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The Era of One Step Forward, Three

Steps Backward.

Comprehensive Review of the Global


September 2009

Those who understand interest: earn it, those who don’t: pay it.

Price is a function of liquidity, it has nothing to do with value

-Charles Biderman, CEO, Trim Tabs.

Research Note
Prepared By

At the outset it is pertinent that this research note be placed in a perspective to enable the readers
to gain a clear understand of what it is and more importantly, what it is not. This research note (I
am not calling it a paper for the simple reason that a ‘paper’ requires greater care when it comes
to acknowledgements and would not like to indulge in plagiarism or worse forms of intellectual
theft). This is essentially a compilation of various problems that we continue to witness in the
global economy which of late have been conveniently forgotten giving the impression that all is
well in the global economy. This note is based on two fundamental premises on which the
argument of this paper are based on. These premises are not based on fancies but are based on
my intellectual understanding of the motors of economic development over the ages. These
include (a) We are in the midst of a structural bear market, which will witness occasional
cyclical bull markets, and (b) The policy makers have not undertaken any structural changes that
are fundamental to solving various problems.

When the idea of a structural bear market view was first put forth in a note on the global
economy that I had written in May 2008, there were quite a few who politely derided me and
many who frankly thought that I was insane. The subsequent events only proved that an
historical understanding of economic development, augmented with a qualitative (not
quantitative) understanding of risk based on a solidly social science methodology goes a long

A word about source of the information is imperative before delving into the details about the
state of the global economy. I would have to thank the innumerable blogs that I frequent and it is
for that reason that I thought it prudent to claim this not a research paper, but rather a research
note. As far as possible I will acknowledge the sources to be the best of my abilities.

This research note will not dwell in a large measure about the events of the past and instead will
look at various parameters for the next few months. At the outset, it is imperative to note that
some of the generalisations are best for the next few months and I would consider them effective
only for the next 6-8 months at best. However, there are times when I will make sweeping
generalisations that may go beyond the 6-9 month period, but these may be more to place things
in perspective rather than as a forecast. There may be times when I will use various technical
parameters and those should be taken as a forecast based on charts rather than fundamentals.
Considering the fact there is often a difference of interpretation based on fundamental analysis
and technical analysis this should be kept in mind.

How did the world escape financial Armageddon?
To recapitulate, the collapse of Lehman led to a complete economic paralysis as very few
understood the counterparty’s solvency. This led to an unprecedented coordinated intervention
by governments through out the world. The governments not only pumped cash but also took up
various measures that assured investors that the banking system was safe, thereby avoiding a run
on the banking system. The factors that enabled the world economy to come back from the brink
 The single most important factor is the governments’ decision to relax all the rules – this
is akin to changing the goal posts just as the opposing team was about to score a goal.
These changes including accounting norms among others. Among the other changes
include the ban on short selling, etc.
 Unprecedented monetary stimulus including drastically cutting interest rates. The
different forms of stimulus are estimated to have cost the G-20 countries nearly 14
percent of their GDP. There is little clarity that this is the last needed stimulus that we
will need.
 Central banks assuming the role of bankers of the first resort in order to overcome
hesitancy of the banks to lend. This has meant that the risks that were previously on the
balance sheets of the private businesses have now been transferred to the balance sheet of
the government.
 Special emergency lending and debt, deposit guarantee provisions

Is the Worst Over?

There is anecdotal evidence would have a logical explanation for the recent spurt in good news.
The evidence would include that related to increase in spending on homes and other items. One
could postulate that a large component of this may simply be the pent up demand or in the case
of homes a simple case of those who were interested in buying a home to live in it. In the case of
the demand for cars, it is clear that the subsidy provided by various governments’ like the recent
US “Cash for Clunkers” programme as it was called led to demand being pushed forward due to
the subsidy. These invariably are short-term measures that cannot be sustained. Thus it is
increasingly clear that as long as the government continues to spend money, the world economy
will not collapse.

The important question one needs to ask: is this form of government subsidised growth
sustainable? The easy answer would be, highly unlikely. It is increasingly becoming clear that
we are bound to witness growth in different segments as long as the government continues to
provide different forms of stimulus. To cite but one example, the case of the US housing market:
the government provides a tax incentive of US$8000 for the purchase of first home. This coupled
along with the low interest rates have led to buyers rushing into the housing market where there
have been substantial price falls. While invariably this is a short-term positive as a stimulus, the
world over, it is clear that unless the government stimulus provides a fillip, to private
consumption it is unlikely to see any sustained recovery.

