Bad is Good

Sometimes being bad (or forced to be bad) is good.
Read Pakistani bonds are the biggest gainers.

Economic Ramblings

Monetary Policy, Fiscal Policy, Inflation, Interest Rates – some of the popular terms any student of Economics will go through, somewhat boringly, in their introductory courses. These concepts when linked to the real world can throw some interesting viewpoints about the various burning issues. In the last 12 months, the central banks/Governments of most countries have, more or less, uniformly and uncharacteristically followed expansive monetary policies to the extent of bringing interest rates close to 0%. This is inline with the Governments’ fiscal policies which are more or less expansive – at least at planning level. An expansive monetary policy and expansive fiscal policy will ring a nice note in one’s ears that things are going fine with the economies. In most cases, this could be true; it may not be so this time around.

If the Governments go for an expansive fiscal policy, the Government will spur spending. For spending, the Government needs money – there are multiple options for the Government to get the money. One, it can print money; two, it can issue bonds and raise debts. The former has its own implications on interest rates and the dreaded fear of deflation resulting in increase of the real cost of borrowing. The latter, however, depends on some other factor so far not mentioned: Debt-to-GDP ratio among other things. The Government’s ability to borrow is inversely proportional to the Debt-to-GDP ratio – less the debt to GDP, the better the borrowing ability of the Government – sounds very intuitive.

There is always a partisan view of the credit rating agencies’ role in the financial world. Irrespective of the side you are in, there is a considerable weight attached to the ratings given out by these agencies. It is only common-sense to believe these agencies downgrade those countries with less borrowing power and less repaying capacity. A very simple indicator of these is the debt-to-GDP ratio. Let us take the case of India. If Debt-to-GDP ratio increases (as this would be most likely the case in the late recession / early recovery stage of the business cycle that we are in; as the GDP would not rise as fast as the rise in debt), the agencies downgrade the ratings of the Government. If this happens, there is a double whammy effect as the existing Government bonds would lose value, investors may begin to dump and the Government would be at a disadvantage at raising money from the markets. Essentially, the market forces would be against an expansive fiscal policy. This is very pertinent in India’s case with a Debt-to-GDP ratio of 58% (compare this to Chinese Debt to GDP ratio of 18%) – so Government may not be able to follow expansive fiscal policy along with an expansive monetary policy.

If it persists with expansive monetary policy in this scenario, there would be too much money chasing too little economic activity, leading to the most commonly known economic term – Inflation. With so much political sense also attached to Inflation, no Government will be willing to let this happen. So, are we heading towards restrictive monetary and restrictive fiscal policies: not likely as this again also has a political and economic cost attached with the R-word and no one wants it. All this means is that the Government has to raise money from somewhere without losing its credit worthiness. The likely sources, I believe, would be PSU divestments, tightening of personal tax regime among other things.

The scenario mentioned about India does hold true for developed economies like US (who monetary policies are more expansive and debt-to-GDP ratio is higher). If China believes the US dollar denominated treasuries are downgradeable, it would be Armageddon – again in 2009. Brace yourself.

Buffett Metric says BUY

Warren Buffett often claims he looks at the ratio of Total Market Value of the stocks to the Gross National Product and if it is less than 70-80%, it is time to BUY. It is presently at 75%. Hmm...So any one listening? I guess it is time to think about beginning to increase weight on Equities as an asset class.

For the detailed report: Click here

Briefly, GNP v/s GDP: A country's Gross Domestic Product, or GDP, is the amount of goods and services, measured at market prices, produced within the country during a particular time period (usually a year). Gross National Product, or GNP, is the amount of goods and services produced by residents of a country, regardless of where that production takes place

RBI Monetary Policy Review

There have been multiple commentaries on the mid term credit policy review of RBI. There are more opinions criticising the policy review than the other way around. But to me, the entire exercise of RBI changing monetary policy is a non-event. A monetary policy assumes significance only if the monetary policy review is transmitted into the markets in the form of additional liquidity and influence the cost of equity capital and debt capital. There is no point when the commercial banks keep the surplus cash that come up because of policy rate cuts in their own kitty and not lend. As long as this systemic flaw of monetary policy influence in India is addressed, the RBI can only be a mute spectator.

