korea’s exports tumbled by a record 32.8 percent in January, foreshadowing a deepening slump in Asia’s export-driven economies.

Shipments fell by the most since figures were first compiled in 1957, and at almost twice the pace of December’s 17.9 percent decline, the Ministry of Knowledge Economy said in Gwacheon today."

My Comments: When the U.S. consumer experiences a sudden stop. Asia falters. India is relatively insulated, but the sheer magnitude of the global demand shock implies that the Reserve Bank of India will ease again. Eventually.

What to Expect from the FOMC

The short rate is close to zero and the Fed's balance sheet has expanded exponentially. What else can the Fed do? Long treasury yields have risen significantly over the last one month. The Fed could announce a program to buy long bonds. This would help in an environment where risk spreads are slow to normalize. There is also talk in some quarters that the Fed could announce an explicit inflation target. This I think is unlikely for now. When nominal rates hit the zero bound, the only way to bring real yields down is by stoking inflation expectations. This would be achieved by a credible inflation target. I am planning to play the meeting by buying TLT (20+ year Treasury ETF) with a tight stop. Buying TIP seems a safer bet given that 5-year 5-year break-evens are still well below 2%.

RBI: Moral Suasion For Now

The Reserve Bank refrained from tinkering policy tools, but urged banks to reduce rates on loans. With fiscal flexibility limited and a weak transmission mechanism of monetary policy, reduction in base rates and flushing the system with liquidity is the only course of action going forward. Expect further easing. I am long bonds and PSU bank stocks.

India’s Tendulkar Wants Central Bank to Lower Rates (Bloomberg)

"Jan. 23 (Bloomberg) -- Indian Prime Minister Manmohan Singh’s top economic adviser Suresh Tendulkar wants the central bank to reduce interest rates further in its Jan. 27 policy statement to stimulate a slowing economy.

“My own preference would be to see some rate cuts there in next week’s policy,” Tendulkar told Bloomberg News in a phone interview today. “That call will be taken by the Reserve Bank.”"

My Comments: More rate cuts on the way. Remain long bonds. Supply concerns seem overblown given the magnitude of the slowdown that lies ahead.

U.S. High-Yield Cheap Versus U.S. Equities

Source: Wall Street Journal


The credit spread on Merrill's U.S. high-yield index was 1674bp on January 16, 2009. There has been significant contraction from the all the high of 2178bp in late 2008. The question is whether the asset class is a buy at current valuations. To answer that question we need to figure out the likely default and recovery rates going forward.

There is a negative correlation between recovery and default rates.

Recovery Rate = 0.52 - 6.9 * Default Rate (Moody's)

This equation suggests that recovery is going to be very low given the 10% plus default rates that we are likely to witness.

Speculative Grade Default Rates
YEAR**Default Rate
1929**1.29
1930**2.13
1931**2.13
1932**7.85
1933**10.81
1934**15.39
1935**5.93
1936**6.09

Source: Moody's

This data indicates that there is a lot of value in the HY asset class even if an economic scenario akin to the Great Depression were to materialize.

One caveat is that the speculative grade market in those days comprised fallen angels. It is important to understand how this segment differs from original issue high-yield bonds. As per Moody's research: "In comparison to other speculative-grade issuers with the same ratings, fallen angels are more risky (more likely to default and less likely to rise to investment grade) for the first two years after being downgraded to speculative grade, but they become relatively less risky than other speculative-grade issuers as time progresses."

Another issue could be whether the current high-yield universe is worse than the previous vintages.

All said, it seems that current spreads discount a pretty bad economic scenario and provide considerable margin of safety. That is certainly not true for U.S. equities.


Source: Default and Recovery Rates of Corporate Bond Issuers, 1920-2004; Moody's Investors Service
http://www.moodys.com.br/brasil/pdf/default2005.pdf
Source:What Happens To Fallen Angels? A Statistical Review 1982—2003;Moody's Investors Service
http://v2.moodys.com/cust/content/content.ashx?source=StaticContent/Free%20pages/Credit%20Policy%20Research/documents/current/2002000000425343.pdf

Japan doing the heavy lifting?!

Japan November current account surplus shrinks 65.9%

(MarketWatch) -- Japan's current account surplus shrank as much as 65.9% in November from the year-ago period because of a sharp fall in the country's exports, official data showed Tuesday. Current account surplus fell to 581.2 billion yen ($6.46 billion) from 1.71 trillion yen in November 2007. Monthly trade balance was a negative 93.4 billion yen, as exports shrank 26.5% amid tough global economic conditions, compared with a 13.7% decline in imports.

U.S. Economy: Trade Deficit Narrows Most in 12 Years

(Bloomberg) -- The U.S. trade deficit narrowed in November by the most in 12 years as tumbling oil prices and slumping consumer spending cut imports.

The gap shrank 29 percent, more than forecast, to $40.4 billion, the Commerce Department said today in Washington. A record 12 percent drop in imports propelled the improvement. Exports fell for a fourth straight month.

My Comments: This is not good news. One of the weakest link in the global economy has been called upon to do the heavy lifting. This data implies another leg down for the global economy.

Thankfully, one big countervailing force will be the huge public dis-saving unveiled by Obama. This should help the world as the U.S. consumer rebuilds savings.

