Don’t Judge tne Market by its p/e ratio when the next market fall happens

Don’t Judge The Market by its p/e ratio when the next market fall happens

The first quarter of 2009, the bottom for US stocks during the financial crisis, is now remembered as what it was a once in a lifetime chance to acquire shares. With perfect hindsight anyone who held their nose, bought near the bottom and held on would have more than doubled their capital in the seven or so years that have passed.

One excuse for those who did not was that back then one of the most widely used benchmarks for US equities, the S&P 500, appeared expensive, trading on a seemingly rich trailing price/earnings (p/e) ratio of more than 20 times. Why the index appeared expensive at its bottom is salient for those not wanting to repeat the same mistake.

A lot of research is carried out debating whether the stock market, typically depicted as an index such as the S&P 500, is heading for a fall or not. Considering the popularity of p/e multiples it is important to understand how the earnings of popular indices such as the S&P 500 and Russell 2000 are calculated, and how this can make shares appear more or less expensive than they may actually be.

The S&P 500 is a market capitalization weighted index, meaning the most valuable of its constituents comprise a proportionately greater part of its price than smaller ones. The performance of the shares of Apple, the largest company by value in the index with a weighting of 3.4 per cent, has a far larger impact on its performance than smaller members. If you spend $100 purchasing a fund that tracks the S&P index today, then $3.40 of your initial investment goes into Apple stock.

This changes when it comes to calculating the earnings of the S&P 500, which are then used to calculate its p/e ratio. S&P adds all of the reported earnings and losses of the index members. A dollar of Apple’s earnings is worth the same in this calculation as a dollar earned by Murphy Oil.

The trailing 12-month earnings of Apple were $47bn, according to Bloomberg data. The combined losses of the four least profitable members of the index over the same period Apache, Devon Energy, Freeport McMoRan and Chesapeake Energy were roughly the same at $48.3bn. Apple as we know makes up 3.4 per cent of the index, while the combined weight of those four biggest loss making companies is just 0.023 per cent. All of Apple’s profits, when calculating the p/e ratio of the S&P 500, are wiped out by these four tiny members of the index.

The top eight most valuable members of the S&P 500 made a combined $135bn in net profits on a trailing twelve -month basis. These earnings are all but cancelled out by the 30 largest loss making companies, which reported combined losses of $125bn. The eight largest companies Apple, Microsoft, Exxon, Johnson & Johnson, Amazon, Facebook, General Electric and Berkshire Hathaway — together have a 15.5 per cent weighting in the S&P 500. The 30 biggest loss makers have a combined weighting of just 4.5 per cent, which is reduced to about 3.5 per cent if you remove Chevron, which reported a loss of less than $1bn.

A different problem occurs if you try to draw conclusions from the p/e of the Russell 2000 index, which is frequently used to represent the performance of US small-cap companies. Russell publishes two versions of the Russell 2000 p/e multiple. The most commonly used version excludes losses, including only the profits made by index constituents. Using this method, the Russell 2000 stands at a multiple of about 40 times trailing earnings. Using the other method, which includes losses, the Russell trades at a considerably higher 84 times last year’s profits.

Ideally a dollar earned or lost by S&P 500 member should be counted the same and the index should be treated like a company with 500 divisions. If one part loses money, the losses are suffered by the whole company.

This does not change the fact that back in 2009 stocks would have appeared to many casual observers as misleadingly expensive if they relied on the p/e of the S&P 500. About 80 companies reported $240bn of losses yet they made up only a 6 per cent weight. The next time a big stock market sell-off occurs investors should take a closer look. Anyone who held on would have more than doubled their capital.

Hence even in the Indian context it is not a good idea to judge the Sensex by the overall p/e multiple but it is better to do a deep analysis of individual earnings of companies to get a better picture and take a call on the overall market valuation.

-        Farzan Ghadially

Turbulence has many Investor Fear for the Worst

Turbulence has many Investor Fear for the Worst

The volatility across markets is likely to last until at least next few hours when the Bank of Japan and the Federal Reserve give their latest decision on interest rates. While bonds and equities have both been hit since last few days, the pain in parts of the market points to the wide range of concerns troubling investors.