Review 1: Financial Express
Review 2: Business Standard

Highlights of the Monetary Policy Review of 27-Jan-2009
- Bank rate kept unchanged at 6 per cent.
- Repo rate has been kept unchanged at 5.5 per cent.
- Reverse repo rate kept unchanged at 4 per cent.
- Cash reserve ratio (CRR) kept unchanged at 5 per cent.
- Statutory liquidity ratio (SLR) kept unchanged at 24 per cent.
- Gross domestic product (GDP) growth target for 2008-09 lowered to 7 per cent.
- Inflation to be in the range of 4-4.5 per cent.
- Inflation to fall below 3 per cent by March.
- Central bank interventions since September resulted in more liquidity of Rs.3.88 trillion (Rs.388,000 crore).
- Permanent cut in SLR has added Rs.400 billion (Rs.40, 000 crore) to liquidity.
- Capital expenditure plans slowing down, but ongoing projects to continue.
- Fiscal deficit target revised to 5.9 per cent of GDP from 2.5 per cent.
- Excise, customs duty cuts may lower government revenues by 0.6 per cent of GDP.
- Consolidated fiscal deficit of states is expected to rise to 2.6 per cent of GDP.

Options Trading Strategy - 1

Strategy followed by one of my colleagues:
Short far-out-of-money call and put options simultaneously, have enough cash buffer to meet any intermediate margin calls and hold them till maturity. For instance, his strategy now could translate to shorting a 2300 Nifty Call option and shorting a 3400 Nifty Put option and hold them (address any margin calls) till 29-Jan-2009.

As is true with any short-option strategy, the upside is limited to the premium amount received while the downside is close to being unlimited.

Asset Allocation Strategy - 1

There have been multiple areas wherein behavioural finance and standard finance differ considerably. One of the few domains wherein these two converge is the significance of asset allocation in the overall financial decision-making process.

One author who has influenced me strongly is Nassim Taleb; and his argument that the difference between the research analysts and the common man is that the common man knows that he does not have material insights on the markets and that the analysts do not know that they do not have material insights on the markets.

With that thought, I, for a while, thought I also do not have great insights. So what should be the asset allocation strategy when your outlook is such. Here's where Taleb's recommendations are striking. He says it is absolute non-sense to allocate your assets among zero risk, low risk, medium risk and high risk investments; he recommends investing only in zero risk and high risk investments - essentially invest only in Treasury bonds or Fixed Deposits of Indian banks (heh!) and in speculative investments. For all self-traders like me, I recommend investing close to 90% in risk free assets and the remaining 10% in long options (be it put or call based on the individual's outlook on the market). I emphasize longing options as against shorting, as in the case of longing options, the downside is limited while the upside is unlimited, the opposite is true in the case of shorting options. The basic objective of such asset allocation is that if the speculative investments back-fire, it should not eat in to the risk free pool.

Warren Buffett's Indian Stock Picks

Uncharacteristically Digital Inspiration's Amit Agarwal has posted on Warren Buffett's choice of Indian stocks. The list is composed of three broad categories, in their declining order of merit as Titans, Heroes and Mortals.

Titans - companies that are best of breed and which would dominate their respective industries in the coming years and are using the current slowdown as an opportunity.Hindustan Unilever, Larsen & Toubro, NTPC, Reliance Industries and Sun Pharma.

Heroes - companies that can surprise investors and become best of breedGlenmark Pharma, IVCRL Infra, Marico, Maruti Suzuki India, Piramal Healthcare and Tata Power.

Mortals - companies that will live forever in the shadow of the titans and heroes, and always follow the leaders in the marketTVS and Unitech

ICICI - The least leveraged Indian bank

There have been quite a lot of hue and cry about the viability of ICICI Bank over the past few months. The markets have also been vehemently harsh on the scrip where in the price of the scrip has been stripped from its 52 week high of Rs 1455 to a low of Rs 283 in the month of September-October. A recent report from Nomura Capital on banking industry lists the 15 most leveraged and 15 least leveraged banks; with the apocalyptic demise of Lehman Brothers, Merrill Lynch etc, any one involved in the capital markets know the value of being less leveraged.

A snapshot of the table is asunder:

One prominent entry, to my eyes, in this safe list is ICICI Bank, I guess this should end all the speculations about the risk involved in the bank for its investors, creditors and depositors.

Death Bonds

There is no limit to the creativity of man, especially those from Wall Street.

At the outset, it may seem like a simple Asset backed investment. The finance engineers have cooked up a product which is backed by the Life Insurance settlements of numerous people - the earlier the underlying policy holders' death - the sooner the profits. No wonder these products are termed as 'Death' Bonds. The best part about this is well summarized in the following:

Firms say death bonds should return around 8% a year, right between the expected returns of stocks and Treasury bonds. Moreover, they're "uncorrelated assets," meaning their performance isn't tied to what's happening in other markets. After all, death rates don't rise or fall based on what's happening to commodities, say. Uncorrelated assets like these are highly prized in an increasingly connected global financial system.

