Markets may fall below 14000 post results season

The results season will be nearing its end next week with some more important companies due to announce their results in the coming week. So far results have largely been in line with market expectations with no major outperformance from any sector. Corporate earnings have grown in the range of 15% -20% with very few companies churning out a disappointing outlook going forward. Given the stunted growth of the economy with tight fiscal/monetary conditions and the pain from subprime crisis not yet having receded, equities as an asset class will have a muted performance for the rest of 2008. Domestically too, we have our own derivatives exposure which is hurting corporates and banks alike. ICAI has actually helped the investing community by making it mandatory for companies to disclose their derivative exposures well in advance of the stipulated 2011 deadline. However there may be a number of cases where these provisions may not be accounted for in the respective quarterly results as marked to market losses. Companies have the option of disclosing such exposures in their notes to accounts. The problem here for investors is that they will not be able to access the notes to accounts of companies until six months from now. So there will be some clarity emerging on derivatives only in second quarter of FY 09. Already SBI has come out with its estimate of its total client exposure to derivatives at Rs.672 crore. This is quite a large amount for a single bank and considering that a number of small and medium companies have taken speculative trades in these currency swaps, the small and midcap listed universe would be an interesting space to watch out for as to the impact of these MTM losses on their bottomline. A classic recent example is eastern silk industries, a fundamentally strong fabric company that has been reporting decent numbers in the past growing at 25% p.a. The entire bottomline has been wiped out this quarter due to MTM losses on currency derivatives. The market was merciless on this stock which collapsed 30% from its existing lows in the last couple of days. We can expect the impact of MTM losses to subside if the dollar strengthens or rebounds against other currencies.

Its also shocking to see that a company like BHEL has fallen 30% from its highs post its Q4 results. A company with such a huge revenue visibility for over 5-6 yrs, its order book at 80000 crore, with an expected addition of 40000 crore this year alone, getting knocked down inspite of posting a decent 17% growth YoY shows the lack of patience and persistence among the investing diaspora. A stock cannot get kncoked of 25-30% when fundamentals are intact with no slowdown in order book growth. The company does face margin pressure and has postponed the booking of some earnings to the next quarter. Fund managers are acting like day traders looking for the slightest negative news in listed corporates. They are sitting on a cash pile of 20000 crore. Certain mutual funds are even cashed out to the extent of 10%. The point here is when one has invested 90% of his funds at higher levels and seen the markets crash by 30%, whats the point in sitting on the balance 10%. FII flows will follow domestic institutions. These FII's who have taken out close to $5 billion from Indian markets since Jan 2008 will not return until domestic institutions bring sanity back to the markets.
As for the market levels, at the moment we have moved beyond 5100 and managed to close above that level. But this being the first day of the new series, position build up generally tends to happen. Therefore we should not read too much into these rallies. How we proceed from here is very important. The 200 day moving average stands at 5031 and we have bottomed out below these levels thrice so far only to stage intermediate relief rallies. The next level to watch out for will be 5393. Given the lack of major positive triggers from corporates and with growth expected to moderate to 7% in the wake of global and domestic factors, we may fall to lower levels again. Everytime we have had bear markets in the past, we have fallen more than 50% from the previous highs. This time around, we have not yet seen the sensex slipping below 12K and unless global events worsen badly leading to a greater risk aversion, we can strongly believe that we are not in a bear market. The above factors will have to be watched closely. I personally believe that the bull market is set to resume in Q3 2009.

Impact of Oil at 115

Oil prices have zoomed to $115 per barrel as per the latest reading. Asian economies are still protected from high oil prices by the respective governments through subsidies. Now a $200 per barrel becoming a possible reality, asian economies need to have a rethink on their continued stance of subsidising the common man at large by shielding him through low prices of consumable oil derivatives. As we all know, petrol and diesel are subsidised at large to prevent the pass through of high crude oil prices to the common man. We also have distribution of other derivatives of oil through the PDS (Public distribution system) at minimum support prices. All the effects of these subsidies take a hit on the balance sheets of governments. The fiscal deficits which are understated in most countries excluding off balance sheet items like subsidies will only rise further with oil at $200 per barrel and a policy such as this will only result in interest rates and bond yields rising further in the long run. The need of the hour is to conserve energy, reduce demand for oil and its derivatives, announce huge fiscal incentives for harnessing non renewable sources of energy and fuelling the consumption of the same. For eg : How about setting up a solar grid network similar to a telecom tower to supply power to each area of major cities? how about adopting ethanol and biofuels for transportation instead of relying on petrol, diesel or natural gas. Hydel power is an area yet to see major investments from corporates. These are opportunities for the modern world to reduce its long term dependance on oil as a source of energy. No doubt, it requires proactive measures with long gestation periods to adopt non conventional and renewable sources of energy but considering the perennial benefits that we would leave for our next gen., its worth the effort. The world would no longer have to put up with the black commodity in triple digits.