Japanese long bonds

This year’s historic debt rally is faltering, but the real pain has been in long bonds. And the chief source of anguish is Japan, where there is speculation the Bank of Japan may pull back from buying long bonds in an effort to shield banks that historically have relied on a steep yield curve for profits.

The yield on the 30-year JGB has climbed from a low of 0.047 per cent in early July to 0.57 per cent, and a chunk of it has come in the past few days. That trimmed gains for the bonds to a mere 22 per cent this year from the even giddier 35 per cent at the peak of their rally.

And no one so far, is buying the dip.  Market consensus seems that may not see global long ends gain traction until we get the BOJ and the Fed meeting hours after it, is behind us.

Energy shares

A sinking oil price had a starring role in the market turmoil at the start of the year. Its current slide is central to the much more modest squall this week. Shares of US energy producers have been among the hardest hit. The energy sector’s 5.4 per cent drop since Friday is more than double that of the S&P 500. US crude has tumbled 6.7 per cent.

Exploration and production groups have sustained steep drops, as investors judge them as being especially sensitive to swings in oil. Marathon Oil and Murphy Oil, for example, have both had double digit declines since last week.

Just as anxiety has flared over whether central banks will sustain their monetary largesse, so has fear that the outlook for the oil price is deteriorating. Those worries were amplified on Tuesday after the International Energy Agency forecast the global oil glut may bleed well into 2017.

Periphery bonds

Although two sharp daily declines in the S&P 500 since last couple of days have grabbed attention, investors’ current disquiet began in the debt markets after the European Central Bank failed late last week to announce an extension of its bond buying programme.

Some of the Eurozone’s weakest economies, including Italy, Spain and Portugal, are still feeling the effects. The extra yield investors demand to hold Italy’s benchmark 10-year bonds instead of German debt has jumped from 1.17 percentage points last week to 1.27.

Spain has seen the spread between its bonds and German equivalents rise 13 basis points to 1.04 per cent, while the spread in Portugal, where investors are growing increasingly worried about the extent of a bank bailout required, has increased by over 20 basis points.

Market participants feel that   the ECB to ultimately extend its stimulus measures to staunch a deeper sell off.

US real estate

American real estate shares shed more light on what is gnawing away at investors. The sector has dropped 5.2 per cent since late last week. Yes, it has been shunned because the shares’ steady dividend streams may be less attractive in a world in which interest rates are rising.

But there is also cyclical component to their under performance, the summer saw the first drop in annual home sales since last November, raising fears among some economists that the rebound in home sales is running out of steam.

Risk parity funds

Risk parity funds have enjoyed a bounce this year after a torrid 2015, but have been hit badly in the latest turbulence.

The strategy involves investing in a broad pool of diversified asset classes according to their mathematical volatility, the idea being that they mostly move in different directions, but over time, should provide healthy returns. But when both bond and stock markets fall the pain can be severe.

The Salient Risk Parity Index had gained over 20 per cent this year until early September, thanks to central bank policies buoying bonds and equities, but has traded water since July, and since Thursday has fallen nearly 5 per cent.

Some analysts fear the funds will pare their exposure to keep their riskiness constant, leading to a feedback loop as their automated selling weighs further on markets in the coming weeks.

_ Farzan Ghadially

Development of the Corporate Bond Market a Step in the Right Direction

Development of the Corporate Bond Market a Step in the Right Direction

Last month, Union Bank of India became the latest state controlled lender to be downgraded to junk by S&P. The pick-up in corporate performance, and the de-bottle necking of stressed sectors, in India is likely to be gradual, hurting Union Bank’s asset quality and similar is the story for many such banks in India.  The stress has pushed up the bank’s non-performing ratio of most banks in India and this has been a very large concern for the public markets on the whole as many investors wonder how much more trouble is really there for banks in India and puts a question mark on the overall asset quality of the banks in India.

Neither India’s economy nor its banks are in the greatest shape. Growth slowed from 7.9 per cent in the first quarter to 7.1 per cent in the second and according to the probably more accurate methodology the government used to employ, the first quarter figure was just over 4.3 per cent.

