Monday, August 20, 2007

Stock market volatility and the long term investor

I have always thought about writing on this topic. But now seems to be an even more appropriate time to do so. Last few days in the global stock markets have been depressing. Indian stock markets have also reacted with hi-fidelity and nosedived into lower values. Suddenly people are waking up to the risks of equity investing and all the talks of bubble have come back to haunt them.

How should a retail investor react to this melee of events and opinions? I classify retail investors as being distinct from institutional ones on account of the simple principle that the retail investors do not have equity investing (or any investing for that matter) as their day job. They invest to grow their wealth.

To start with, I would like you to ask yourself a question. Why have you invested in equity? Is it because everyone else is making so much money out of it? Is it because that seemed like the right thing to do last year? Is it because you are building a long term corpus and are trying to get higher returns? Is it because it is a good hobby to have and you get a kick out of the ups and downs?

I am addressing here the concerns of the investor who has invested in equity as an asset class to build his wealth over long term. This long term in my view is longer than 5 years at the very least. I am not trying to run away from answerability in the interim. All I am saying is that the arguments below make sense only for this horizon.

When you buy a stock, you essentially buy a piece of a company. Why would you do that? Because at the price at which the stock is quoting in the market, you believe that the company is worth as much or more. And how do you infer that the company is worth more or less? In traditional asset pricing models, you will discount all future dividends from the company and thus arrive at a fair price. You can add to that other valuation models and triangulate your findings regarding the right price for the company. In light of this, why should there be a price variation in the market price of a stock?

That is because individual investors have different opinions of the company’s value. To keep matters simple, if you assume that all investors are using similar valuation techniques and have similar values for risk free rate and risk premia, the primary difference of opinion would come from the degree of faith each investor has in the company’s future. In theory, all the investors have different price points for a given company they partially own or wish to own. This creates the demand curve and supply curve for a company’s stock. The prevalent price is one which matches the demand with the supply of the stock. The stock prices move on account of various factors. To start with, let us focus on just the company. This means the stock market has only one stock which investors buy and sell. If things do not change from one quarterly result to another, the stock price would not move at all. However, real life is never so still. So when there is any news that might have an impact on the company, investors alter their expectations and thus the price they are willing to pay for the company. This shifts the demand and supply curves. The demand curve is built by those who want to own the stock while the supply curve is built by those who do own the stock. A given investor can of course be on either side at different price points (assuming she owns the stock or shorting is allowed).

Now, the news shifts the demand supply graphs and the intersections leads to a new price discovery.

Now add to this the fact that there are a multitude of companies. These companies all trade on the stock market and are individually priced as per their investors’ expectations. At this stage, the other factor that enters the picture is the correlation of the stock price of different companies. Since the investor can hold different companies, she no longer needs to take as much risk as she took earlier with one stock. Without getting into the complexities of the arguments, it suffices to say that the presence of other companies and a broader market allows investors to reduce their risks from a single company. Hence they might be willing to pay higher for a given company all other conditions remaining the same. All it means is that the discount rates used for the valuing a company can become more lenient if the investor is diversified.

This hypothesis makes an even bolder claim. It goes further to say that not only the investors can reduce the risk and price assets better, they actually have to do so because those amongst them that hold the market portfolio can effectively price out those that don’t. Everyone is forced to either diversify and hold the asset at a given price or is left to live with uncompensated risk in a single company (since the agreed price in the market for that asset does not account for the individual company risk).

That apart, around this time, another element that enters the picture is the sheer complexity of the impact various pieces of information can have on the market prices. That would have been all right if it was not for the emergence of another group – namely speculators. The speculators are not betting on what the company is fundamentally worth. More often than not, their interest is primarily in benefiting from the impact a certain piece of information can have on the market price. If the central bank is likely to reduce rates, the speculator would take huge long positions in the stocks affected positively by the rate cut – housing, automotives etc. She is not keen on valuing the companies fundamentally and thus owing them as an asset. All that matters to her is how the fundamental investors are likely to recalibrate their expectations in light of the new information.