The End of Great Recession as we know it
The past few weeks have seen euphoria over the fact that the Great Recession (as this fall has
been classified) is about to come to an end. The world is about to recovery-at least statistically.
Policy makers the world over are patting themselves on the back. Going by the headlines in the
popular press they seem to believe (or at least want the public to believe) that half their job is
By any estimate, this recession is the worst since the Second World War
Indicator 1975 1982 1991 2009 Average
Output per capita (PPP weighted) -0.13 -0.89 -0.18 -2.50 -0.40
Output per capita (Market Weighted) -0.33 -1.08 -1.45 -3.68 -0.95
Industrial Production -1.60 -4.33 -0.09 -6.23 -2.01
Total Exports & Imports -1.87 -0.69 4.01 -11.75 0.48
Unemployment 1.19 1.61 0.72 2.56 1.18
Capital Flows 0.56 -0.76 -2.07 -6.18 -0.76
Per Capita consumption 0.41 -0.18 0.62 -1.11 0.28
Per capita investment -2.04 -4.72 -0.15 -8.74 -2.30
The column average refers to the average of 1975, 1982 and 1991 recession.
Source: IMF, World Economic Outlook, April 2009.

The IMF has an interesting chart about the possible ways by which the recovery could take
place. The zero represents the trough of the recession. If we were to assume that the trough has
actually been reached then we could believe that world trade will take about 4-5 years to reach it
pre-crash level. It is likely that employment would take longer. Other estimates speak of the
output gap being bridged only by 2012. If these were to be assumed to be accurate then we are
likely to witness a slow recovery that would be extremely fragile. The interesting aspect would
be to look at what difference the liquidity that is sloshing around would make. If serious
structural changes were to be made in the world of finance, then this liquidity would disappear so
it is likely that policy makers would not risk undertaking drastic structural reforms in the way
finance operates. We are likely to witness a lot of half-hearted measures with a lot of rhetoric
rather than substance. Hence global capital would largely continue to circulate in a manner
similar to the pre-crisis era.
It is pertinent to note that global finance capital would continue to operate in a highly
financialised manner. To cite but one example, take the case of the Exchange Traded Fund,
United States Natural Gas Fund (UNG) and the attendant controversy about its operational
parameters. This process of financialised is a process that can be undone in the short-term with
out dramatic negative consequences. The process of reducing the influence of the financial sector
is presently not only difficult but also prone to various pitfalls considering the rampant
speculative nature that global finance has metamorphosed over the past couple of decades.

Since the recession has come to a statistical end, it would probably be prudent to take stock of
various segments of the global economy. A very interesting observation was made by PIMCO,
the largest bond manager in the world. They cited Moody’s data to claim that the recovery rates
for defaulted debt has fallen below 20 percent from about 40 percent and importantly, it believes
that business and economic conditions are worse than in the third quarter of 2008, though credit
spreads have returned to pre-Lehman levels 1 . It apparent that only the heavy hand of the
government has enabled the credit markets to maintain a semblance of normality.

The following alternative estimates of US GDP are given below

1 (Website visited on 2 September
What to expect when we pay back the bill?
A look at Japan, twenty years after the crisis started is a look at a very plausible scenario. The
two charts of the Nikkei and the rising debt provide a graphical feast of what the world may look
like in the next few years. Both the charts clearly indicate that there are historical precedents in
the near past (not the Great Depression) to look at what can go wrong. The only difference is that
this time the scale is exponentially larger because of the fact that the scale of the boom as well as
the crisis is much larger – it is global in nature.

The past twenty five years (which was the era of the credit bubble) was the age that was based on
a combination of de-regulation, increased money supply and more importantly lower taxes which
led to higher deficits and the increased frequency of bubbles. Bill Gross, the CEO of PIMCO has
said that he expects real growth of about 1.5 percent and nominal growth of 3-4 percent over the
next few years that would be half the pace of growth that we witnessed over the past 25 years.
The OECD has forecast a ‘moderate’ recovery and expects the G-7 countries to shrink 3.7
percent this year, less than the 4.1 percent it expected in June. It left unchanged its estimate of a
2.8 percent contraction in the U.S. this year, while the euro-zone will contract 3.9 percent rather
than 4.8 percent. Japan will slide 5.6 instead of 6.8 percent, the worst slump in the G-7 in 2009.
It expects Germany to contract 4.8 percent against the previously estimated 6.2 percent, while
UK will deteriorate and will contract by 4.7 percent, worse than 4.3 percent previously

US Stimulus money: how it will be spent?

The following chart illustrates how the Obama stimulus could be spent2. While the arguments
about the nature and impact of the Obama stimulus can be endlessly debated, it is clear that the
US will have to live with exponentially large deficits for the next decade (at least).

Source for the chart:
It is yet to be seen how much of the stimulus money would be spent by different segments and
what proportion of that would be saved by different beneficiaries in different sections of the
recipients chain. The recent case of UK and the US consumers clearly shows that people would
rather save than spend the money.

