An Incovenient Truth - Its all about leverage

"As to new financial instruments, however experience establishes a firm rule, and on few economic matters is understanding more important and frequently, indeed, more slight. The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes its distinctive character to aforementioned brevity of financial memory. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version. All financial innovation involves, in one form or other, the creation of debt secured in greater or lesser adequacy by real assets. ...All crises have involved debt that, in one fashion or another, has become dangerously out of scale in relation to the underlying means of payment."

So said John Kenneth Galbraith in his famous 1990 book "A Short History of Financial Euphoria"

"We learn from history that we learn nothing from history."

So said George Bernard Shaw

Hath I say more?

Destination unknown - global financial crisis

Conventional market logic argues that whether a stock is attractive or not is a function of price - at a given price any stock will be attractive for buying and at another given price the same stock would be extremely expensive to own.

However in the current environment, I would argue that this logic has been turned upside down (so far as it pertains to financial stocks in developed markets).

There have been many instances of a solid franchises falling 50% and then another 50% and in a few cases another 50% (Fannie, Freddie, Lehman, Bear, AIG, Merrill, HBOS, Morgan Stanley,UBS)... The inherent complexity of the situation is beyond the ability to fathom for even the most sophisticated investors. No one knows whats going on and no one knows where things are going to blow up next.

Thus the present situation is quite unlike a conventional economic cycle where things get bad but we know they will turn for the better. There will be a few years of disappointing performance but things will get better. Even now things will get better, but when established franchises go bankrupt (and more than one such franchises has met such a fate) in a matter of days things are unlike anything we have witnessed in recent past.

Trying to pick a bottom is crossing the thin line between being brave and being foolish. Its akin to shooting in the dark - we may hit the target but there can be little to take credit for. In this regard we are in the midst of a journey into the unknown - with too many unknown unknowns out there...

The dust will settle eventually, but it needs to settle before we can fathom the true scale of the crisis that has hit us. But as some guest mentioned on CNBC the other day, its too late to panic as well...

The Fate of Irrefutable Presumptions

If I look back at the end of last year or start of this year, there were a many 'cannot go wrong' assumptions about how things will unfold through the course of the year.

• Foreigners would continue buying Indian stocks - theydon't have any options in a slowing global growth environment (Oh the middle east guys are sitting on over trillion dollars of petro-dollar liquidity - where will it go?)

• India is immune to slowdown globally - we will continue to grow around 8-9%

• Interest rates in India are headed lower due to lower inflation and widening interest rate differential to global interest rates

• If commodity prices correct, India would be a natural beneficiary from an equity market standpoint)

• Valuations do not matter when you are swimming in sea of liquidity

• Rupee is in a secular uptrend - reflecting robust capital flows, structural improvement in trade balance once gas discoveries come on stream etc...

One by one, all these assumptions have come crashing...

• Foreigners have actually on a net basis sold over US$7bn of stock. Overall capital flows would likely be down 50% in FY09 over FY08
• India's growth is slowing - and part of the reason for slowdown is higher commodity price led inflation leading to RBI tightening
• India's interest rates have actually increased - and increased significantly. It was naive to argue that on one hand our growth is uncorrelated to global growth but our monetary policy is...
• Commodity prices have corrected - Oil is down 30% from peak and from a market perspective we are less than 10% away from the lows of this year
• Valuations do matter - the worst performing stocks are amongst the most expensive - valuations may not becorrelated to fundamentals on a day to day basis - but theydo cross paths every now and then...
• Rupee is amongst the second worst performing currency amongst the major emerging markets and it has depreciated in the recent past even as oil has come off sharply - anyone who argues that in the short or even medium term currencies behave in accordance with trade flows needs to wake up...

What next? What are the current 'cannot go wrong' assumptions in the market? In my view, the following:

• FII's have sold US$7bn in the first eight months of the year - rest of the year is unlikely to see selling anything close to that magnitude

All I would say is after pausing for July and august when FII'scumulatively sold under US$1bn of equities, in the first two weeks of September they have sold almost US$1bn. Even after the selling and market crash FII's own over US$150bn of Indian stock!

• FY09 is a aberration - commodity prices will come down and so will interest rates and so in FY10 we will resume growth momentum with growth back in 8-9% range

In FY10 there is a real chance of growth slipping below 7% in my view - financial community is in denial mode over growth slowdown. If growth does not slowdown, you will get even higher interest rates to curb inflation. Growth has to slowdown.

• Interest rates will come down; inflation is already showing signs of moderating as commodity prices moderate

It is absurd to expect RBI to even signal softer monetary policy when inflation (as measured by WPI) is running above 12% and growth still around 8%. Four weeks of inflation hovering around 12-12.5% does not imply inflation has moderated. Only caveat I would add would be a major overseas event which forces RBI to backoff purely due to 'liquidity' reasons.

In my view, as the rest of the year unfolds, even these three 'cannot go wrong' assumptions would come in question and fall apart like many others have done so far this year...