Black Monday is here

There are a lot of people who think it is a technical situation, it is a liquidity situation. Don't believe them. It is a pure and simple solvency situation. Equity prices can go -ve.

How?

There is a difference between enterprise value and equity value. It is called debt. So while EV can't go negative, equity value can, depending on the debt. That is why debt deflation is so dangerous.

But will never see negative prices on screen. So isn't my statement wrong?

To which I will say, look at UBS. Its market cap is $37bn. It has raised close to $32bn in equity so far over the last year. And then they just moved $60bn of assets to the Swiss govt. So last year, before this crises began, UBS's equity value was negative. The only reason we didnt see it negative was because of repeated capital injections in the bank.

This is also going to happen in a lot of other industries and companies. Repeated capital injections.

We have gone into a huge -ve feedback loop.

What is Long Term Investing..

I am now seeing a lot of earning downgrades and rating downgrades notes. What happened to looking out 5-yr growth stories? Oops. Sorry investors. We lost you 70%, and now we realize that we can't see where the world is going next week, let alone five years. Unfortunately, the world is not linear, it accelerates and decelerates, and right now it has gone off a cliff.

As Buffett said in his last letter, "When the tide goes out, we see who is swimming naked. We find Wall Street was a nudist beach." He can add the entire Indian sell side and buy side community to the list. They have been happily ensconsced in their 8% growth rate assumption and not even once tried to figure out what is happening around in the world. It was all too macroeconomic, India was decoupled and they wanted to go to company specific detail. 90% of them wouldn't have still heard of CDO and CDS.

Long-term investing doesn't mean that we need to project 5 years out and do a DCF etc. It is all hogwash. Who knows what the right discount rate is? What we need to figure out is

(a) What is the history of the company?
(b) What did the company do when faced with similarly tumultous times - remember 1997 and 2001?
(c) What is the capital allocation policy of the company - the most important decision that long term investors should care about. How does the company raise capital? Does the company use excess free cash to do stupid acquisitions, hoard cash on balance sheet, or return to shareholders?
(d) Is the company reasonably valued on cyclical adjusted EPS and ROE's?

And in these times, I will also add
(e) What is the debt maturity profile of the company. What is its capital structure?

It is widely known that Buffett spends less than 15 min to figure out whether he wants to invest or not. The reason is simple - he knows the history well, and he bets on his knowledge of history. History might not repeat itself, but it is the best guide to the future. The only way to look forward is to look behind.

Kamal Nath and Chidambaram are doing a great disservice right now by insisting that everything is fine and the rupee movement is an aberration. It is not. Currency movements are self-fulfilling prophecies. They need to get together with other Asian countries, particularly Japan and China asap, to intervene in the currency markets. Developed countries are intervening in banks, emerging markets need to intervene in currencies.

Will Fed cut to 0% next week

If we are going into a deep recession and inflation is not a problem particularly with dollar rallying, why not cut to 0%. Till asset prices stabilize, there is no bottom to this mess.

This is deflation. And we now see the terrifying impact of it.

Sep and Oct have lived up to their reputation of being the worst months of the year. Will Nov and Dec now live up to their reputation of being better. You never know. Nothing ever goes down in a straight line, even though there is a lot of pain left. The giant Ponzi scheme of ever increasing asset prices has blown up spectacularly.

This is what Greenspan says

It was a four hour testimony, so I only have some snippets from WSJ. Here are the best ones:

a) Mr. Greenspan was asked when he knew there was a housing bubble and when he told the public about it. He answered that he never anticipated home prices could fall so much. "I did not forecast a significant decline because we had never had a significant decline in prices," he said. -

Now we are talking!! A bet on ever increasing prices - also called gambling in Vegas. There have probably been more real estate bubbles than commodity price bubbles in this world.

b) If the best experts were not able to foresee the development, "I think we have to ask ourselves, 'Why is that?'" Mr. Greenspan said. "And the answer is that we're not smart enough as people. We just cannot see events that far in advance."