The speculator has been the centre of controversy for various reasons. I do not wish to pass a value judgment on the philosophy. All I wish to point to here is the fact that the presence of the speculators adds to the variations in the market prices. It is compounded by the fact that various groups of speculators play the expectations game from across the globe on a more real-time basis than the fundamental investors do. The speculators interest is in second guessing how price revision would take place in a given asset – it matters little what the specific price level is, the direction and amount of change is more relevant. Often enough, in the process, the fundamental buyers of assets are pushed aside and the stock market becomes predominantly a meeting place for speculators betting on the impact on various events. They become a self-sufficient ecosystem because there are enough of them to bet on either side.

All in all therefore the stock market is combination of the market for the assets and market for betting on the price variations of these assets. I do not wish to denounce the latter. I would like to point out however, that if you wish to use the stock markets for fundamentally investing in equity as an asset class for wealth building, you need to acknowledge the presence of the speculators and learn to live with it.

How does one do it? It is straightforward really. Consider investing in the broad market index for instance. You need to estimate the rate at which the corporate profits of listed companies are likely to grow. For today’s India, starting with 8% real GDP growth expectation in next five years, we can estimate the nominal GDP to grow at 12-13% (with 4-5% inflation.). If agricultural growth is 4%, manufacturing and services will have to grow at nearly 10-12% to make the overall GDP growth 8%. Hence the revenues of the manufacturing and services industries will grow by 14-17% in nominal terms. If I were to make two simplifying assumptions that these are a proxy for the listed companies and the productivity growth is nil (so revenue growth is same as profit growth). Considering the upper hand larger listed companies have in garnering the fruits of growth as also the sharper rise in profits than that in revenues, both of these assumptions are conservative at best. All in all, we can expect the listed company profits to grow at 14-17%. That would be your first guess for the growth in the value of your equity holdings if you are going to hold the index. Similar analysis will apply for individual companies.

Where does the speculator fit into this? Well, she is going to speculate that the sub-prime debacle in the west is going to unnerve the FIIs and hence lead to general meltdown in prices. She is also going to bet on the monsoon’s effectiveness and the prospects of the central government and mid-term polls. She might make a killing by getting some of these right as also lose her scarf (losing shirts might be rather embarrassing for women) in getting some others wrong. You on the other hand would keep going to work at 9AM and return home at 8PM and watch some reality TV show with your family and sleep in peace. Five years hence you will take stock (literally) and find out that you averaged 18% year on year (not bad!) or 9% year on year (could have been better!) or some such number.

The difference lies in the way you look at the investing process. Speculation is betting of the sort you will do in horse racing or cricket. Asset purchase is of the sort you will do in buying a house (for renting out). The assumption in asset purchase philosophy is that you do not mind holding the asset for eternity if you had to. The idea is that the asset will generate cash flows enough to justify your purchase price. In practice the presence of liquid stock markets ensures that should you get a better price or change your expectations of the cash flows from the asset or simply need cash, you can offer the asset to some other buyer at a mutually agreed on price. The difference between you and speculator is that the speculator would never purchase an asset with the understanding that she will hold it for eternity if required. Her hope is that the price of the asset will increase because changes in the expectations of the asset buyers or other speculators.

