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2008: A year of black swans

By Surjit S Bhalla
October 04, 2008 14:13 IST
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There is only one further bad news expected -- the real economy worsening. But stock markets bottomed out three to six months before. Is October the bottom, again?

This has been the year of the Black Swans -- unlikely events, or incidents that are at the extremes of probabilities.

For those involved in stock markets (which should include most members of the middle class, both in India and abroad), this has been the year of maximum pain, and no sense of the future direction of markets.

There is old advice to help us through these trying times -- buy when there is blood (and bodies) in the streets.

All of us would like to know what the future entails, but if we knew that, even with a reasonable probability, we  won't be middle class or even rich -- we would be super rich.

But try we must to speculate about the future. Herewith, an analysis of some factors that will be in play over  the next few months.

Hedge funds: What could be the most important piece of information about the future trends in different markets could be the following -- the joint news that the hedge funds, the really big players of 'other people's money', (a) have had their worst year since the dotcom bust of 2000-01; and (b) are facing strong redemptions.

The honouring of the redemptions would mean that the hedge funds would have to get out of their trades. A sense of what their trades have been can help in identifying the future direction of the market.

A favourite of the hedge funds has been to be long commodities, especially gold and black gold, and to be short equities. Redemption pressure should mean that equities should move up, and gold and oil to move down.

Inflation Cycle: 2008 has been an unusual year for world inflation. Inflation rates have been low since the last peak in the mid-1990s.

Regardless of whether a country had a central bank or not, and especially regardless of whether they had inflation targeting, the pattern of inflation has been near identical in most countries since the early 1990s.

Not so coincidentally, inflation last peaked in the world in 1994, and the dollar made a bottom in March 1995; inflation is most likely to have peaked in 2008, and the dollar made a bottom as well.

Going forward in 2009, it is reasonable to expect inflation to 'collapse' to the levels prevailing in 2004 to 2007, which is around 5 per cent for India.

Real Business Cycles: Whatever the cause, the world economy goes through cycles and it is a reasonable bet that 2008 has been the worst year in recent memory (at least since 2001-2).

Indeed, given the financial turmoil, it is close to the worst year since World War II (and the Great Depression that preceded it). Can it get any worse -- of course it can. But the question investors need to answer is how much worse from present low levels?

Sub-Prime Financial Crisis: With no investment bank left in the US, and all the major governments in the world intervening to support the banks, it is a fair bet that what we are witnessing today is history, hopefully in the literal sense of the term.

US Congress and the Bailout Package: Again, this movie has had more horror than an extraordinary thriller -- more like Psycho, Birds and Shining all in one. It will be over in a few days; again, like most recent bad news, we are close to the end.

Central Bank Actions: Never bet against the collective might of central banks. The policymakers are worried, extremely worried about the state of the world economy.

And worse is past the breaking point, both politically and economically. Even the not-on-planet-earth European Central Bank is watching the European economies crumble, and broadly hinting that the next move in European interest rates is downward.

So with or without the US bailout package, look for a coordinated interest rate cut among the major economies.

The justification: Inflation high, but declining fast; commodity and oil prices have already declined by 30 to 50 per cent in the last few months, and oil should be expected to go towards $70 to $80 in the near future.

World economy at a standstill and liable to tip over without central bank help. If on such occasions the central banks do not act to give the economies a lift, then one needs to ask: why have a central bank?

Investor Behaviour: Every investor has lost money, and lost big. If she needed to get out of the market, she already has. Whatever remains, she is likely to hold onto.

So expect little selling from this investor.So the markets are faced with the following set of facts: The world economy is in doldrums. The stock markets have been collectively mauled, and mauled in a synchronised manner.

The Central Banks (outside of the US) have been hesitant to cut rates in the face of imported inflation, and have been in error. This error is expected to be rectified soon. Commodities have just retreated from the top of their price cycle, and how!

The Big Boys (hedge funds and investment banks) have lost Big money and are facing redemptions.

The only trade they have made money in is in being short stocks, which with redemption pressure, they have to buy back. Warren Buffet is buying.

Thus, the future holds a large promise of a turnaround and it is helpful that traditionally, October has been the bottom in stock markets. So tell me why October 2008 will also not be the bottom?

The author is chairman, Oxus Investments, a New Delhi-based asset management company. The views expressed are personal.

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Surjit S Bhalla
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