Subprime Tsunami

The mortgage securities market in US is at 50% of its GDP at $6.5 trillion. The financial stability of Bear Sterns was invariably linked to repayment of loans that it had underwritten. Just a few days prior to the collapse of the investment bank , Carlyle Capital (PE), one of the oldest private equity funds the world had known, went bust after its mortage losses wiped out its entire equity. Carlyle capital was leveraged to the extent of 32 times its book value. Though Carlyle had not taken any exposure to subprime assets and was holding only AAA rated mortgage bonds of Freddie Mac and Fannie Mae, many hedge funds had sold these bonds on the fear of a credit crisis prevailing in these two government guaranteed institutions resulting in excess supply of these bonds in the market. As a consequence, excess supply resulted in bonds prices falling and margins calls getting triggered for more collateral from Carlyle. The fact that most of the lenders of Carlyle were investment banks like Bear Sterns who dint want to extend any lenity was an indication of the problems they themselves faced internally.
Subprime mortgages were sold to homeless borrowers with lax credit standards on the pretext that they could refinance their homes to pay up later. But what was not explained to them was the interest rate clause would be reset every two years. As long as the interest rates were low, there was huge demand for housing and there was a construction boom that was witnessed all across the US which eventually resulted in excess supply of real estate. The situation was almost surreal with houses getting refinanced for a second mortgage just to fund consumption in the US. A consumption boom was also necessary to finance the US war in Afghanistan and Iraq. Government agencies operated in full swing bringing out ads to fuel consumption in US. As inflation spiralled out of control and interest rates began to spike up, these loan reste clauses came into effect. The subprime borrowers began to default unable to meet their liabilities. Most of these subprime borrowers had no source of income whatsover or had falsified the records while submitting the loan applications. Once they started to default, there were only two options, either to sell the house and meet the committment or subject the property to foreclosure. But with property rates having fallen under high interest rates and excess supply of real estate, they could neither refinance their house nor dispose them at falling prices. Most subprime borrowers have foreclosed their accounts by surrendering the plot resulting in the mortgage companies being left with houses whose value/collateral was way below the Loan value. The subprime contagion had begun and had a chain reaction throughout the economy. Today, the monster has resulted in losses close to $ 1 trillion in the US economy, almost the size of the Indian economy.The losses faced by mortgage companies resulted in many of them filing for bankruptcy and all the bonds securitised by them in the form of pass through certificates after a due diligence rating from the S&P's and Moody's of the World were reduced to nullity in terms of value. This resulted in huge write off's in the balance sheet of hedge funds and investment banks who had to mark to market assets held by them.
Similar was the case with Bear Sterns, the second largest underwriter of mortgage bonds in the US. The exposure to exotic derivatives at Bear sterns was almost the size of the US economy at $13 trillion. As has been proved over the last one year, these derivatives have indeed become weapons of mass destruction. The collateralised debt obligations and its liabilities on Credit defualt swaps underwritten had led to the collpase of two hedge funds owned by it. Post Carlyle's collapse and the FED's surprise interest rate cut by 75 basis points, credit spreads began to widen, there was panic among the market participants that there are more skeletons waiting in the closet. Rumours started doing the rounds that Bear Sterns was in trouble. Bear Sterns also handled the largest volume of trading transactions on the bourses and hence had huge deposits of collaterals and margin money from clients. These clients started withdrawing cash from the company and the latter was put into a liquidity crisis. Margin calls coudnt be met on mortgage bonds and CDO's. The firm sold its holdings in equities all across global markets held through its investing arm BSMA triggering off a fire sale of equities in most EM's. Bear Sterns was set for bankruptcy before the FED stepped in and aided JP morgan Chase to buyout Bear Sterns at $2 per share. The share price had collapsed from a high of 170$ before the subprime crisis broke out to $30 when the crisis was as its peak, almost wiping out the lifetime savings of its employee base who had put their hard earned money into Bear Sterns equity.