Wadala, 19 August 2007

Saturday, August 18, 2007

Black swan and epistemology

I have bought the book named Black Swan by Taleb and am reading it thesedays. The interesting aspect so far emphasized upon in the book is that we know far lesser than we claim to. The experts are no better than a well organized storage of parts of human knowledge.
The knowledge itself is a small section of the total reality. In any case, the great minds have always claimed that they know only a much smaller sliver of the reality than appears to an untrained eye. I used think that this is their humbleness and it is generally fashionable to make such deep sounding statements when one has intellectually arrived in life. But the more one thinks of it, more one realizes that they are right. It is almost like, the horizons of the reality around you keep expanding as you know more and more of the world. It is not static entity of which you can keep knowing larger and larger proportion. The true reality if any is very highly uncertain. Even in theory i do not think it possible to be able be gauge the extent to which we as humankind have managed to approximate The Reality.
That leaves us with this limited version of reality and our limited understanding of that limited version. In this context JBS Haldane's comment suddenly stops looking like yet another unintelligible profundity and becomes more like a statement of fact.
"The Universe is not only queerer than we imagine, it is queerer than we can imagine". This is what i mean by the double layer of the remoteness of our models of reality from the reality itself. First of these layers is our limited version of steady state reality that we hope to achieve and second of these layers is the extent to which we approximate this limited version itself.

Where does that leave us? We as human beings have always had many roles - which increasingly got split over time as society evolved. I guess in early days, the same individual who gathered food and protected his family did not have much of time left to ruminate about how much he knows of the ultimate reality. Nor did he probably have very crystallized urge for the same. However, one can't rule out any urge in this direction altogether. Otherwise, we would not be thinking about this today.

The complexity of human mind in today's days is a curious combination of the survival instincts that brought us thus far in evolution and the not-so-directly-relevant-for-survival urge to know more of our surroundings. To be sure, not all of us share it. A vast majority goes about the survival part pretty much without the need to understand universe around them. This is not to pass a value judgment on them. It is just to say that even today, despite the split of roles which enabled some of us to think of such higher pursuits, we have a limited understanding of the true nature of the universe around us.

Black Swan claims that the issue which is emerging now is the misplaced arrogance of the seekers of knowledge. The experts are getting smug and have lost the humbleness of the previous generations. Is this a structural change? If so, it would mean that for a long time to come, the limited resources mankind employs in seeking higher knowledge would be restricted in the ideas they are likely to fund/support. Are the mainstream knowledge explorers becoming prisoners to their own attitudinal limitations? Is there any way we can transcend these limitations?

Another more demoralizing possibility is the physical limitation on the human brain in terms of what all it can manage to imagine and thus explore. In quantum mechanics and relativity we have managed to transcend the boundaries of our natural intuition regarding objects (e.g. the particle wave duality is impossible to imagine for us, though we believe in the theory). I cannot fathom how far this can be stretched. And as we go farther from the intuition, how reliable are our theories going to be? The instruments we use to support our claims have their own limitations. Thus in turn, in the domain of knowledge of the physical aspect of the world, our instruments of experimentation are going to limit the boundaries of our knowledge. On other fronts such as dealing with the non-physical aspects of the universe, i am not sure what can be relied upon if not intuition. How can we refine the processes of knowledge gathering without relying on the intuitively appealing concepts? Is there a mental equivalent of the experiementation instruments which can come in handy to test several theories and claims of modern epistemology?

Wednesday, August 08, 2007

Too much of laisseze faire

Having read the comments of several champions of the market economics and laissez faire, i have come to grow a little weary and wary of their arguments. Government is bad at this and worse at that and leave to the markets, individuals, entrepreneurial initiatives and so on. I am not a fan of interventionist government. However, i do not think the answer is in saying that let there be nothing instead! Of course several sections of the economy would like to be left alone today - to their wishes and fears and greed. I do not care if stock market tanks. Though if interest rates are going to go up because the mad rush of capital in my country has led the RBI to tighten money supply, and that in turn increases my home loan EMI, i am bound to be justifiably worried. Who wants this capital? Is it creating the value it was expected to? Or is it yet another ploy of the proponents of laisseze faire to blind me with arguments of market efficiency being in the best interests of all in the end?
I do not know the answer. All i am saying is that we need to stop saying "leave the markets alone and the market forces will take care of everything". They will take care of a minority of established interests and probably few lucky ones new to the system. Apart from that it seems like a novel system to perpetrate the existing inequality under a new guise. If we have overcome the shackles of state dominated socialism with so much effort, it is not for letting the aristocracy of the capitalists to take charge instead in the name of efficiency. As participants in the economy, the masses need to understand that the ideologies are just that. Finally, everyone is going to be driven by self interest and unlike what the market proponents claim, it does NOT result in a socially optimal solution. The only chance we have is to transcend the ideological boundaries of being in the capitalist camp or communist camp and really take on the basic question of maximum happiness for maximum number of people. The ideology should then evolve from that and not the other way round.

