Monday, February 16, 2009

Financial Intelligence - Part XX

Golden Dreams, Ironic Reality

Just like Pyrite, commonly referred to as ‘Fool’s Gold’, the allure of investing in the stock market is just as irresistible. After all, wasn’t the fortune of one of the richest man in the world today built solely on investing in the stock market? Unfortunately, just as the road to hell is paved with good intentions, the stock market is also littered with many who have lost their fortune by gambling in it. Let us set aside the golden dreams we have of striking the lotto in the stock market and look at the cold ironic reality of investing in the stock market.

[Click on the chart to enlarge it]

Long term Capital Appreciation
The market capitalization of our listed companies in Bursa Malaysia was approximately RM132 billion as at end of 1990. As at end of 2008, this amount has risen to RM664 billion as at end of 2008. Over a period of 18 years, the compounded annual growth rate (CAGR) is a mere paltry 9.39%. Assuming the average interest rate of fixed deposit during this period was 4%, the stock market yielded only an additional return of approximately 5% for the risk taken.

Gross Domestic Product (GDP) Growth vis-à-vis Capital Appreciation
Briefly, GDP can be considered to be the market value of all the output produced in a nation in one year. Let us consider the nominal GDP growth in Malaysia from 1990 to 2007 (i.e. inclusive of the effects of inflation). Nominal GDP in 2007 was RM641 billion as compared to RM119 billion in 1990. The CAGR over a period of 17 years is 10.41%. There appears to be a strong correlation between the long term growth rates of our GDP versus the capital appreciation of the market capitalization of Bursa Malaysia as a whole. Both have grown approximately 10% per annum over almost a period of two decades. Comparing these two indicators may give us a indication whether the stock market has bottomed out.

Market Capitalization as a % of GDP
A review of this ratio indicates that this ratio has been hovering between 1.0x to 3.6x from 1990 to 2008. The ratio was at its’ peak at during the Bull Run in 1996 just prior to the Asian Economic crisis. This may be a good indication that valuations of the stocks listed on the then KLSE were excessive. As indicated in the chart above, at Point A, market capitalization in the then KLSE exceeded nominal GDP by RM553 billion. In fact the value of the entire stock market was three times more than the GDP. Clearly this was unsustainable and more than RM431 billion was wiped out in the stock market crash in 1997.

At the end of 2007 as indicated at Point B, the market capitalization in Bursa Malaysia again exceeded our GDP by RM465 billion. The market capitalization as a % of GDP ratio of 1.73x indicates that stocks were possibly overvalued, although on less excessive scale as compared to 1996.

Where are we now?
Market capitalization as at end of 2008 was approximately RM664 billion. Assuming Malaysia’s nominal GDP grows at a conservative 3% from 2007, 2008 GDP would be approximately RM661 billion. Based on the overall trend, one could say that the Malaysian stock market may have reached attractive levels at the ratio is now at a historical low of approximately 1.0x. However, this may not necessarily be the case. The growth in our stock market from 1986 to 2008 was largely fueled by the transformation from an agrarian industry into a manufacturing industry catering largely to exports to US. With the current US economic recession and the emergence of competing countries including China, Vietnam, Cambodia etc, the Malaysian economy is at crossroads. Our economy may recover, or it may not. So, it would be foolish to extrapolate past trends into the future. Having said that, valuations of stocks on the Bursa Malaysia appears to be reasonably priced at this time and one should consider cautiously entering into the market in 2009.

Thursday, February 12, 2009

Financial Intelligence - Part XIX

Investing in the Stock Market
The above slide illustrates a very CRUCIAL aspect about investing in the stock market. When one begins to invest in the stock market, the most illusory aspect about it all is the relative sense of calm. Stock prices don't move up or down much most of the times. Instead there are long periods of boredom where it increments up and down in minute amounts. Where is the excitement and roller coaster ride I signed up for?

As Jason Zweig points out here,

Nearly all of us try forecasting the market as if each of the past returns of every year in history had been written on a separate slip of paper and tossed into a hat. Before we reach into the hat, we imagine which return we are most likely to pluck out. Because the long-term average annual gain is about 10%, we "anchor" on that number, then adjust it up or down a bit for our own bullishness or bearishness.

But the future isn't a hat full of little shredded pieces of the past. It is, instead, a whirlpool of uncertainty populated by what the trader and philosopher Nassim Nicholas Taleb calls "black swans" -- events that are hugely important, rare and unpredictable, and explicable only after the fact.

History shows that the vast majority of the time, the stock market does next to nothing. Then, when no one expects it, the market delivers a giant gain or loss -- and promptly lapses back into its usual stupor. Javier Estrada, a finance professor at IESE Business School in Barcelona, Spain, has studied the daily returns of the Dow Jones Industrial Average back to 1900. I asked him to extend his research through the end of 2008. Prof. Estrada found that if you took away the 10 best days, two-thirds of the cumulative gains produced by the Dow over the past 109 years would disappear. Conversely, had you sidestepped the market's 10 worst days, you would have tripled the actual return of the Dow.

