Wise Wealth Advisors

D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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Understanding cycles is understanding markets

Posted by Muthu on December 4, 2011

There has been very good response for what we wrote under It’s a matter of understanding. Many NRIs have also mentioned that they are able to understand better as to why investing in India for long term makes sense.

There are some who say that I’m an eternal optimist. Nothing can be farther than truth. Had it been so, I would have avoided lot of worries; most of which never happened:-)

It is just that I’m lucky enough to come across Buffett and Graham and able get some of their perspectives deep inside my skin. Can one cultivate their abilities? Extremely difficult and personally I would say it is impossible for me. But can one fine tune his approach and perspective like them? To a greater extent, the answer is yes.

The term ‘long term’ is itself is confusing for many. Rightly so. There are various analogies floating around that if your forefathers started with an ounce of gold at the time of Christ, how much your family would be owning now and so on.

For people who forget cyclical nature of the markets, economy, civilisations and above all human behaviour and keeps projecting compounded growth rate forever; the following analogy mentioned by Jeremy Grantham of GMO may serve as a useful pointer. If ancient Egyptian civilisation which has been there for 3000 years, had they just started with a cubic meter of physical possession and compounded it annually at 4.5%, it would be worth 10 to the power of 57. A billion of our solar systems would not be sufficient to store these!

Look at where Egypt is today. Likewise nobody would have imagined today’s Greece in the period of Alexander.

So projection of power of compounding for 2000 years is at best amusing.

How many families we know are able to pass on the wealth successfully atleast for couple of generations leave alone for centuries? Let us assume I build some significant wealth and pass it on to Vedanth. I would be naïve if I assume that it would continue to grow the way it grew when I managed it. He may decide to spend it all! Since the sex ratio is getting skewed, he may have to end up gifting the entire wealth to marry a girl of his choice:-) 

At best what I can do is to educate him, if and when he is ready to listen to me. At present he his completely preoccupied with how many times he can keep on turning around; a skill he mastered recently:-)

The interesting thing in finance is the nature of history to keep repeating itself. It is not progressive but cyclical. Innovations are rare to make in this field and even when it happens it is mostly counter productive. For people who think that derivatives are of recent phenomenon are not aware of the future contracts the merchants and traders have been engaging in for centuries. What is recent is turning a hedging instrument completely into a speculative one.

Earlier only parties who have financial stake in a contract used hedging and now people who have no such stake whatsoever keep speculating. For example, two complete strangers may make a contract on when I may die, one gaining and the other loosing depending upon when I die. You think this is sheer madness? It is. That’s why I suggested you to see the movie ‘Inside Job’.

I’ve been keenly interested and observing the markets for over 2 decades and that’s what made me to go and work in a stock broking firm for nearly 3 years in mid nineties.

From my experience, which includes fair share of mistakes, reading and observation, I’m able to understand and even appreciate the nature of market cycles. In investing, one cannot afford to learn everything only by experience. Our life span, more so investing life span is short, and compounding needs time to start showing results. As I repeatedly say, history and philosophy helps much better to approach markets than understanding alpha and beta.

Let me first talk about MIPs, which are hybrid debt oriented conservative products. Even some fund houses position this as a one year product. We’ve always positioned this as a 5 year product or barest minimum 3 year product (depending on certain situations), even when the previous one year returns were good. We said the same thing to people who invested in MIPs last year. It is not that I was aware then that RBI would be raising interest rates more than a dozen times and equities would be choppy. But what I’m aware is that interest rates are cyclical and if we recommend a product which would get influenced by this cycle; for one year, then there is a possibility that an investor can get caught in the phase of hardening rates.

Instead taking a 5 year view would ensure that the investment goes through a cycle and the product would be capable of delivering the returns it is capable of delivering:-)

Interest rates are generally linked to inflation. But I wouldn’t be surprised in the coming years even if there is a higher inflation and lower interest rate scenario inIndia.

It is amusing that even when it comes to inflation or interest rates, people always assume it would go only in the direction it is currently going.

In 2008, when inflation was 12% and interest rates were 11%, there were forecasts of 18% inflation and 20% interest rates!