Sunday, August 05, 2007

The Limitations of Capitalism

Capitalism broadly stands for the system of beliefs in efficiency of self-controlled markets. The central tenet of capitalism seems to be “leave the markets alone” to the extent possible. The expectation in turn from markets is to send the right signals to right parties and to allocate resources in the most optimal manner. It is possible to debate in detail the shortcomings of this expectation as has been often shown empirically. However, I do not wish to expound on market failures. Because a study of market failures starts with the underlying assumption that markets are expected to work everywhere and then we are studying where they did not. My disagreement is with this belief. I am revisiting the more basic question of the mechanism of resource allocation.

What has prompted this is the two sided worry of the misuse of this system by the capitalists and the inadequate attention the underprivileged get in even a well functioning capitalist economy. On the former, the answer from the believers in capitalism is often in the form of regulatory frameworks built and run by the state. The response to latter is that the capitalist societies have often proven to be less hostile in treating the underprivileged than any other system. Both of these are attempts to arrive at solutions from within. However, my intuition tells me that the fundamental forces at work in a capitalist society are very likely to make both of the above basic flaws in the capitalist system and not merely ineffective operationalization of its principles in specific contexts. Take India for example. The advent of capitalistic orientation in policy making has certainly resulted in great many developments. License control raj is receding. There is greater common good being served by competition amongst private enterprises and at times even public ones. Now the question is how reliable is the hope that the effects of these developments are finally going to trickle down to the downtrodden. Also how real is the hope that eventually Indian enterprises are not going to behave like Enrons of the west. Over and above all of this, there is growing concern that materialistic progress alone will leave us as much at the risk of loss of purpose as today’s west. Can we look to evolve a better system of governance and socio-economic organization? Can we target the right parameters as measures of our success? Can we make the growth to developed country status an endeavor broader than one limited to upper middle class?

Why have markets failed India’s poor? The opportunity at the bottom of the pyramid is too risky and the risk return trade off at the top of the table is much more alluring. The enterprise with its focus on making profits can do so very well near the top of the pyramid. Only those with some dependence on bottom of the pyramid populations are making any active efforts in that direction. For others the charity through CSR is enough. There is huge amount of money and resources being deployed at the top of the pyramid in catering to the needs of the well off while the poorer sections are left without even most basic of services. Market failure anyone?

Markets will not get there. Not in the current form. The farmer suicides are an example. The revolutionary tides from the poorer sections will probably sweep the top of the pyramid sooner than the trickle down can take effect in an appreciable manner if at all. The ecosystem of the modern day economic relationships in India is very much in favor of the established ones. It also favors the gifted individuals from amongst the poorer sections. However, the large majority with little extra-ordinary talent can take or leave a limited range of options. You can do white collar jobs or take up a blue collar job if you are in the city. However, if you live in village, you can try your luck at agriculture or a small local service sector or else join the daily laborers bunch. If I am to be a profitable enterprise, I have to make the laborers work at the minimum wages possible in the given demand supply scenario. By the looks of it, the labor supply in India in the unskilled sector is going to be fairly large for a long time to come. Given this, it is unlikely that the real wages of Indian laborer in village or in city will rise in a big way. On the other hand a small section of the lower middle class is moving up through exhibition of its skills. I belong to this group. I have come much farther than any of my cousins. They send me their CVs to apply for jobs which are lower end of the white collar ones or at times even the blue collar ones. The markets have little to offer them. My services are useful because of my extra-ordinary IQ. They are not in demand because what they have on offer is rather freely available. Market has not obligation to create opportunities for them or the others who do not even know what a CV means. Market economics would generally put the argument as follows. Over time, the GDP growth would require workers in larger numbers and that would lead to increase in demand and thus higher employment as well as growth in real wages. The standards of living of these laborers will improve because the rich and poor alike would want more goods and services. In the end everyone is better off than status-quo. Agreed. However the comparison is with the status quo. I can compare it with an alternate scenario where the income distribution is such that it brings about highest amount collective utility.