Oil prices surged to a record high above $112 last week. The current crude prices are nearly 10 times the levels less than a decade ago. Crude oil prices behave much as any other commodity with wide price swings in times of shortage or oversupply. The crude oil price cycle may extend over several years responding to changes in demand as well as OPEC and non-OPEC supply. The impact of crude oil prices on growth in developing countries is thought to be significantly higher, because energy-intensive manufacturing generally accounts for a larger share of their GDP.

Since 2002, major oil producing countries have been investing in exploration and development. Furthermore, planned gross capacity additions from new projects in non-OPEC countries (including non-conventional sources) would add to supply.Oil-consuming countries have also started diversifying their fuel-mix by switching to alternative sources of energy like natural gas and renewables. The interplay of these forces can drive down the prices of crude oil from the current levels.

On the demand side, while consumption in the past has been driven by OECD countries, particularly the US, much of the current incremental demand is coming from emerging economies, particularly China and India, which contributed more than 40 per cent of the incremental global consumption during 2000-06. Global oil demand is expected to increase to 100 million barrels per day (mbpd) by 2015 as against 85.7 mbpd currently.While oil demand is projected to increase significantly, supply may struggle to keep pace. The production from the existing fields is declining by 4 per cent per annum which means that new capacity needs to be added every year just to offset the decline in existing production.

The depreciation of the US dollar and the worsening US economy are also held as major culprits for the price rise. The falling dollar coupled with the declining stock and credit markets also increases traders' interest in commodities such as oil,which further fuels price rise.Speculative investment by major hedge funds also seems to play a key role on oil price volatility.They are not liquidating their positions until clarity emerges on the dollar front.

While, one cannot rule out the possibility of the volatile crude prices from receding somewhat in the near future, driven maybe by a dip in global demand as a result of sustained economic downturn in the US, what does appear is that over the last few years, the equilibrium price of oil has shifted upwards and the volatility has increased significantly, leaving prices vulnerable to fluctuations even due to the slightest disruption in supplies (like the recent one of a cracked pipeline at Tennessee which cut supplies of more than 1 million barrels a day to the US) or changes in demand.

Random notes on subprime

The sub-prime mortgage crisis is the major financial crisis of the new millennium whose origin is in the United States (US) housing market. Subsequently, this spread to Europe and some other parts of the world. The gradual softening of international interest rates during the last few years, coupled with relatively easy liquidity conditions across the world, provided for increased risk appetite of investors leading to expansion in the sub-prime market. The word ‘sub-prime’ refers to borrowers (who are not rated as ‘prime’) and who do not have a sound track record of repayment of loans. The risks inherent in sub-prime loans were sliced into different components
and packaged into a host of securities, referred to as asset-backed securities and collateralised debt obligations (CDOs). Credit rating agencies had assigned risk ranks (e.g. AAA, BBB) to them to facilitate marketability. Because of the complex nature of such new products, intermediaries such as hedge funds, pension funds and banks, who held them in their portfolio or through SPVs, were not fully aware of the risks involved. When interest rates rose leading to defaults in the housing sector, the value of the underlying loans declined along with the price of these products. Institutions were saddled with illiquid and value-eroded instruments, leading to liquidity crunch; the crisis in the credit market subsequently spread to the money market as well. The policy response in the US and the Euro area has been to address the issue of enhancing liquidity as well as to restore the faith in the financial system. The sub-prime crisis has also impacted the emerging economies, depending on their exposure to the sub-prime and the related assets.
India has remained relatively insulated from this crisis. The banks and financial institutions in India do not have marked exposure to the sub-prime and related assets in matured markets. Further, India’s gradual approach to the financial sector reforms process, with the building of appropriate safe-guards to ensure stability, has played a positive role in keeping India immune from such shocks.