Saturday, August 13, 2011

2011 predictions revisited - trying to make sense of the market

My last blog on the economy written on June 3rd started with lines - “Just like the sea which seems calm at the surface but has massive amount of energy boiling inside it, I am seeing business as usual on the outside but large amount of chaos beneath this calmness.” As I wrote those lines, I was sensing trouble ahead – but I did not expect that it will erupt so soon.  Last fortnight - the chaos finally surfaced – just like a volcano erupting, all over the globe, the markets turned extremely volatile.

Even as this was happening – I see experts in CNBC calling the situation “temporary” and urging people to invest in mutual funds and equity as the Indian markets are attractively priced at around 17000.  

I do not believe this is a temporary situation. Kenneth Rogoff, Professor of Economics and Public Policy at Harvard University, and former chief economist at the IMF,  has presented a very apt analogy – he says, “for instance, if you have pneumonia but you only think it's a very severe cold - you go on a completely wrong medication which instead of curing your disease further alleviates your woes.  In a nutshell, this is exactly what happened with the developed world. They misjudged the real problem. Governments and central banks used the wrong medicines. They tried to treat a debt-problem with more debt. No wonder the health of the economy became bad to worse.”

 The current Fed decision to keep the interest rates in US to near zero levels till 2013 is a similar decision. This is aimed at encouraging people to leverage up, with the knowledge that their borrowing costs will likely be very low for a long period of time. Fed expects the people to take risks by investing in equity, business etc and this will hopefully keep the US economy growing.

In the past two decades, the developed economies have gone through a massive credit expansionary phase. People were living off credit (future income), assuming that the future will be brighter than the present – appreciation in real estate fuelled this feeling of wellness – however, the rise of China and India and the resulting slowing of western economies changed the situation –the future today does not look brighter than the present for the western economies (in India and China the future looks brighter than the present) – those who borrowed and leveraged highly could not repay – and from individuals the virus has spread to countries – today we have countries like Greece, Portugal, Ireland etc which cannot pay their debts – and that is bringing down the Euro zone. 

I believe that the recent downgrade of the US debt is just a starting point - and there is more to come – may not be in the form of downgrades by rating firms – it may be in the form of wild swings in the bond market, series of defaults, financial repression measures and not to mention, inflation. I expect much more severe turmoil in the months ahead.  The world economy is likely to experience an extended period of contraction and deleveraging.

India is not safe too and we are one of the countries identified by economists where there is a risk of rating downgrade.

In these times of uncertainty, I believe there will be opportunities to invest – I suppose Warren Buffet is investing heavily right now - however, for ordinary people, these are times when one must be careful – it is better to be safe than sorry.

In these times, I advocate investing in Gold ETF’s –I have been advocating this for the past one year now and I stick to my recommendations. Gold has given a 30% return in the last 12 months and there is more to come – so even if the prices of gold looks high  - enter in dips (there are dips every fortnight) and wait patiently – I expect 15-20% returns in the next 12 months.