Fixed investment contracted more quickly, hardly surprising given that utilization of the economy’s current capacity remains low. It is just above 70 per cent overall, while in some industrial sectors such as steel and paper the figure is as low as 50 per cent and most companies struggling to survive and make ends meet for paying the interest to the respective lenders.

At the same time there had been a near full stop in bank lending to industry, as the banks have become very careful on the loan book and in being ultra conservative credit has become a big problem for most medium and small companies in certain cases being larger companies.  Without credit, economies cannot grow. However, for many sectors there is both little demand for bank credit and little supply, thanks to the combination of broken bank balance sheets and excess industrial capacity. Cost of capital, especially for bank borrowers, remains lofty far higher than almost anywhere else in emerging Asia.

But there are signs of a potential easing of the logjam. The Reserve Bank of India is introducing rules that should reinvigorate the corporate bond market, creating a less dependence on banks funding the next leg of the investment cycle. The development of the bond market will reduce pressure on the banks. This could be possibly the best last master stroke by the former RBI governor Dr. Rajan.

It could be that the RBI is pushing an open door. Banks, with their need for capital to fix balance sheets, have been reluctant to pass on any rate cuts to corporate customers. It is more attractive for companies to issue debt than bow down to their bankers.

To make sure that large companies turn to this alternative source of funds, the RBI is imposing higher capital charges and provisions for loans to bigger borrowers. To encourage smaller companies to access the market and to encourage investors to bet on them regulators raised the credit enhancement limit from 20 per cent of the bond size to 50 per cent.

Foreign investors will find it easier to hedge their rupee exposure something that has in the past been a big cap on their involvement in the local bond market.

The challenge always was the lack of depth and liquidity, as the turnover was less than $1bn a day.

Although these measures are incremental, they should ultimately make a difference when there is more basic demand for credit.

The promise for an Indian economy that has slowed does not end there. A significant swing factor is the monsoon it largely accounts for the difference between the worst and best economic cases. After two disappointing years the rains have been generous, giving rise to lower food prices. That should lift rural income, boosting consumption.

Meanwhile, to the extent that there will be a re-acceleration in economic growth, some of it may come from the government, as it ramps up spending to build desperately needed roads, upgrade decrepit railways the average speed of a freight train is 25kmh and improve ports.

The government has been a big part of the problem. Organisations such as the National Highway Authority would rather dispute than pay bills for work from the big infrastructure companies, contributing to both the physical and the financial logjam. As the corruption that gave rise to blockages and delays eases, fiscal spending will be more effective.

With inflation coming down and public spending less wasteful, the RBI can finally move more aggressively to cut rates and reduce borrowing costs. That is the proper sequence of actions a sequence from which other governments and central banks could learn as the cost of capital is far higher than almost anywhere else in emerging Asia

_Farzan Ghadially

Block Chain Technology: Dawn of a new Era

Block Chain Technology: Dawn of a new Era

Early bitcoin enthusiasts hailed the cryptocurrency as a revolutionary way to side line banks in a libertarian drive to upend the traditional order of capitalism.

Since then the banks have fought back. Nowadays most people attending conferences about the block chain technology that underpins bitcoin are more likely to be wearing suits than the hoodies and ripped jeans of a few years ago.

Having kept their distance from bit-coin, fearing the risks of fraud and criminality, big banks now see huge potential benefits from harnessing block chain to make the existing financial system more efficient.

In today’s banking world, it is all about cost savings, as they are all struggling with low returns, and that is why they are all locking on to the block chain.

The four banks UBS, Santander, Deutsche Bank and BNY Mellon, which are working with UK broker ICAP and developer Clearmatics Technologies  stress that they are not creating a new cryptocurrency but will revolutionize the way payments are made and develop a utility settlement coin a new form of digital cash.

Instead, the system they are developing uses block chain technology to create different coins that are each directly convertible into existing currencies deposited at central banks. In essence, it is a way of putting dollars, euros and pounds on the block chain.