US Federal Debt held by the Public


US Federal Debt held with the Public: Past, Present & Future (1790-2050)

Source: US Congressional Budget Office

The spending by the US has come at a cost. The US Congressional Budget Office (CBO) has
pointed out that the current tax and spending policies the deficit would jump from US$459
billion in 2008, to US$1.6 trillion in 2009 and US$1.4 trillion in 2010 and fall to US$921 billion
in 2011 3 . It also expects corporate income tax receipts to fall from US$304 billion in 2008 to
US$142 billion in 2009, a fall of 18 percent. It is pertinent to note that they grew by about 30
percent a year during the period 2003-07 4 . The US Fiscal Deficit would continue well into the
next decade, even by the projections of the US Congressional Budget Office. The following
charts clearly elucidate the fiscal problem for the USA in the next one decade. Invariably this
will mean that the era of low taxes is over and on the contrary we are bound to see the era of high
taxes, a factor that will be a long-term negative for taxes.

US Fiscal Position: Past and Present (as a percentage of GDP)


The charts above clearly indicate that the problems for the USA seem to be just starting. Hence
the governments as well as investors need to be prepared for the highly complex problems over
the next 5-7 years. There are a few scenarios for the US economy that we underline. They

(a) The US economy moves sideways with the occasional good quarter or two (which would
be due to government measures) and it takes time for the excesses to readjust. This
readjustment is normally a long-drawn out process.
(b) The economy picks up steam for about two quarters (maximum) and then goes back into
a free fall.
(c) A possible scenario is that the monetary easing leads to a collapse in the value of fiat
currency and this in turn leads to sharp rises in interest rates in order to combat inflation.
However, it is pertinent to note that as long as we have huge spare capacities in the US
(where industries are running at 68%) and the rest of the world, inflation should not be a
major concern as long as demand deflation is the major concern.

4 (p.7)
The case of Japan is instructive. The borrowing binge invariably leads to a system that will have
long drawn out effect on a country.

Japan: Public Debt over the Years

Source: IMF, Finance & Development, March 2009, p.29

The chart below of Nikkei from 1982 seems to be an excellent indicator of what we can expect
the markets over the next few years. A look at the two charts 5 (Japan: Public Debt over the Ages)
and the chart of Nikkei is clear that a large part of the rally in early part of the century was
largely because of the money being pumped into the system in the form of stimulus. Therefore
we could speculate that we could expect the asset inflation to continue if this liquidity pumping
continuing. We could also assume that this would continue as long as the policy makers have
clear cut evidence that the economy is on the recovery path. They would like to err on the side of
caution after being caught on the wrong foot over the past two years.

Nikkei 1982-2009
The Chart below outlines the movement of the Nikkei 225 (the benchmark equity index in Japan)
from 1982 to the present.

The rounded off zones are the times of sharp rallies, essentially bear market rallies. It is clear that
one should not be overly optimistic about the present day sharp rally in the equity markets, for
the simple reason that there is a historical precedent. There have been times when the Nikkei
actually went beyond the previous peak (for various fundamental reasons) only to collapse back
with greater intensity. This is not to claim that the equity markets will collapse like in the case of
Japan, just that one should not rule out their possibility because of the inherent bull in all of us,
after all hope springs eternal.

Unfortunately, I am not so tech savvy as to diagrammatically extrapolate the two charts.
The problems in the US economy started with the problems in the housing sector. Unless there is
a recovery in the housing sector, we are unlikely to see a sustainable recovery. There have been
recent reports that the US housing sector has stabilised at lower levels. This is only partly true.
The growing number of transactions are largely a product of growing number of foreclosures.
According to Moody’s commercial property prices have fallen nearly 35 percent since October
2007. This has led to problems of refinancing about US$165 billion worth of commercial
mortgages. There are two estimates of the problem mortgages: One talks about 30% of the
properties being less than the worth of the loan 6 , another talks about 48% (or 25 million homes)
being underwater 7 . The chart below shows that the US is set to witness large scale adjustments
of mortgage rates in 2010 and 2011, precisely the time when the consumer can least afford. We
have provided the details about loans of the US banking sector and it becomes clear that the real
estate and consumer loans are the largest component. The downturn in the commercial real estate

sector will only add to the pressure on the balance sheets of the banks. US banks hold nearly
30% of the originate-to-hold’ mortgages on their balance sheets.

The shipping industry which is an advance indicator due to the fact that about 90 percent of the
world trade is carried out through the sea routes continues to be mired in problems. By the
estimates of the industry participants, if the present conditions continue (which means that there
is no further deterioration) then the industry could probably recover from the middle of next
year. Unfortunately for the shipping market, that is unlikely to be met if the Chinese continue to
not only regulate their capacity but more importantly open some of their mines. The Chinese
attempts to encourage local industry would invariably harm the shipping industry, considering
the fact that the rising in shipping rates since March has largely been due to their large scale
import and hoarding of commodities.