Thats not true. There were a lot of people who saw what was happening, and have made billions shorting the real estate market in US. I got the feeling after reading Greenspan's book that he started thinking of himself as God. So probably he closed his mind to positions and beliefs that conflicted with his belief and ideology.

People in democracies keep criticizing their politicians saying that they are all corrupt etc. Why are technocrats better? Probably the biggest problem is not Greenspan's philosophy, but that he was Fed Chairman for 17 years - thats a very long duration in a position of enormous power, and would make any human being think that he/she is a God. It was Bill Clinton's mistake.

There is one thing in all this that makes me respect the US - people are after the right person (Greenspan), even though he left 2-1/2 years ago. If it had happened in India, they would be after the current incumbent. Congress will blame the next govt for the mess that is going to happen in 2010, even though the seeds have been sown under their watch.

Greenspan says he was wrong

Just got a snippet of live testimony of Greenspan in front of US Congress on BBC. He said that there is a basic flaw in the model of the world that he has used for the last 40 years. It is a very profound statement and is probably a big setback for the entire Republican establishment. I am looking forward to read the entire testimony tomorrow.

I think one should feel privileged just to be living today. All the obscure philosophies of the past few centuries are going to get a new life as people try to figure out the best way to organize man and machines. The longer the crises, the more incentive there will be to change the entire system. So while materially we will all end up poor - whether you put money in cash/stocks/real estate you will end up worse two years down than today - we are entering a very different period philosophically. By a quirk of fate, it is possible Obama is the best guy to lead US at this time.

Bears - take a bow

The ultra-bears of this world should take a bow - they took substantial risks with their careers and have been thoroughly vindicated. It requires guts to argue that stock x will fall 90% from its peak when the "smart money" of the world is investing expecting it to double.

We approach the golden age of long-term investing. Competition is about to thin out as hedge funds/PE funds are taken to cleaners.

Global Coordinated Action Happens

One good thing about freely falling markets is that they make policy makers act quickly. The bad thing is that they are forced to act without thinking things through. By intervening in the markets, govt can limit the downside, but it will also limit the upside. This is going to be a very slow drawn out affair.

It will be interesting to see how big a hole the US Social Security and pension plans have at the end of this year. Equity markets have delivered 0% return in 10 years, when they are budgeted to deliver 8% return.

Climate Change and Stock Markets

If this is how Mr. Climate plays out - i.e perceived stability and equilibrium over a long time despite pressures building into the system, and then the system cant take it any more and it collapses - then I am scared. It is time to pay more attention to the climate doomsdayers. At least the stock markets are not killing us physically - not so far that is.

The big game right now is in the currency markets - the more a currnecy collapses, the more toast it is. India should be scared about rupee..

Use $700bn to buy 3.5mn homes

October is supposed to be the month when the big blowups happen. Oct 1929, Oct 1987, Oct 1998 spring to mind. Add Oct 2008 to the list.

There is one way in which $700 bn can be used to just stop all this in its track. The average price of a US home is about $200,000. So, $700 bn can buy 3.5mn homes. There is an inventory of 4.7mn homes in the US currently - a 11 month supply at current sale pace. If I remember correctly, 5-6 months of inventory is considered more normal. So, if the US Treasury were to indeed take 3.5mn homes off the market, in one fell swoop it would have taken care of the inventory overhang depressing house prices. As US house price stabilize, investors can then better calculate the value of a mortgage backed security and all the other alphabet soups (CDO etc). You might indeed have a rush to buy these distressed securities.

Now this is going to massively distort the markets in unforeseen ways for sure. But who knows what the current plan ends up doing? The job is to use $700bn to stabilize the financial system, and I can't figure out how buying MBS and CDO's will encourage banks to lend, if real estate prices keep falling because of the inventory overhang.

People are talking about nationalizing banking - why not nationalize housing?

The entire problem lies in the way inflation is defined. If one were to include asset price inflation in calculating inflation, Fed would have been forced to raise rates much earlier in 2003-2004, which would have prevented this huge housing boom.