While other digital cash projects are being examined by banks such as Citigroup’s “Citicoin” or Goldman Sachs’ “SETLcoin” this is the first time several institutions have teamed up to create a digital cash utility for use in financial markets.

So how does it work? And what problem is it trying to solve?

Coins are stored on a network of computers, all of which must approve that a transaction has taken place before it is recorded in a chain of computer code. Cryptography keeps transactions secure and costs are shared.

Details of transfers are recorded on a ledger that anyone on the network can see, eliminating the need for a central authority, which is why the technology has been dubbed a distributed ledger.

The aim is to speed up clearing and settlement in financial markets by allowing institutions to pay for securities, such as bonds and equities, without waiting for traditional money transfers to be completed in the so-called delivery versus payment process.

By switching clearing and settlement of financial markets on to a distributed ledger, the banks hope to do away with much of their costly back office operations that process trades and keep records up to date.

Quicker settlement should also free up capital that banks hold against trading risk.

Every bank, exchange and clearing house, have their own sets of the same data, which get out of sync and have to be updated and reconciled. The distributed ledger is the first technology which could implement a shared golden copy of that data.

Total savings from using block chain technology in payments, securities trading and regulatory compliance could reach $15bn-$20bn a year by 2022.

The consortium behind the universal settlement coin is aiming for a commercial launch by early 2018, by which time it expects to add many new members.

The project still faces challenges. One is transaction speed. Bitcoin is often criticized because its block chain can handle only about seven transactions a second, as opposed to, say, the 24,000 that Visa can. There is also a question over whether the banks will lose almost as much revenue as they save in costs. They make $1.7tn a year, or 40 per cent of total revenue, from global payment services. How much of that could be replaced by a block chain payments solution?

Finally, the proliferation of various block chain projects among banks, already numbering in their hundreds, raises fears of whether they will coalesce around a single standard or end up using several incompatible technologies.

Some people in the financial markets feel that the banks are missing the point. This is banks talking to each other and the point of block chain is to establish consensus in the presence of potentially untrusted actors, as with bit-coin, on the internet.  It would be a sorry state of affairs, that technology is not going to fix, if the banks don’t trust each other.

$20bn is the potential savings from using block chain in payments, securities trading and compliance by 2022 and $1.7tn is what banks make from global payments services, offsetting the potential savings so in times to come it will be seen if block chin technology implemented and integrated well will change the face of making payments and money transfer.

_ Farzan Ghadially

OIL no Longer the Evergreen Asset Class: Has the Oil Demand Peaked.

OIL no Longer the Evergreen Asset Class: Has the Oil Demand Peaked.

Timing is everything when it comes to investing in commodities. In 2014, oil was considered one of the safest bets. The reasoning among big financial investors was straightforward. Regulation and technology might crimp demand in the industrialized west, but as more of the developing world’s poor moved into the middle class, oil demand and prices would remain strong. Skip forward to 2016, and many analysts, including those in strategic planning departments of big oil groups, are starting to warm to the idea of peak oil demand globally, not just in the OECD.

In part the exercise has been driven by shareholders and activists who say the companies are ignoring the risks to their business from a global climate accord. A number of organisations, notably the International Energy Agency but including oil companies such as Statoil, Shell, BP, Total and Conoco Phillips, are modelling outcomes based on a breakthrough in battery technology or that global temperatures rise by no more than 2 degrees Celsius.

These scenarios include rising solar energy and natural gas use, cheaper car batteries, urbanization supported by millennial ride sharing and public transport, and advanced, digital energy-saving technologies. Many of the studies project a fall in oil demand to 75m barrels per day by 2040, from about 95m b/d today.

After testing for oil demand sensitivities and found that a combination of factors; slower than expected growth in the developing world, improved logistics, advances in vehicle efficiency could, perhaps with a push from policy, see demand for oil peak, at least for a decade or two.

The implications are bigger than they might seem given the number of ifs that surround the idea that oil demand could peak. For the past three decades, investors have assumed that oil under the ground today will be more valuable in the future. That has led them to seek companies best positioned to deliver growth. But if the rise in oil demand is uncertain, all bets might be off. That means investors do not simply want exposure to crude. They will need to select a management team that is nimble, no matter whether demand rises, falls or remains flat.