This gets into the question of the relationship between consumption/resources and utility. The general theory I wish to put forward is as follows. Below the poverty line, utility and consumption/resources are directly proportional. As an individual moves up Maslow’s Hierarchy, her needs evolve and non-consumption factors enter the picture. The relationship becomes somewhat non-liner. In this phase, more consumption or asset ownership may not necessarily bring about higher levels of utility. However, for individuals in this phase, the first derivative of income and assets has a more direct bearing on the utility levels. “Moving up in life” has a stronger impact on utility levels than the absolute level of resources and consumption. There is point beyond this level where the consumption and asset ownership becomes merely a hygiene factor and the utility levels are driven very weakly by the change in the resource level. Very many other factors enter the picture the linkage is nearly lost. What one can claim with some degree of certainty is that this section of population would be miserable if it gave up its wealth but the wealth per se does not add to its utility levels much.

The marginal utility of money is more directly observable and shows clearer trends. The poor of course have the highest marginal utility for money while the richest individuals have close to zero marginal utility for money. Unless it occurs in really large chunks, few more extra rupees are not very relevant to the richest individuals. This probably would apply in % terms as well.

Given this, the market will in all likelihood create a rather sub-optimal outcome in terms of the potential utility levels achievable with the given level of resources and the actual ones realized. The actual state realized, even if is the utopia described by the market enthusiasts, will still have large income inequality and instances of extremely divergent marginal utility of money within the system. What the utopia manages to achieve effectively is a beautiful machine which is probably stable, very elegant in its operations but has unhappy cogs with little choices but to be part of the machine. The market system can in its simplest form have say 10 companies providing goods and services to the economy. These companies employ 90% of the working population while the remaining 10% own the companies. Depending on the relative scarcity of labor and capital, the owners will earn more or less than the workers. If history is any guide, the owners will earn lot more than the workers since the owners always have an option of working should they realize that they earn less as owners. This system is stable. But assume that the labor supply is such that the real wages are 1/100th of the return on a unit of capital for the owner. In essence, the owner can spend her money in spas and collectible item purchases while some children in the remaining 90% could be dying of malnutrition. The rich owner can once in a while have some pangs and pay for a few kids’ food and education and donate to some trust somewhere. The general trend however remains that the laborer is selling her time and skill and will get a price from the capital owner in line with the demand supply dynamics of the market. While the market may be a good answer to the general price discovery, applying the same principle to the incomes of a large majority of individuals participating in the market is flawed.

Market implies that the owners treat employees indifferently and strive to make a profit by offering goods and services to customers. The market economy is a well oiled machine to get the manhours from the employees, the capital from the owners and put it together to create goods and services which people in turn pay for out of their returns on time and/or capital. The system does seek stable optimality. The issue is that it seeks a systemic optimality which seems to be an end in itself. It ignores the individuals which are the whole point of it anyway. It is also structured too much in the manner of buyers and sellers – which in the end does not always lead to a socially stable and optimal result, when viewed in terms of utility. It is a system very much in favor of capitalist today since the stage of socio-economic evolution that we are in is characterized by a strong tilt of balance in favor of capital. Maybe if the tables were turned and capital was too widely available and labor is scarce, the returns on labor might exceed the returns on capital. The point however remains that the results of the market mechanism are always a good result from the point of view of systemic optimization. It does not incorporate explicitly the fact that ultimately the economic system is a means to an end which is furthering human happiness. It is a marvelously stable solution to an optimization problem that human economics is. Whether it is human enough a solution is unclear.