It has been pointed out that the Industry not only faces the problem of reduced commodity
imports from China but also a growing supply of ships, exactly as the market finds that there is
less amount of freight.

 Even cartelisation has not been successful in raising the freight rates, due to the collapse
in demand. The rate for leasing Capesize ships is expected to drop 50 percent from the
current US$37,865 to a low of about US$18,000 before the end of the year 8 .
 Worryingly the Baltic Dry Index seems to be moving sideways indicative of the period of
stagnation for the world trade. The index has been gradually sliding downwards over the

past 3 months. However, the only positive for the index seems to be that it is in highly
oversold territory.
 The Baltic Dry Index reached its peak of 11793 on 20 May 2008 and collapsed to a low
of 663 on 12 May 2009. It now is around 2413 on 3 September 2009. More importantly
the index has been stagnating in a narrow range of 1000 points indicating that the world
trade may continue to languish and stagnate.
 OECD predicts a 16 percent drop in world trade in 2009.
 The Economist cites various studies that indicate that about 10 percent of the world’s
merchant ships are anchored at different ports due to the collapse in world trade 9 .
 Shipping companies are expected to lose about US$20 billion on a turnover of about
US$180 billion 10 .
 2010 is expected to be worse than 2009 due to an increase in the number of ships that will
hit the routes. This excess supply (which is in addition to the decline in world trade) is
expected to last till 2011-12 11 .
 The volumes of freight on the busy Asia-US route have dropped by nearly 20% in 2009.
More than 520 container carriers have been idled as of June 2009 12 (this excludes other
categories of ships).
 Forward freight agreements show that the fourth quarter rates average price will be about
7 percent lower.

Banking & Financial Services

The banking sector with its extreme form of securitisation caused this crisis. The crisis was
aggravated by the fact that the ‘shadow banking’ system in the form of the banks off-balance
sheet system created the crisis. Unfortunately nothing has been done till date to mend the system.
However, it must be pointed out the government has stopped a run on the banking system that
commenced in earnest after the collapse of Lehman Brothers. The governments not only
provided billions of dollars in capital but also provided guarantees and assurances worth trillions
of dollars that has effectively enabled the stabilisation of the system. The banks have till date
written off more than US$1.4 trillion dollars, thanks to the aid provided by the governments.

The paradox of the ‘Great Recession’ or crisis, especially in 2009 has been that everybody agrees
that the structural fundamental problems of the banking sector have not been resolved. Infact
there is no effort even to resolve them, yet the banks are making money. This is due to the
largesse of the government. Interestingly, the money making has been possible only because the
central banks have assumed the risk and are providing a perennial supply of credit at literally no

cost. On the other hand banks simply refuse to lend cash to consumer. There are growing reports
to this effect in the USA, Europe as well as other countries. The only exception to this seems to
be China, where the government has directed the banks to lend large amounts. This has enabled
the banks to lend the equivalent of nearly US$1.1 trillion in the first half of 2009, nearly the total
amount lent in the whole of 2008.

A recent Bank of England report pointed out that loans to private non-financial corporations fell
in July, the biggest monthly fall since record began in 1997. Lending for the full year was down
2.9 percent 13 . Small and Medium manufacturing enterprises in UK continue to complain that
credit is difficult to come by 14 .

One important aspect of the credit crisis has often been overlooked by a number of observers.
That is the slow but steady increase in the cost of capital, even for companies that are large. This
is a phenomenon that will continue for at least another 3-4 years if not more.

Interestingly various studies have pointed out that the European banks have not yet started the
process of write offs. The head of the Federal Association of German Banks has warned that
German banks posses about Euros 800 billion (about US$1.35 trillion) of bad assets from the
previous bubble era on their books and Germany could face a credit crunch 15 . The British
manufacturers are claiming that credit is hard to come by as the banks are still not willing to
lend. On the other hand the German government has decided that it would lend directly to
manufacturing companies as the banks are not willing to lend.

Banks are still refusing to lend. US Banks are stated to be hoarding cash and have nearly US$1
trillion in the form of various deposits that they have raised but are not lending. This is therefore
either starving businesses of capital or even when capital is available, the cost of borrowing is
prohibitive. A large part of the Global banking system survives only because it is able to borrow
at low cost from their respective central banks at about 1 percent or less than that. More
importantly, the central banks have now become the lenders of the first resort. Recently the
European Central Bank lent nearly US$1 trillion dollars for one year at one percent to their
banks. Similarly US, UK and European Countries have given debt guarantees worth trillions of
dollars. In the case of UK the bail outs to the financial sector (including guarantees) are
approximately about 13 percent of GDP.