Moreover, in a more competitive world where producers might have fewer opportunities to sell its product, all investable oil assets will not be equal. Investors will have to know what the production cost basis is for a company’s reserves or how well positioned their refinery network is to beat global competitors. Location of assets will matter. Owning a refining and marketing network in California, or Germany, where demand will almost certainly fall off, might be less attractive than in India or Malaysia.

The use of automation and other emerging technologies to drive returns will matter. Technology advancements had lowered the company’s production costs excluding taxes to $2.25 a barrel for horizontal, low enough to compete with Saudi Arabia. By contrast, operating costs in Canada’s oil sands are estimated at $37 a barrel.

For 30 years, the industry has operated under the principle that it will have difficulty meeting demand. Against that backdrop, adding reserves to the balance sheet was an end unto itself, sometimes more important to management than if those reserves could be profitably produced.

The thesis was that oil would become increasingly scarce as easy to reach reserves were depleted; the value of booked, warehoused reserves would appreciate with global prices and a day would come when even ridiculously expensive assets would be profitable to produce.

But if oil demand declines before those expensive reserves are needed, mindlessly booking reserves is not a strategy Wall Street will want to reward. Investors might ask more critically what a company’s revenues outlook will be this quarter or next, like most other ventures. Understanding which companies can pivot best to new realities will be key to smart investing in oil.

All investable oil assets will not be equal in a more competitive world.

-     -   Farzan Ghadially

Gold: The Good Money

Gold: The Good Money

Gold prices have rallied more than 30 per cent since the lift off in US interest rates in December. A sharp reversal in pricing, sentiment and positioning driven by myriad factors has left gold bears and bulls as polarized as ever.

The bearish camp, with analysts such as those at Goldman Sachs, tends to have a constructive view on the US dollar and the ability to raise interest rates and normalize global monetary policy, and generally a benign view on the global economy and inflationary risks.

In the bullish camp, the view tends to be more pessimistic on the global economy and the unintended consequences of monetary policy without limits. It sees the recent price action as the beginning of a multiyear bull run in gold.

There are three main factors that support the rise of Gold prices, resulting in gold being the good money in the years to come.

The first is the limits of monetary policy. In response to the Lehman crisis and to combat the threat of deflation, central banks have deployed a wide range of unconventional monetary policies. Quantitative easing and negative interest rates have been game changers, distorting the valuation of government bonds, breaking the theoretical ceiling in prices, squeezing shorts and underweight positions, and feeding what, is one of the largest financial bubbles in history.

At the epicenter of the problem are the central banks. Investors and savers around the world, faced with extraordinarily low and even negative yields in cash and fixed income, have been incentivised if not forced to lengthen the duration in their portfolios, increasing the risk of capital losses, liquidity and volatility beyond what they might intend or be able to tolerate.

Second, examine the edges of credit markets. The bubble in government bonds and duration has driven risk taking across equity and credit markets, and lending to weaker and weaker credits, often ignoring or underplaying the risk of capital losses, liquidity and volatility. It’s a bull market that feeds on itself and benefits the weakest players most, such as emerging markets or high yield.

In a world with limited investment opportunities, excessive risk taking can lead to speculation and, of course, bubbles. The damage is done but can get worse, especially if countries such as China respond to future crises with more aggressive credit expansions, as it did this year.

The current path of monetary and credit expansion is unsustainable and will eventually burst, leaving investors struggling for the return of their capital, instead of return on their capital an extremely bullish scenario for gold and other real assets.

Third, the limits of fiat currencies are being tested. Unlike in the global financial crisis of 2008, this time there won’t be any monetary bullets left. Interest rates are already at record lows, asset purchases suffer from the law of diminishing returns, and competitive currency devaluations only increase underlying problems and global imbalances.

Over the past few years we have witnessed the first stage where by bad money displaces good money, and we are at the early stages of the second and final phase, whereby good money displaces bad money.