I now clearly understand what an 'uncorrelated' investment is worth - life. What is not clear to me in such products is how the underlying policy holders are ready to accept the securitization concept when people are placing (though not explicitly) their bets on their death. The speculators may take out policies on the individual's behalf, pay them something up front, cover the premiums and then wait for the people to die. Seriously macabre. The most important of all questions in my mind is how these bonds be valued? The underlying policies may be those of healthy 30 year olds or octogenarians or terminally ill patients.

Cross-posted at : http://amazer.blogspot.com/2007/07/profiting-from-mortality.html

Avoiding Entry Loads in Mutual Funds

There is widespread confusion on whether or not entry loads be levied on purchase through the various online trading portals. The SEBI circular released in January 2008 had forced the Asset management companies not to charge entry loads if the investor directly buys the units from the AMC.

This next entails the question: what is meant by directly? Does buying ICICI Prudential Mutual Fund units through ICICIdirect.com or HDFC funds bought from HDFC net banking or Internet trading portals considered direct purchase from the respective AMCs? The answer is a bleak NO.

The entry loads are waived only if you do one of the following:
1. Go to the AMC's designated offices in your city and buy
2. Get yourself registered in the websites of these AMCs (the process of that requires that you previously hold units of that AMC and have the Folio number and then fill up a form, complete the KYC norms, essentially a painful and long winded process)

So, when your investments in mutual funds are going to be on a higher side wherein the 2.25% will be material (more material than the efforts involved in the steps mentioned above), then it is advised to get on the direct channel of investing.

Research Reports

DreamGains is a site that accumulates reports available on the Internet. The latest research reports of the various broking and research firms of India like Sharekhan, Motilal Oswal, Emkay, Enam, J P Morgan, Citi, Indiainfoline, Morgan Stanley, Anagram, Kotak, ICICI, HDFC, HSBC can be obtained at this site.

Click here to access DreamGains Reports

Disclaimer: Lifestyle-Investments.blogspot.com has no link with DreamGains whatsoever.

Constructive Sales

I have blogged about the use and applicability of Constructive Sales in an Indian context here: http://amazer.blogspot.com/2008/12/constructive-sales-is-it-tax-haven.html

Replicating the same here:

If you are one of those who holds a low basis stock - e.g., you are some one who had shareholdings in a private company, which later got listed and still trading at a premium or you bought into some shares and they are now trading (still) at a substantial premium (eg. Educomp Solutions) – and want to exit those positions, you would have to encounter capital gains tax at 10% + the surcharges. (N.B.: Capital gains tax for shares traded through the exchanges is levied only if profits are booked within one year). There is a way out to defer these taxes and probably end up not paying any tax ‘legally’ (as Indian Capital Gains taxation window is just one year) if you enter into some form of ‘constructive sales’.

Constructive sales is just that for whatever profitable positions you hold, the realization of which might entail capital gains tax, you can enter into an offsetting position like shorting its future, or direct shorting of the stock (if allowed, at present it is not allowed). The day you enter into such a transaction, you have virtually locked in your profits; you are more or less insulated from future price movements, at the same time you are technically not liquidated your position which means you have eliminated your risk, essentially booked your profits but do not have to pay the capital gains tax. Let’s see how the second leg of the ‘short sales’ work. After one year of your initial share purchase, you can sell your initial shareholdings in the market which attracts zero capital gains tax and also close your short position simultaneously (or sometime later).

Let’s see a hypothetical example. I bought 10 shares of Educomp Solutions on June 1, 2008 @ INR 1000/share. On July 1, 2008, Educomp solutions had reached INR 1900 per share and I decide to close out the position and book profit. If I do a direct sale of the share, I would have booked a short term gain of INR 9000 (900x10), for which I need to pay tax of at least INR 900 (10% of INR 9000). The constructive sales alternative: On July 1 2008, I enter into a short position in the far month futures contract of Educomp, say at INR 1950. On expiry of this futures contract, I roll it over with the far month contract available then. I keep doing this till June 2009. In July 2009, I decide on closing out the short position in futures. If in July 2009, the futures contract of Educomp is trading at INR 2500, I will incur a short term loss of INR 550 (2500 minus 1950) in FY 2009-10 which can be set off against any short term gains and a long term gain of INR 1500 (2500 minus 1000) which attracts zero tax. Effectively, my net gain from the entire set of transaction is INR 950 (1500 minus 550), but I do not end up paying any tax even though I eliminated any risk after just one month of entering into the deal (June 2008 to July 2008).The above is called constructive sales and the same is disallowed in US. But I am unsure about the same in India and so as long as it is not disallowed, we can make some amount of tax avoidance (and not tax evasion ;) ) All of the above has an assumption, the individual has enough liquidity for the futures contract margins and the transaction costs are not very high (I assume the latter is true in case of an HNI with adequate investible amount and transactions).