Source: St Louis Federal Reserve (

As on 7th August 2009.

Any sustainable economic recovery will have to generate employment. The recent boom which
spanned the financial services and the housing segments not only provided cheap credit but also
created employment on a large scale. More importantly as there were greater disposable incomes
(and the easy availability of credit) it became possible for a large number of Americans to
borrow and own homes. A rise in price invariably meant that there the wealth effect only
facilitated greater spending.


But due to the downward spiral after the bursting of the credit bubble, the falling home prices
were also accompanied by an ever rising tide of unemployment. By official count, the
unemployment rate stands at 9.4 percent, unofficial count believes that it is nearly double that
figure. This difference of opinion is largely the result of the methodology the US government
adopts to calculate the number of unemployed.

Official estimates claim that the if a person does not find employment for six months, then it
would like to believe that it is because they do not want to work rather than not finding work and
hence are not officially counted as unemployed. Irrespective of the manner in which US
commutes its state of willingness of people to work, suffice to say that the US is estimated to
have lost nearly 6.7 million jobs since the recession officially began. There are about another 3
million people who are working part-time because they cannot find full time-employment. These
people are not counted as unemployed, so the official statistics may be understating the problem
at hand in USA. If there were to be a jump in meaningful employment that is likely to occur only
after these part-time workers are absorbed due to the rising need for workers, an event that seems
far-fetched over the short-term. Europe fares no better with unemployment reaching a 10 year
high to 9.5 percent. European Central Bank estimates that unemployment will peak at 11.5
percent in early 2011.

It is commonly believed that employment is a lagging indicator, however the speed of

retrenchment in the present crisis seem to indicate that technological change works both ways
and hence it may not be a lagging indicator, though more empirical studies are needed in this

The following chart provides an alternative to the official government statistics (as on 7 August

The good thing about myths (and bubbles) is that it takes only a pin prick to bust the euphoria.
The actual pricking of the bubble or bursting of a myth may not seem insignificant at first sight.
The recent reports about the pick up in manufacturing as symptomatic of heralding a recovery is
a one such event. The report by ADP that companies eliminated more jobs that forecast in
August proves that the recovery will be more statistical than real.

A pick up in manufacturing is always accompanied by rising business investment and more

importantly employment – neither of which are taking place (or at least are invisible) 16 . It seems
very clear that the pick up in manufacturing is largely because of the spending by the
government and more importantly due to an increase in auto production, which was due to the
government subsidy. Since that has now concluded, it would be interesting to see how much the
inventory correction could lead to a rise in manufacturing.

However, it is pertinent to note that the next three months (at least) would invariably see a rise in
manufacturing as there would be some form of inventory additions. A bottoming of the recession
should normally be accompanied by an increase in the Capex of the companies. Interestingly,
Capex has been unchanged over the past two quarters indicating the corporate sector is not
convinced about the end of the recession. In other words, they too clearly believe that the
recovery will be more statistical than otherwise, hence the hesitancy of the corporate to increase

The above chart is indicative of the problem with sales. Inventories have been rising quickly
largely because of the collapse in sales.

A clear trend seems to be emerging in the manufacturing sector. The stimulus and other
measures will enable the growth of the manufacturing sector, but the equity markets may have
already discounted this factor. More disconcertedly, it is clear that the positive impact of the
stimulus is likely to fade in the next three months (from September). It is pertinent to note that
the July factory order increased by 1.3 percent, lower than the 2 percent expected by economists.

While employment has been one of the concerns that is well documented, a more stealth impact
on the balance sheet of consumers is the fall in wages and salaries. They fell by 4.7 percent in the
past 12 months (upto June). This has added pressure on to the consumer to save more.

Rising unemployment means that consumer delinquencies are on the way to reach a record. It
has been pointed out by the American Bankruptcy Institute 17 that bankruptcies are set to rise by
nearly 34 percent by the end of this year. This will only lead to defaults on the credit card
market, where JP Morgan has estimated that it would reach 10%, the highest in more than a
decade. Europe seems to be no better with unemployment already above 10 percent. In the case
of Spain it is nearly 17.5% and expected to rise further. The IMF has estimated that about 7% of
Europe’s consumer debt (US$2.467 trillion) could end up in default. In the case of USA this
default could be as high as US$1.914 trillion 18 .