Gold and the dollar are best placed to play the role of good money, which could result in a substantial appreciation against the bad money currencies. But the inability or unwillingness of the US to normalize its monetary policy leaves the door wide open for gold to retake its reserve currency status and put an end to the monetary super cycle that started in 1971 with the end of Bretton Woods. It is a period in which the outstanding volume of paper money has grown disproportionately to the amount of gold that once backed it.

Time will tell if central banks and governments will be able to engineer a smooth solution to the challenges ahead, or if the remedy will be worse than the disease.

Monetary policy without limits will lead to a very wild and bumpy ride and a larger crisis than the one we have been trying to resolve: which could result in a perfect come back for Gold as an asset class that would shine in times to come.

_ Farzan Ghadially

Liquidity Liquidity Every Where Will There Be a Recovery!!

Liquidity Liquidity Every Where Will There Be a Recovery!!

With the gush of liquidity from most Central banks around the world, the markets are moving to new highs without a real recovery in the earnings, will this ever greening of liquidity help in actual revive or does it just postpone the eventual danger of the collapse of markets world over.  

Policymakers have chosen to ignore the central issue of debt as they resuscitate activity. Since 2008, total public and private debt in major economies has increased by more than $60tn to more than $200tn about 300 per cent of global gross domestic product, an increase of more than 20 percentage points.

Over the past eight years, total debt growth has slowed but remains well above the corresponding rate of economic growth. Higher public borrowing to support demand and the financial system has offset modest debt reductions by businesses and households.

If the average interest rate is 2 per cent, then a 300 per cent debt to GDP ratio means that the economy needs to grow at a nominal rate of 6 per cent to cover interest.

Financial markets are now haunted by rising debt levels which constrain demand, as heavily indebted borrowers and nations are limited in their ability to increase spending. Debt service payments transfer income to investors with a lower marginal propensity to consume. Low interest rates are required to prevent defaults, reducing the income of savers, forcing additional savings to meet future needs and affecting the solvency of pension funds and insurance companies.

Policy normalization is difficult because higher interest rates would create problems for over-extended borrowers and inflict losses on bond holders. Debt also decreases flexibility and resilience, making economies vulnerable to shocks.

Attempts to increase growth and inflation to manage borrowing levels have had limited success. The recovery has been muted.

Sluggish demand, slowing global trade, capital flows and demographics, plus lower productivity gains and political uncertainty are all affecting activity. Meager commodity prices, especially energy, and overcapacity in many industries have kept inflation low.

In the absence of growth and inflation, the only real alternative is debt forgiveness or default. Savings designed to finance future needs, such as retirement, are lost.

Additional claims on the state to cover the shortfall or reduced future expenditure affect economic activity. Losses to savers trigger a sharp contraction of economic activity. Significant write downs create crises for banks and pension funds. Governments need to inject capital into banks to maintain the payment and financial system’s integrity.

Unable to grow, inflate, default or restructure their way out of debt, policymakers are trying to reduce borrowings by stealth. Official rates are below the true inflation rate so over-indebted borrowers to maintain sustainability high levels of debt. In Europe and Japan, disinflation requires implementation of negative interest rate policy, which entails an explicit reduction in the nominal face value of debt.

Debt monetisation and artificially suppressed or negative interest rates are a de -facto tax on holders of money and sovereign debt. It redistributes wealth over time from savers to borrowers and to the issuer of the currency, feeding social and political discontent as the Great Depression highlights.

The global economy might have become be trapped in a quantitative easing forever cycle. A weak economy forces policymakers to implement expansionary fiscal measures and QE.

If the economy responds, then the side-effects of QE encourage a withdrawal of the stimulus. Higher interest rates slow the economy and trigger financial crises, setting off a new round of the cycle.

If the economy does not respond or external shocks occur, then there is pressure for additional stimuli, as policymakers seek to maintain control.

Economist have been very pessimistic and feel that there is no means of avoiding the final collapse of a boom brought about by credit expansion. The point is   only whether the crisis should come sooner as a result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved. Negative rates are a de facto tax on holders of money and sovereign debt.

-        --Farzan Ghadially