"Although we could make a bundle of money if we could accurately predict those good and bad days," says Prof. Estrada, "the sad truth is that we're very, very unlikely to do that." The moments that made all the difference were just 0.03% of history: 10 days out of 29,694.

There may be those who are prescient with an ability to gauge exactly when those 10 days are. For the rest of us mortals, it would be better to understand the intrinsic value good companies we are interested in. Wait for those 10 days to appear and have your cash ready to swoop in on them when Mr. Market is an extremely suicidal mood.

Sunday, February 8, 2009

Global Economic Crisis: Who are the Winners?

I don’t know about you but I’m feeling quite depressed nowadays. When one hears about people being retrenched and the spike in the unemployment rates, the blood pressure usually goes up and moodiness sets in. There’s something wrong with this picture somehow and this post is an attempt to answer a puzzling question I have about what’s happening right now.

Physical Wealth
From a global perspective, nothing major has happened in the physical realm that we live in. There were no major wars, earthquakes, tsunamis or any form of massive destruction of our assets, people or resources. I feel that I’m correct to say that if the entire planet’s resources were valued monetarily, there would be no significant changes from 2007 vis-à-vis 2008.

Financial Wealth
From a financial perspective, there has been a major seismic shift originating from the US. Major financial institutions have either collapsed or required government bailouts. These include branded names such as Citibank, AIG and Lehman Brothers. Additional bailout packages are being debated and approved as we speak, to help jumpstart the US economy. The effects of this seismic shift in the US have begun to reach the shores of other countries causing contraction in the major economies of other countries including Europe, Asia, China and Japan.

The Zero Sum Game
One of the reasons why I have always abstained from gambling is because it is purely a zero sum game. If you win, someone else loses. There’s just a transfer of wealth since nothing of value is being created. Let’s compare this with the current crisis. Is there something not quite right here?

The Cake Analogy?

A simple analogy should suffice here. Assume that the global resources of the earth are represented by a cake. Now instead of cutting this cake and handing a slice of this to everybody equally, everybody is given coupons as a claim over the cake. Assume the global population of the world consists of 100 people.

Ever person has a 1/100 coupon. Let’s denominate these 1/100 cake coupons as 1 cake dollar. So, the entire global resources are worth 100 Cake Dollars. Every person has a Cake Dollar and his happy with this arrangement. All these Cake Dollars are being held with ABC Bank Inc. One fine day, ABC Bank Inc says that 60 Cake Dollars have gone missing. Where has it gone? ABC Bank Inc says that’s not important, what’s more important is that it needs all the existing citizens to subsidize the losses. So, it asks the government to print an additional 60 Cake Dollars to make up for the shortfall. Each Cake Dollar is worth 60% less due to inflation. In other words, each Cake Dollar allows the citizens to claim 0.4/100 of the world resources.

Wait a minute here! Let’s see… So 100 persons now have 100 Cake Dollars. The total of these 100 Cake Dollars has a stake of 40% over the world resources due to inflation. Heck, who’s swindled off the remaining 60% of the global resources of the world?

Well, perhaps if you look hard enough, it’s likely that the original 60 Cake Dollars couldn’t just have disappeared, could it? Money just doesn’t disappear into thin air. Most likely, the missing 60 Cake Dollars were cashed out by the winner and he’s just taken the 60% slice of the entire cake from the table. And his gain is at whose expense? It’s the people still holding the Cake Dollars being asked to subsidize for the losses of ABC Bank Inc that’s left picking up the pieces.

How Could the Bank Lose?
As an analogy, assume ABC Bank Inc betted 60 Cake Dollars against *someone* that Roger Federer would win the Australian Open in 2009. ABC Bank Inc lost.

Normally, we would just let this bank fail. You made a bad call, you pay the price. Unfortunately, all the Cake Dollars are held with this bank. If it fails, there would be a run on the bank and everyone would start realizing their Cake Dollars are worthless. So, the 99 persons in the world have to absorb the 60% losses by ABC Bank Inc to avoid starting a world wide panic and riots.

In Real Life
The 2009 Australian Open bet is akin to the gambles taken by the financial institutions in CDOs, CMOs, CDS and the like. How could the derivatives arm of these major investment banks and financial institutions earn returns in excess of 20 or 30% per annum? Only if you play the zero sum game! And when you win big, you can also expect to lose big sometimes. And the banks have lost BIG against someone. The fact they need so much money is that they’ve used the depositor’s money to pay of their bad bets. Now, they don’t have any money left to pay the depositors money they were supposed to hold on trust for us.

As we are talking about huge losses of trillions of USD, *someone* must have made a hefty gain at the expense of the banks and tax payers. In addition, since everyone is feeling depressed, prices of commodities (i.e. real resources) are under priced. This *someone* is going to have a bonanza time taking over commodities and companies at fire sale prices.

Anyone has any idea, who this *someone* is?

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