The chart above clearly highlights that the household liabilities in all forms have continued to
shoot up over the past three decades. Interestingly, on in the last few months do the consumers
seem to have become more cautious, indicating that this will be a multiyear readjustment to the
new reality, where consumers would probably prefer to repay debt rather than assume more debt
– which anyway has become unsustainable. There is a lot of evidence that consumers have
become more frugal and more savings oriented. It has been reported that the US shoppers have
increased their use of discount coupons by almost 20 percent this year 19 . Additionally consumer
bankruptcies continue to rise. In August they rose 24 percent. They are expected to cross 1.4

million this year 20 . The following chart provides an overview of the fall in retail sales (as
provided by an alternative websites) clearly point out to the intensity of the fall due to consumer
retrenchment. The data since the end of the Second World War (in the chart below, since 1948)
clearly shows that the recovery from a fall of this magnitude will be a slow and steady process,
which will in the best case will be more like the period after the LTCM collapse and the South
East Asian Crisis. So it is pertinent to keep in mind that the process will be a slow and gradual
process and hence any hope for a “V” shaped recovery should be tempered with the sober reality
that is dawning in the new age, which will be the age of frugality rather than the other way

US Real Retail Sales

The chart below shows the savings in billions of US Dollars in the USA. The important
consequence of this is that it will lead to less reliance of that country on foreigners in buying
their debt. That in turn has two sets of consequences, while it is good for the US economy, it is
invariably has negative repercussions on the more export oriented Asian countries. Unfortunately
for the Asian countries the reality is yet to dawn on these countries (other than China, which has
not only realised this but is taking efforts to make the transformation) that they are the flavour of
the season for hot money rather than serious foreign domestic investment (FDI) which is not in a
hurry to invest.

The markets are a generic term used for the credit, commodity, currency, equity as well as other
different markets. However, for our analytical purposes we will take into consideration only the
Credit, commodity, currency and equity markets. A remarkable feature of the equity as well as
commodity markets is the fact that the volumes are extremely low. It has been pointed out that
since March through to August 26; in the equity rally stocks with the lowest quality rating have
outperformed those with better quality rating. Those stocks with C or C- and below have
produced an average return of 141.8% while those with an A- or higher quality have gained
44.3%. Overall volumes in the NYSE have been around 20% less than normal 21 . More
importantly, if one were to exclude the top traded counters, in terms of stocks traded (which
include Citigroup, AIG, Fannie Mae and Freddie Mac) the volumes would be drastically less.

The following chart (as on 2nd September 2009) clearly shows that the volumes in the recent rally
have been one of the lowest in the recent times. What is interesting is that the volumes were
extremely high, when the market fell by nearly 185 points, technically a bad sign. Moreover the
fact that the market broke through a important technical trend line with heavy volumes should be
a sign of things to come.

Then it would be pertinent to ask the question where we are in terms of the equity market and
where we are headed. The following chart shows one of the possibilities. While a number of
indicators (technically) have been flashing warning signals, nobody knows when the next shoe
will fall. This uncertainty springs from the fact that the market there continues be an
exceptionally amount of liquidity in the system. It has never been easier for financial companies
and speculators to borrow directly from the central bank.

The following chart gives us an overview of the amount of money that is there sitting on the
sidelines in money market funds. Even if a fraction of the money were to come into the equity
market (as it seems to doing so), the low volumes will invariably have a magnified impact on the
prices. There is about US$3.57 trillion dollars in US Money Market funds. A cursory glance at
the chart below shows that the fear has still not been completely overcome. Though the amount
of money in these funds has declined since March 2009, it is still at highest level since 2005.

Source: Bloomberg

While there is increased talk about risk aversion declining, on the other hand stories about the
problems in the pension and other sectors, especially university endowments means that we are
seeing a structural change in the way people invest. This will be a major issue over the next few
years for the simple reason that the credit crisis has led policy makers to give less importance to
the issue. But the demographics of the western world mean that this is a problem that cannot be
overlooked for long.

Of more immediate concern should be the losses that various pension and other long-term
investors have suffered. It has been pointed out that the US pension funds contributed nearly
US$1.2 trillion to private equity groups, which was then leveraged and this played a large part in
the stratospheric rise in valuations. The three largest US pension funds have till date suffered
losses of about US$53.8 billon since they started investing in these funds since 2000 22 . This is
not just a USA specific phenomenon. It has also been pointed out that FTSE 100 firms have a
pension deficit that is now more than 96 billion pounds (more than double the deficit estimated
about one year ago) 23 . Another estimate by Deloitte claims that the pension deficit of Britain’s
100 biggest companies is nearly US$490 billion 24 . This would mean that companies would have
to either forgo paying dividends or would have stop paying pensions.

Another interesting chart is given below and probably explains that there is an historical
precedent for the present move in the equity markets.

An interesting aspect would be to look at valuations after the present rally. The following chart
indicates the precise health of the US corporate sector. The ludicrous levels of stocks clear force
us to recall the statement of Keynes, who once said that the ‘markets can stay irrational for
longer than you can stay solvent’.

One would be forced to ask the question, how rational are investors buying into the index at such
heights. It is clear that stocks have run far ahead of the supposed recovery. One reason could be

due to the under-ownership of US stocks by various institutions at the end of 2008. The
following chart shows the inflation adjusted earnings of S&P 500 in the USA.

