The next financial bubble

Attendee at a seminar: “There are bubbles in the market every now and then. What are the indicators of the next bubble?”

Expert speaker: “The day you stop thinking of this question, that is an indication of the next bubble.”

When everyone is hundred percent sure that the markets can only rise up, that is the time to be cautious.

Sir John Templeton has said, “Bull markets are born on pessimism, gorw on skepticism, mature on optimism and die on euphoria.”

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“Will the market fall?” – A wrong question to ask …

Here is a very interesting paragraph from Ronnie Screwvala’s book Dream With Your Eyes Open – An Entrepreneurial Journey:

Understanding and accepting failure now will give you the clarity and the resolve you need to survive the big bumps. No matter who you are, how solid your connections, your financial status, or any of the thousand other factors that determine success of a business, understand one thing: At some point, you’re going to fail. And not just once. Internalise that reality and make it part of your entrepreneurial and leadership DNA. The only question you need to answer is: When I fail, how will I respond?

A wrong question to ask for any entrepreneur is: “Will I fail?” The correct question to ask is: “How do I respond when I fail?” Similarly, the wrong question to ask is, “Will the market fall?” The right question is “When the market falls, how do I respond?”

Asking this second question is all about preparedness. We have repeatedly said in the book Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget: “If you cannot predict, protect”. And protection must start with preparedness.

He further adds:

What’s worked for me over the years is to recalibrate and consider my worst-case scenarios, gauge my ability to cope, and work on viable solutions without panicking. Once you can do that, you’re already on the road to recovery.

This is also important to be a good investor. And in order to recalibrate and consider your worst-case scenarios, it is important to read the history and see the follies of others in the past. You do not need to walk the whole path all over again. You can start with reading Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget. The book highlights many episodes that happened in the world of financial markets and how people responded to the situations.

Learn from the events and learn from the way people responded. You would be able to build a solid investment strategy for yourself. If you are an investment advisor, it would help you build investment advice for your clients. You may also consider gifting the book to your clients as reading the same would help them appreciate your perspective.

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The seeds of the crash are planted in times of the boom and vice versa

The proximate causes of these successive crisis are very different – emerging market debt problems, the new economy bubble, default on asset-backed securities, the political strains within Eurozone – yet the basic mechanism of all these crises is the same. They originate in some genuine change in the economic environment: the success of emerging economies, the development of the internet, innovation in financial instruments, the adoption of a common currency across Europe. Early spotters of these trends make profits. A herd mentality among traders attracts more and more people and money into the asset class concerned. Asset misplacing becomes acute, but prices are going up and traders are mostly making money.  …

… Yet reality cannot be deferred forever. the misplacing is corrected, leaving investors and institutions with large losses. Central banks and governments intervene, to protect the financial sector and to minimise the damage done to the non-financial economy. that cash and liquidity then provide the fuel for the next crisis in some different area of activity. successive crises have tended to be of increasing severity.

The above paragraphs have been taken from John Kay’s book “Other People’s Money – Masters of the Universe os Servants of the People”.

Different market cycles appear different, but there is a lot of similarity in each. I have written about the anatomy of a market cycle in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget” that echoes the above words to a great extent. If you observe, the parallels are often staring you in the eye. However, very often, we choose to ignore the signals.

The seeds of the crash are planted in times of the boom and vice versa. As Lord Krishna tells Arjun in the Bhagvad Geeta

Bhagvad geeta 2-27

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Can the Governments and regulators prevent the next crisis?

Recently I came across an article from Knowledge@Wharton. The article quotes two  professors: Wharton’s Peter Conti-Brown and Carnegie Mellon’s Allan Meltzer. I would like to highlight one point in particular that Prof. Meltzer talked about..

Meltzer noted that regulators failed to anticipate the 1929-1932 financial crisis and others that followed over the decades. “The whole idea that the government, the Federal Reserve or any other agency — clever, intelligent [and] smart people that they are — will anticipate the next crisis is very small,” he said. “It will come from a direction in which they are not looking. That is why crises blow up, because they aren’t looking in the direction where the crisis is coming from.”

Meltzer argued that regulation alone will not solve financial crises, and called for banks to have higher equity as a proportion of their total capital. “We can regulate the mistakes of the past; we can’t foresee the mistakes of the future …”

At the same time, they discussed that the only way is to increase the bank’s own capital. The skin was not in the game for the banks. Many banks were hugely leveraged. Though the banks are required to maintain a capital adequacy ratio, many banks took off-shore routes to register their SPVs (Special Purpose Vehicles) and heavily used derivatives. Lehman Brothers, the famous failure of the 2008-09 crisis had more than 50 times leverage.