China has US by its balls

In the mid 1940's, Britain was a spent force. Following the two wars, it had a huge debt problem. US helped it out, but made sure that it occupied the centre-stage thereafter.

US needs external capital to finance its bailout and many more future bailout proposals. It needs Japan and China. Can the Chinese govt say, for ex, take those ships away from East Asia, calm down on Taiwan etc.? It is at these times that the geo-political situation of the next 50 years is written. Can the Chinese exploit the situation to their advantage? I will bet they do. Chinese are far more ambitious than Japanese.

Global Central Bank Coordinated action

Central banks globally need to step into the money markets and act as counterparty to all transactions to get the money flowing again. If money markets don't unfreeze in the next 7 days, I think we will see multiple bankruptcies beginning this month. It needs to happen this weekend. A globally coordinated interest rate cut might help too, but I am not sure that will really unblock the money markets. The issue is counterparty solvency, not liquidity. An interest rate cut cannot solve the counterparty solvency issue.

The problem with this action is - if some bank fails, its central bank, and by extension its govt, will be on hook for billions. So this is a fiscal decision, which a govt should take, not a central bank.But considering that the Treasury now has $700 bn, it can surely spend some money here.

We need some luck now to avert a catastrophe. Otherwise, there is nationalization of a host of industries on the horizon.

Is it that there is a supercycle of regulation-deregulation, capitalism-socialism that overlays the smaller business cycle?

There is no free lunch

So finally, the US govt has done what it should have done a year ago, but which is politically not feasible till a few companies blow up. The way brokerages and AIG fell last week resembled a bank run by depositors - only that the run was by shareholders, which made capital raising prohibitively expensive.

There are a few things that one can bet on right now:

a) Tax rates are going up in US. Somebody needs to finance the bailouts, and it is the tax-payers. So buy muni-bonds. This ain't a free lunch.

b) Earnings estimates are high now simply because corporate tax rates next year are going to be higher than this year. So forget $90 S&P EPS estimate. Be happy if we see $75.

c) Debt issued by financial sector companies is now a great place to invest, particulary with the US govt stepping in as a buyer in the credit market. If this enables the financial companies to clear their balance sheets and raise equity from marketplace, debt holders can really benefit.

d) The impact on dollar is unclear. Any other country, and I would have said short the currency. But because this is the US, and dollar has the safe haven status, I dont know what happens here. If there is a run on the dollar, it will become a bad nightmare.

e) Because the direction of dollar is unclear, the direction of commodities is unclear. Buying gold might not be a bad option after all right now. If the world loses faith in the dollar, gold can go up 2x-3x easily. All the Indian grandmothers will have a smirk on their face at that time - for they would think thet figured this out sitting in the homes while the high flying financiers on Wall Street got bankrupt.

A Global Sell Off

For probably the first time in this bear market, the prices of stocks across sectors has started falling simultaneously. Financials, retailers etc were falling in 1H. Now they have been joined by commodity and tech - which were rallying in 1H. This is the first true global sell off. The crisis has moved from Wall Street to Main Street.

An industrial capex slowdown?

One of the most resilient sectors of the last year has been industrials. It has been industrial exports that have kept US afloat over the last year. Now it is not financials, FMCG, tech, restaurants, retailers etc that industrials sell the majority of their goods to. Industrial capex thrives due to capacity expansion by commodity producers (steel, oil and gas etc), refining/chemical buildout, infra buildout, new power plants, auto plant expansion etc etc.

Have commodities fallen so much in the last month that commodity producers start thinking about scaling back their capex plans? Who is going to provide them funding for their capex plans if they havent yet tied up the funding? These are all long gestation projects - so if debt investors start demanding a higher interest rate for the risk, a project IRR's will decline sharply.

The slow beginning of deflation - the case for bonds

Commodity prices are cracking up left, right and centre. Ospraie - one of the stars of the commodity hedge funds - has blown up. The speed at which things unravel is sometimes startling.