Well if you don’t remember, inflation dropped to as low as -1.61% in 2009 and interest rates too dropped from 2008 levels.

Again it is not that I was able to foresee the rates in 2009; but I was very much aware of cyclical nature of these.

That is why we recommend equities also for a period of not less than 10 years. There are 3 year, 5 year periods (why in bull markets even one year period) equities have given excellent returns; but again markets being cyclical, either excellent or negative short term returns; both are not true indicators of possible long term returns. Again we tend to extrapolate the direction the market is going at a given time forever as if it is no longer cyclical. It has always been cyclical and would remain so forever.

Now the trend is to predict the returns from gold based on the performance of the last decade. By nature, gold goes through long cycle (unlike stock markets or interest rate which have shorter cycles) and if someone buys at an all time high, it may even take decades before getting the original price, without even adjusting for inflation.

In the world markets, gold touched the price it reached in 1980 only again in 2008; just 28 years to get back the capital:-)

If I’m correct, silver is yet to touch its all time high even after 3 decades of waiting. Commodity buffs can enlighten me further on this.

Some experts say that many commodities go through a 30 year cycle; 10 years+ of bull phase and 20 years+ of bear phase. In commodities, if you get caught in the peak of the cycle, there is every possibility that the recovery would be very long.

One of the successful trader / speculator, George Soros has sold off his gold positions this year.  

In equities, the best thing is to invest regularly irrespective of market cycles. In fact concept like SIPs are designed to make us invest in bear markets, which we otherwise would not do, but which is what actually gives us good returns. When the valuations are attractive, lump sum investments can be made. Likewise, it is advisable to avoid lump sum when valuations are high; not that you would loose but the time taken would be more for getting good returns.

What I’ve said above is applicable only for equity funds; to be little more precise, for non-thematic and non-sectoral equity funds and NOT for stocks. Stock picking is totally a different ball game and please do not apply whatever I write for equity funds into stock picking. The results can be terrible. Especially when you buy shares in a company in a euphoric market, that too when that company or sector is the fad of the market, it may even lead to permanent loss of capital. The cardinal principle in investing is not to do something which can lead to permanent loss of capital; which many direct stock pickers forget at the time of euphoria.

Again when I talk about equities capable of giving good returns in 10 years; I’m only talking about Indian markets. The sub-cycles happen differently based on the overall economic cycle. So what I say for India need not hold good for Greece. Each country’s structural cycle is different.India is in for a very strong structural growth over next 2 decades, of course with various sub-cycles in terms of inflation, interest rate and stock market movements. Each cycle may find a fresh top and bottom. If the long term perspective is correct, short term cycles are meaningless or can be take advantage off as it would provide us many opportunities too.

When you hold an investment for the tenure it is supposed to be held; good years would automatically take care of investments made in bad years too. Though it may sound paradoxical but for those bad years, the rewards would not be significant in the long run. Bad is good because ‘bad’ implies cheaper prices.

And if you think if you can enter and exit the cycles in timely manner and there by get extremely good returns at every phase of cycle – good luck. I don’t know how to do it and people who claim to do it also appear phony. They may promise so that they can get good business and do well for themselves.

Understanding the cycles and timing the cycles are completely different things. I don’t confuse the former with later; hope you too wouldn’t.

2 Responses to “Understanding cycles is understanding markets”

  1. Sunil said

    Two of the best long term performing and highly rated and recommended Monthly Income Plans by Value Research Reliance MIP G and HDFC MIP LTP G has given 1 year return of 1.3% and 1.5%. I do understand the equity market has been choppy and there’s been a phase of hardening rates (so the bond prices fall). But what about Birla Sun Life Dynamic Bond Fund RP G which has given 1 year return of 9%. Isn’t that a bond fund too? My question is why doesn’t the debt i.e, bond portion of the MIP performing if equity has not performed well for the same period? If MIP allocation is 75:25 then isn’t the bond part of MIP suppose to give returns on 75% of the assets?

  2. Arun said

    Dear Mr Muthu, am an ardent and regular reader of your blogs. Your views have been very useful. However the frequency of your blogs has come down drastically. We would greatly appreciate it if this is restored to the old times when you used to post blogs twice or thrice a week.

    Arun

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