Even if the rate were to go back to the 1990s level of mid 30s, stock prices on a fundamental
basis would be grossly overpriced. Interestingly, the present estimate for earnings is about
US$13.50. Ironically, the earnings estimates were at the end of March 2009 were US$14.15,
while at the end of 2008 they were US$19.92. It is this context that I put forth the argument that
we could witness an era like that of Japan as can be seen from the Nikkei chart reproduced in this
note. It is plausible that while the real economy gradually sinks deeper into a morass the markets
could periodically shoot up on a short-term basis, but each short-term up move would be
followed by a sharper and longer fall. The causes for such sharp rallies could be many including
new stimulus packages, or simply short-covering rallies.

Bond Markets
The bond market is less sanguine about the state of the economy. They are less optimistic about
the possibility of a quick recovery that will be more like a “V”. Instead they seem to be preparing
for long haul. July saw the spreads tighten in nearly all segments of the bond markets. The charts
of most of the US Bonds especially the 10 Year Treasury notes seem eerily similar to the pre-
Lehman times. This is not to claim that we are about to witness another collapse. It essentially
means that the optimism that pervades in the popular press is not justified. Interestingly, the five
year TIPS have declined nearly 14 bps from their recent highs. Curiously this is happening when
there is an increasing talk about recovery.

 Speculative longs in 2 Year UST are at their highest in recent times.

 The difference between high investment grade corporate bonds and the US Treasuries is
still the time of Bear Stearns, though less than during the post-Lehman times. It is still
double the average rate of the past 5 years.
 The yields on US Treasuries are similar to those during the Great Depression.
Considering the fact that there is a predominant fear of deflation, how come the yields are
so low?
 A possible economic recovery should mean that the US 10 Year Treasury notes should be
rising. They are actually falling. Since the US Federal Reserve is not buying these notes
from the open market, this fall should be all the more perplexing, unless there are two
things in mind: (a) the US is not about to recovery, or (b) the bond markets expect some
trouble ahead so investors are rushing back into treasury notes – both of which are not
exactly a positive for the equity market.

A lot hope rests on the ability of China to provide the momentum required to carry the world out
of the present economic troubles. The World Bank President claims that the chance of a ‘truly
global recovery’ has increased due to China’s expansion. Hope springs eternal. Andy Xie, has a
different take on China. He believes that China is a bubble and the Chinese markets could crash
by another 25 percent. It is imperative to note that Andy Xie studied the Japanese bubble for his
doctoral dissertation. It is my personal opinion that greater emphasis should be given to a person
such as Xie rather than a political appointee of a half wit (George Bush) based on an obscurantist
ideology rather than intellectual ability. China runs the risk of borrowing growth from the future
for today as the pace of monetary supply risks creating more capacity which will be detrimental
to future growth. The fact that China’s exports continue to dip means that any new capacities
being added due to the stimulus will not have the desired affect. Pushing credit to borrowers who
are not exactly in the pink of health is akin to throwing good money after bad money. Rampant
and imprudent lending as the Chinese seem to be taking up at the present juncture means that we
will invariably see an increase in bad debts if there is no improvement in business environment.
Therefore in the near future we donot have to see any further deterioration, if there is no
improvement in the environment then earning the cost of the repayment of this borrowed money
becomes all the more difficult.

Technical Factors
The technical picture of the financial markets is highly pessimistic to say the least.
 There is a gradual slow down of money that is entering the emerging markets. According
to statistics put forth by EPFR, new capital inflows into the Asian Mutual funds has
declined to about US$300 million in August from the average of more than US$3.5
billion a month between April-July.
 This has also been the period when the world biggest pension funds are reducing their
long-term equity exposure – at a time when the markets have had their biggest rally since
the 1930s 25 .
 According to Trim Tabs, Insider selling in August was nearly 30.6 times insider buying,
the highest since 2004. Insiders have been bearish and have been net sellers of stocks for
the past four months. They have sold nearly US$105.2 billion in shares.
 NYSE short interest continues to plunge and is down by more than 10 perecnt.
 Margin debt has jumped by 5.9% in July.

 TRIN is at levels that are associated with the market tops of 2000 and 2007.

All the above are contrarian indicators that usually signal a market top.

