Vijay Kumar Gaba: Real Economy

Wednesday, May 13, 2020

Financial assets have two clear manifestation. Which one you see?

Continuing from yesterday (see here)

Many readers have asked a very pertinent question, viz., "why the stock prices are not reflecting the economic reality?" It is a common knowledge that the outbreak of COVID-19 pandemic and consequent socio-economic shutdown has caused extensive damage to

After pondering over this question for many days, I have reached the following conclusions:

All financial assets (Bonds, Equity, MF Units, Derivatives etc.) have two clear manifestations - (i) Interest in some underlying business(es) or loan to some underlying business with or without a charge on the assets; and (ii) independent commodity without any regard to the any underlying business or asset.

When someone buys equity shares of a company with the intent of acquiring an interest in the underlying business of that company, he is considered an investor in that underlying business. He may use the services of stock broker or may buy directly from the company or some other shareholder. Such a person is mindful of the price he is paying for acquiring the interest in the business. He usually would not like to pay much more than what he believes is the fair value of that business, based on various parameters like future cash flows, replacement cost of assets, market leadership (product, technology, brand, accessibility etc.), competitive advantages etc.

This person would be usually concerned with the performance of the company as reflected by the profitability, cash flows, solvency margins, and sustainability etc. The price at which the stock is trading on the stock exchanges would be least of his concern.

Similarly, when a person lends money to a business with the intent of earning a regular fixed income over the predefined term of loan, he is concerned with the liquidity, solvency and viability of such a business during the term of the loan. How the yields on benchmark government security or other corporate securities move on day to day basis would be least of his concern.

When a person buys a security which is regularly traded on some platform like stock exchange, or buys units of a mutual fund in which the underlying asset is the security regularly traded on some platform, with the intent of selling these securities at a higher price at some point in future, he is a trader, dealing in securities as commodities. He is concerned with the day to day market price of the security.

The interest in business of an investor is mostly linked to the real economy. Good businesses will usually do well in a growing economy; and these will do relatively better in a declining economy. Nonetheless, during the down cycles of the economy growth of most of the businesses will slow down.

However, when we consider financial assets as commodities, the dynamics completely changes. The day to day price of the stocks or bonds is determined purely by the forces of demand and supply on that particular day. The factors like storage capacity (margin money or loss bearing capacity) and carrying cost (interest rates, forward premiums etc) significantly influence the demand and supply. Temporary demand or supply disruptions (ban on short selling, hike in margins, market shut down, credit freeze etc.) significantly impact the market prices. The day to day prices usually have little or no connection with real economy.

In past three months, global central banks have added significant liquidity to the global financial system. This additional liquidity is available at near zero cost. Naturally, the demand for "securities as commodity" is higher due to higher holding capacity and lower carrying costs.

Similarly, when someone buys units of a mutual fund, he has no control over the asset or securities underlying those units. It is the discretion (or decision) of the fund manager (or index manager in case of ETF) that would decide what would be the asset underlying those mutual fund units. I wonder how could someone be termed as an investor or lender if I have absolutely no control over the security or asset I am buying or the entity I am lending to?

Also, consider if a fund manager tells you that I will interest in these five businesses and hold it for next 20years regardless of the market price of their stock, and charge you 2% every year for holding stock on your behalf. How many investors would agree to this proposition?

Obviously, when you buy units of a mutual fund, you entrust your money to an expert who has a track record of dealing in "securities as commodity". Your bet is on the jokey (fund manager) and not the horse (underlying securities); because you have no clue about or control over the horse.

Therefore, basically buying mutual units is also trading in "securities as commodity". The gains and losses from this trade are closely linked to the day to day demand and supply equilibrium without any regard to the strength of ultimate underlying business.

The occurrences in the debt mutual funds in past 12-15 months aptly illustrate this point. A debt mutual fund receives a large redemption request (excess supply) on a day when the liquidity in the market is tight. To meet the redemption obligation, the fund manager sells bonds below fair value causing loss to the unit holder. The company who had issued this bond is working perfectly fine and is fully solvent. This phenomenon can only be explained if we treat MF units as commodity, which realized less money because supply was more than demand on that particular day.