Madoff and Raju: May be we are Ignorant

TRUE LIES
(What Raju owned up to)
* Inflated cash and bank balances of Rs 5,040 crore
* Non-existent accrued interest of Rs 376 crore
* Understated liabilities of Rs 1,230 crore on account of funds arranged by Raju
* Overstated debtor position of Rs 490 crore
* Q2 ‘08-09 profit stated as Rs 2,700 crore and operating margin of 24% revenues. Actuals: Rs 2,112 crore profit and 3% of revenues
* Profits inflated over “last several years”; attained unmanageable levels as company grew
* Aborted Maytas deal was “an attempt to fill the fictitious assets with real ones”

Source: Business Standard

Buffet: "Diversification is a protection against ignorance. It makes very little sense for those who know what they are doing."

My Comments: Satyam and Madoff: Both these cases are high profile and one would reckon that investors were privy to extensive information. All major brokers covered Satyam and big institutional investors owned the stock. Henry Kauffman – a Wall Street legend – lost money in Madoff’s Ponzi scheme aside from several other prominent people.

I do not want to sound cynical. But if a company like Satyam could pull-off such a scam, what do we really know about those obscure small caps?

This is a lesson for all of us - "proud stock pickers" - who can rant indefinitely about our ability to read company managements.

Diversification is important because may be we are ignorant.

Why India Won't Rebound Soon (Barron's)

"FOR THOSE TEMPTED TO WADE INTO THE INDIAN STOCK MARKET with a view to making a quick killing after its massive slide, consider the advice that Punch magazine once gave a person who was about to marry: Don't.

Although India's benchmark Sensex has fallen about 55% from its peak a year ago, the market is still not attractive as a short-term investment. November's terror attacks in Mumbai aren't even the half of it: The Indian economy, valuation issues and broad political uncertainty all argue for real caution."

My Comments: Agreed. India is still not an attractive short-term investment. But not because of issues inherent to India. Instead, I do not see a sustained revival in global risk appetite in the near future.

Get Out Now! (Barron's)

"The bubble in Treasuries looks ready to pop, sending prices on government debt sharply lower. But just about every other corner of the bond market beckons -- and could provide competitive returns with stocks, even if the equity markets have a strong 2009."

http://online.barrons.com/article/SB123094029415750267.html?mod=ba_mp_view

My Comments: I agree with the basic thrust of this article. Risk-reward favors shorts in U.S. treasuries. But to reduce the downside risk, I am keen to play it through break-evens. 10-year break-evens imply virtually no inflation. The market’s price escalation outlook seems at variance with the current level of 10-year real yields. If rates decline further, inflation protected securities should keep pace with nominals. More likely, there will be a vicious sell-off in nominal bonds at some stage.

Manufacturers suffer record declines in activity (FT)

"US manufacturing activity contracted at its sharpest pace for nearly 30 years in December, a closely watched survey suggested on Friday, underscoring the downward momentum in the economy at the turn of the year.

The Institute for Supply Managers survey index declined from 36.2 in November to 32.4, much worse than expected, while new orders and production measures hit their lowest level since the survey began in 1948."

My Comments: Economic data continues to worsen. I doubt the sustainability of this January rally in equities. Tactically, I am inclined to reduce risk as markets move higher. I am fairly certain that the Fed will not hike in 2009. Not only that, I think that the Fed's easing bias will remain intact through the year. The RBI cut the Reverse Repo rate by 100bp last week. I think that further easing is likely going forward.

India IPOs Slide 46% as Worst Year for Stock Index Halts Offers (Bloomberg)

"Indian initial share sales slumped 46 percent last year as a record decline in the benchmark index spurred investors to shun stocks and Emaar MGF Ltd. and Jaiprakash Power Ventures Ltd. to cancel offers."

My Comments: IPO volumes are often contrarian indicators. High numbers are generally seen around market tops.

India Exports Fall a Second Month, Adding Pressure to Cut Rates (Bloomberg)

"Overseas shipments dropped 9.9 percent to $11.5 billion from a year earlier after contracting 12.1 percent in October, the first decline in seven years, the government said in New Delhi today."

My Comments:Look for depressed industrial production numbers going forward. I think a 100bp cut in the reverse repo rate is a foregone conclusion.

New Forbes Index Forecasts Economic Recovery (Forbes)

"Our index includes four indicators. The dollar volume of insider buying shows what managers honestly think about their own companies' prospects. Spreads on bond yields give a sense of what investors think of the chances of recovery. Road congestion at peak travel times (as measured by traffic tracker Inrix) tells us whether businesses are buying, workers are commuting and shoppers are shopping. Finally, mentions of the word "recession" in the news media illustrate the degree to which the downturn is on the public's mind.

Testing back over the last five years, we find that the Forbes Chirp Index typically leads economic activity by ten months which brings us to the possible August recovery. More road congestion and insider buying nudged the Chirp Index higher in November, overriding an increase in the number of mentions of the word recession."

My Comments:The bigger question is the contours and the strength of the eventual recovery. Consumption boom of yesteryears seems unlikely. Direct government spending needs to step in to fill the gap. Infrastructure focused investments would be the winners in this scenario.