There are so many instances referred in the book:

  • Benjamin Graham later said that the mistake was that he owed money.
  • The leverage at LTCM was way too high. At some point, it was more than 50 times the capital. Leverage can enhance returns when the cost of borrowing is lower than the return on investment. However, when the returns are poor, the cost and the liability of repayment can be detrimental.
  • Easy availability of cash (foreign capital, easy credit, leverage – in whatever form) is one of the common factors among all the market frenzies.
  • Leverage used to invest in illiquid assets also poses a risk. Once again, if you do not have an alternative cash flow and the asset is illiquid, repayment of borrowed capital becomes difficult.

I have just highlighted a few from the book.

Two important points here: Every crisis looks very different in the beginning. This happens since we keep looking at the events that happened without understanding the lessons. We keep looking for the old crisis to happen again from the same place. Government and the regulators are no different.

The crisis is not new. It just crops up from somewhere else.

#RidingTheRollerCoaster – 171

Thinking in a bull market and a bear market …

If you attend investor meetings in various market cycles, you realise that there is a pattern in the questions. In a typical bear market, the questions tend to focus on challenges and risks, whereas in a bull market, the focus shifts to opportunities.

See the following post and the article on which it was based:

Unicorns, cockroaches and investment decisions

A good story is seen with suspicion in a bear market under the influence of fear and doubt, whereas questions are set aside when greed takes over – a typical bull market.

It is important to understand that in all market citations, there are opportunities and challenges. However, neither can be controlled by individual investors or advisors. We can at best take advantage of these. Or we can protect ourselves from the negative impacts of these.

That is possible only if we focus on what is in our control and what is not.

Read the “Serenity Prayer” (Page 199 of the book) and the subsequent discussion.

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Tomorrow never comes …

There are many small stories in the epic Mahabharata. In one such story, a beggar comes to the Pandavas asking for some help. They are in the midst of a discussion, and Yudhisthira, the elder brother, asks the person to come the next day. Hearing this, his younger sibling, Bheema reminds Yudhisthira of the audacity of assuming that he would be alive tomorrow. This story highlights the importance of understanding uncertainty associated with the future.

However, we have always wanted to know the future.

Often, the experts get swayed by the same emotions and get their forecasts wrong.

To read more “On Forecasting and Expertise”, see the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”

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Perspective on the recent market crash

“Sensex falls by 807 points” – this was a major news item in many leading dailies – general purpose or the pink papers. It looks threatening. Losing more than 800 points in a day is scary. Sensex lost 807 points on 11th February 2016.

It has happened only the 13th time since 1980. In other words, this was 12th largest single day drop (measured in points) in Sensex (on 10th Oct, 2008 Sensex lost 800.5 points, which was the 13th largest Sensex fall – the lowest among the 800+ point falls).

In other words, we have witnessed 800+ points falls 13 times in 36 years, which is roughly once in a three-years event. Once in 3-years does not look as threatening as 12th largest fall. See the beauty of the language. The same event presented differently, looks less threatening – emotions at play.

However, if we dig deeper into the history, it was only in May 2006 that we saw the first ever 800+ points fall in Sensex. And then, it has happened 12 more times since. So now we can say that in the last 10 years, this has happened 12 times. Oh God, the markets have become so volatile of late! See, the same thing looks scarier now.

Having said that, it was only on 8th April, 1990 that Sensex closed above 800 points. Hence, there was no way it would have dropped by 800 points in the first decade of its existence.

However, a “points-drop” should not bother an investor. It is the percentage drop that matters and not the points drop.

So how big was the Sensex fall on 11th February 2016 in terms of percentage of the previous day? It was -3.40%.

Once again, we looked into the historical data. Such a fall has happened 188 times in the history of Sensex (I have data since 2nd January 1980. So, if something happened before that, I have no idea). This makes it roughly a little over 5 times a year.Something happening more than 5 times a year may be considered as normal. Mumbaikars expect to lose one day a year due to heavy rains and water-logging. People travelling to (or within) North India expect delayed flights / trains due to heavy fog at least for a few days every winter. Such events happen. One need not and cannot plan to avoid such events.

The first time (as per the data available), Sensex lost more than 3.4% on 6th June 1980. Incidentally, the drop was 5.76 points and Sensex closed the day at 122.55 points.

See the wonder: it is often not the event, it is how it is presented that evokes the emotions.

807 points loss looks threatening. 3.4% makes it look acceptable.

It is important for investors to develop the ability to put things in a proper perspective, else the environment has the ability to test our resolve, often without substance.

Rise and falls are natural to the markets. So long as people can transact based on their opinions, the prices would remain volatile.

To be a better investor, you need a balanced mind. If you still need help, consult someone who has one.

Enjoy the roller coaster ride. Happy investing

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