Slowly but surely, the global real estate asset price deflation is moving to other asset classes. Is there any link between asset price inflation/deflation and consumer price inflation/deflation? Considering that we had a period of 2002-2007 (and many more periods before that), when asset prices (esp real estate) moved up sharply while CPI remained contained, one would argue that these are two different categories of inflation. So one should be careful in extrapolating asset price deflation to CPI deflation.

At the same time, I would be really surprised if we continue to have asset price deflation and CPI inflation. I haven't read any paper which has looked at the historic correlation between these two, so this is more of a hunch than anything else.

If this assumption indeed is true, it has profound implications. The wrong thing to do in a CPI deflationary environment is to buy equities. When prices that companies charge for their goods fall, they might pull down absolute profits left for shareholders, because it is not necessary that price declines lead to volumes picking up in a depressingly deflationary environment. The best time to buy stocks are when interest rates are rising from low levels to moderate levels (in response to accelerating growth), than when they are being cut from high levels to moderate levels (in response to decelerating growth).

So one needs to be higher up in the capital structure. Considering that spreads on bonds are also quite high these days when everyone is still worried about inflation, one can end up making a killing in bonds on a risk-adjusted basis. Over the next 5 years, inflation might come down and spreads might compress, so there is money to be made.

My biggest bet of the last year - being long on USD and short on Rupee - has wiped out all losses from 1H08. But, if things in US are as bad as I think they still are, Fed will cut more. The recent commodity price deflation and the USD strength has given them enormous wiggle room. So we might see another period of USD weakness in the next 9 months. But that again is bullish for bonds. The interesting thing to watch would be whether it leads to another commodity spike.

There was one more trade I had tried to do earlier this year - shorting the pound when it was at 1pound = $2USD. I couldnt figure out how to execute it economically. Now it is $1.80. It is amazing to see how currencies move around to transmit the positives/negatives across countries and continents.

Verizon will make a bid for Vodafone in 2012 - the depreciation of the pound has not ended by any stretch of imagination.

Om Shanti Om in Beijing Olympics

In the women rhythmic gymnastics event, the Israeli team choreographed the last 60 second or so of their last routine on "Dhoom Taana" from Om Shanti Om. They finished 6th. Very strange indeed!!

In 2004 Olympics, China won 73 medals and India won 1. In 2008 Olympics, China won 100 and India 3. Indian Olympics is a much higher growth story (growth of 200%) compared to a maturing Chinese story (growth of only 40%). Giving a 200x multiple to India's 3 medal count (there is a huge runway of growth left) and a 6x multiple to low growth China medal count story (this is a cyclical peak due to home country advantage, besides how much more can they go to), we come to a valuation of 600 for both. India has finally caught up with China!!!!

Freddie Mac

It seems Freddie Mac is going out of existence soon. For a $2bn market company (as of now, when stock has fallen another 20% after being massacred throughout the week), how does it raise $10 bn? Bush administration is going to be forced to do something dramatic just before it bows out of the White House.

I just saw the fight that really launched HBO (and the cable TV industry) in 1975 on ESPN. Thriller in Manila - the fight between Ali and Frasier - was the first live telecast using satellite. Gerald Levin was the brain behind this. He was also the CEO of Time Warner 25 years later when it merged with AOL - the largest M&A deal ever.

A Verizon takeover of Vodafone

A speculation here. The biggest M&A deal in the world of the next 4 years is going to be a Verizon takeover of Vodafone. Verizon might then divest its landline business and become a global wireless operator - somewhat on the lines of what Vodafone did to Mannesmann at the beginning of the century.

It all boils down to Verizon Wireless - in which Verizon owns 55% and Vodafone owns 45%. It is probably the best wireless operator in the world with a churn of sub 1.2% and is a crown jewel. Because of the way Verizon has manipulated the situation, Vodafone's stock has become relatively undervalued, while Verizon has become relatively overvalued.