If the market participants assimilate these two manifestations of the financial assets, it would be much easier to navigate through market cycles and business (economic) cycles.

Tuesday, May 12, 2020

Nothing looks outside of the realm of possibilities

Thirty years ago, the period between May 1990 and December 1990, was a watershed in global social, political and economic order. In the 7 months, the world changed the most in the post WWII era. For India, in particular that was a defining period in post independence history.

In global context, some of the key events that took place in those seven months included the following:

(a) Apartheid ended in South Africa, marking the end of one of the darkest chapter in world history.

(b) The process of USSR dissolution begins. The Supreme Soviet of the Soviet Union grants Gorbachev special powers to secure the Soviet Union's transition to a market economy.

(c) Soviet Union collapse marked the end of a bipolar world that had divided the world in two camps in post WWII era. In the subsequent two decades, USA would reign over the world as the only super power.

(d) End of cold war between USA and USSR with treaty to destroy chemical weapons and most of the nuclear arsenal.

(e) Iraqi forces invaded Kuwait. This was followed by the invasion of Iraq by 34 nations in a joint operation, first of its kind in post WWII era. This was followed by a long bloody war between the super power USA & its allies on the one side and radical Islamic forces on the other side. The war on terror thus started still continues, but many key supporters like Saddam Hussain, Muammar al-Gaddafi, Osama Bin Laden etc have been eliminated.

(f) Reunification of Germany, ending more than four decades of separation of German people, healing the post war wounds.

(g) LTTE guerillas massacred 600 unarmed Lankan policemen intensifying the long violent conflict in Sri Lanka.

(h) WHO removed Homosexuality from its list of diseases, erasing the centuries old stigma attached to the practice.

(i) The era of Iron Lady Margret Thatcher ends in UK.

In the Indian context also many significant events took place, which changed the course of Indian politics, economics and social milieu forever.

(i) Massacre & exodus of Kashmiri Pundits in January 1990 was followed by firing by CRPF on funeral procession of Mirwaiz Moulana Muhammad Farooq in May 1990. These events triggered a long intense terror war in the valley, nearly destroying the heaven on earth.

(ii) Mandal Commission report was implemented in India, reserving 49% of government jobs for SC/ST and OBC in India. This changed the politics of India forever, marginalizing the Congress Party and strengthening the regional parties who contested elections on social justice slogan not the poverty elimination.

(iii) BJP President L. K. Advani undertakes a road trip (Rath Yatra) to mobilize support for a Ram Temple in Ayodhya. The V. P. Singh Govt falls, after Advani is arrested in Bihar. The BJP rises as the primary challenger in India's national politics. 6 year later Atal Bihari Vajpayee would make the first BJP led coalition government in India that lasted 13 days.

(iv) Chandrasekhar, a socialist leader becomes prime minister and initiates the transition of Indian economy from a controlled economy to free market economy. The job would be carried forward by the Congress government formed in 1991 under leadership of P. V. Narasimha Rao.

This was also the period, when the stock markets globally, including India, did rather well disregarding all the turmoil, uncertainty and concerns.

Three decade later, the circumstances are almost similar to the summer of 1990. The outbreak of novel coronavirus COVID-19 has completely shaken the global economics, politics, geopolitics and social framework. The things look set to change dramatically.

Nothing looks outside of the realm of possibilities. The ways people work, travel, socialize, live, eat, and communicate are all set for major changes. The global strategic and trade relations face the prospects of dramatic paradigm shift.

India will also be a participant in these changes. Marking "anything", yes I repeat "anything", as unlikely or impossible may not be appropriate at this juncture. The more uncertainty we face, more certain we must believe in the change.

The resilience of stock markets in light of this uncertainty has perplexed many market participants. Many readers have asked about my views on the divergence in the stock indices and real economy.

I will share my thoughts on this in next couple of days.