Here is why. A lot of telecom investors are focussed on dividend yield and free cash flow yield. Verizon controls the board of Verizon wireless and it has argued against Verizon Wireless paying a dividend to its parents to reduce its leverage for years. This works fine with Verizon. It consolidates Verizon Wireless, so the consolidated cash flow statement includes all of Verizon Wireless's cash flow (including Vodafone's piece of it). So the free cash flow calculated using cash flow statement overstates Verizon's free cash flow power. Besides, as debt reduces at Verizon Wireless, it makes consolidated leverage at Verizon look better (if one forgets to count minority interest as debt).

Vodafone has no such luck. It carries Verizon Wireless as an investment on its balance sheet. Because it doesn't receive any dividend from VZW, its cash flow statement doesnt include any benefit from VZW, and so its free cash flow is understated. Whatever free cash flow Vodafone generates today, it is from its properties other than VZW, and it is from this that it is paying out its dividend.

So on a free cash flow yield basis, Vodafone is cheap. A big cause of it is VZW. Verizon can capture this discount. Pound has started weakening, and if it continues to weaken further as UK falls off, UK takeover targets will become attractive in the next 3-4 years. Someday, Sprint will get its act back in US and it will become difficult for VZW to grow by churning Sprint subs. Growth in US wireless through domestic M&A will be difficult - after Alltel, there is hardly anyone of scale left to acquire. VZW will spend 2-3 years integrating Alltel. That is when Verizon will pounce on Vodafone.

Oil, dollar and interest rates

I had thought in April that commodities will weaken as Fed ends its interest rate cut campaign, because that will support dollar. http://gaurav1.blogspot.com/2008/04/time-to-short-commodities.html. That didn't happen. Then I thought that probably Fed needs to hike interest rates to make dollar strong to kill commodities.

What has happened is different. Expectations on Europe have changed from rate increases to rate cuts. So the expected interest rate differential between dollar and Euro has narrowed, strengthening the dollar and weakening commodities. A valuable lesson. Relative interest rates are more important than absolute interest rates in the forex market, and by extension commodities.

There is a clear linkage between credit crunch and commodities through interest rates and forex moves. A lot of people think these are two seperate problems. They are not. All these demand-supply theories on commodities are BS in the short run, and not enought to explain oil prices going up from 100 to 145 in 3 months.

This is another evidence of the point made by Charles Kinderberger in "Manias, Panics and Crashes" - asset deflation moves from asset class to asset class and country to country - often through capital market linkages. Oil price spike caused by credit crunch has made sure that emerging markets weaken significantly.

Commodity crack-up..

Commodities are cracking - finally. If it becomes a deeper slump over the next 24 months, there are going to be lots of issues with industrial companies and banks that are heavily exposed to steel, cement and other commodity companies. The swing factor for a lot of these commodities is China, and I have no clue about what is happening there.

In the immediate term, commodity stocks might fall a lot and start pricing in a very pessimistic scenario. One of the key learnings of the last 9 months is - nothing goes down forever. So there might be a quick trade here. But there is a global slowdown/recession, it is spreading, and high commodity prices dont fit in well with a theory of global slowdown. I think inflation is going to turn into deflation over 24 months. So need to be careful with commodities.

Sold out Aban at a loss of 30% - there are much better oil drillers available cheaply now with lower leverage, higher exposure to deepwater drilling, and better corporate governance. This stock didn't rally when oil was moving up in May June because Indian markets fell, and hasn't rallied since when Indian markets have gone up in July-August, because well oil has been falling. Now when Indian markets fall again, and their fall this time will have nothing to do with oil, this stock can crack up further. For a highly leveraged company, its stock price is paramount to its survival.

Why will India markets fall again? They have been rallying since RBI apparently surprised the markets with more tigheting than the markets bargained for - because oil is falling. Interest rates and inflation are high and they are not coming down for the next 5 months, and all you need is 5 months to turn the cycle decisively. Earnings estimates are way out of whack for all Indian companies.