Grappling with the Unexplained:

There are too many parts of the economy that cannot be satisfactorily explained. These include:
 The continued correlation between all asset classes. Nearly all commodities are moving
in step with oil and equities. Even asset classes that in the past were thought to be
negatively correlated are moving in tandem. That should seem odd, considering the well
known fact that higher commodity prices invariably lead to an erosion in the profits of
the corporate sector
 Higher oil prices invariably mean a decline in the equity markets (at least that has been
the case till now).
 If the case for an economic recovery was that solid, then Gold should have tumbled. It
has tumbled, though conversely it has not gone up. So are we heading for years of
sideways movement?
 If valuations were actually so attractive, then why are we not seeing an increase in
mergers and acquisitions activity?
 51 percent of the PE players expect M&A activity to decline in 2009
 The markets seem to have already discounted the present marginal revival in the global
economy with their sharp jump. How would they react to the possible out come of the
world economy moving sideways?
 How to explain the fact that there continues to be rise in the inventories of some of the
important metals even while capacities have been shutting down. Copper inventories
continue to climb, Aluminium have ceaselessly climbed since October 2008, Lead has a
similar story, only that it has climbed continuously since December. Interestingly the
price of Lead is at a 16 year high, copper has recovered about 70 percent of its fall.

Does all this mean Deja vu all over again? Just like 2001 when all the analysts had called an end
to recession only to have the year end at zero percent growth?

The future problems areas:

This section comprises of various problems that could spring a surprise in the future. They are
essentially black swan events, which may occur. This is not to claim that they are about to occur,
just that they are entirely plausible.

 Remember that the threat of deflation has not disappeared. On the contrary it seems to be
winning the battle. The first indication of that would be when the US Treasury notes
reach near Zero.
 The single biggest risk for the future lies in the growing risks that the sovereign
supported institutions going bankrupt or wilting under the pressure of bailouts. While this
seems far fetched at the moment, it is entirely plausible. To cite one such problem
institution could be the FDIC (US Federal Deposit Insurance Corporation). Its funds have
been depleted to the tune of about 40 percent. In order to replenish their funds, the FDIC

would have to charge banks, which in turn would reduce their profitability or simply not
cover their deposits beyond a certain limit (not politically or economically feasible).
 Sovereign risks may resurface. The era of financialisation has brought about an important
change. A country need not actually be at risk of default but a perception that it may
default would cause capital to dry up. It is now possible for any investors to have a look
at Credit default swaps and come to their own conclusions. Interestingly the last month
has seen the credit default swaps of countries such as Mexico and Brazil to rise. Though
this rise is only marginal, it invariably needs to be watched closely.
 The growing risks posed by small banks in the USA disappearing. The FDIC has a list of
nearly 416 problem banks in its confidential list. Most of these banks are stated to be the
smaller regional banks. As these banks go bust or are closed down, the credit situation
will dramatically deteriorate, leading to an aggravation of the economic situation. It may
also lead to a number of loans, which till now are not yet problem loans, being recalled,
thereby pressurising the balance sheets of the consumer. Invariably it may lead to a
greater retrenchment of the consumer instead of leading to the consumer loosening of
their purse strings.
 What would happen when the governments run out of money to pump into the system?
Though this measure is about 2-3 years away, deterioration in the economic conditions
could bring these pressures to the forefront.
 Banks have still not resolved the problem of toxic assets. They still remain on the books
of the banks. Though the difference has been that the banks are now able to use these as
security to borrow from their central banks.
 Technically, the US Dollar index seems to be set for an up-move. It would be interesting
to see what the impact of this up-move would be on different parts of the world. Over the
last two years, an up-move in the US dollar has been accompanied by a crisis. Does the
currency portend something? While there is no need to panic on the dollar, the fact that
the predominant expectation is for the dollar to collapse. If the reverse were to happen,
what would happen to those caught on the wrong side of the dollar volatility and what
impact would that have on the balance sheet and payment related issues? The Chinese
have already set the cat among the pigeons when the regulator is stated to have cleared
defaults on some derivative products 26 .
 How would the world react if another major (or a few hedge funds) were to lose large
amounts of money? Considering the fact that global finance is intricately interlinked, this
could just be the next major issue.
 There is however, one major positive (apart from the huge amount of capital on the
sidelines): a large number of people are still bearish. Though I would not be sure that
they would be bearish for long if stocks were to rally another 5% or 10%.
 It is pertinent to note that unlike in the past the governments have little ammunition left to
take up further stimulus measures. The last time, the world faced such a severe recession
was in 1981-82. The Fed rate was a high 20 percent and the deficit spending helped push
down the unemployment rate to 7 percent by the end of 1985. This time, the government
has no leverage left half way through the crisis.

What about India?
This yet another tricky aspect that this note attempt to grapple with satisfactorily. A lot has been
made out of the recent GDP numbers as well as the IIP numbers. But the growth was largely due
to three major items: Electricity and related aspects, finance, mining and related items. All the
other components had growth that was less than the last year. It is indeed interesting that much is
being made about electricity consumption in a country that is deficit in power and that too in
summer months. Mining success story may have more to do with China’s import of commodities
than anything else. The easily explained item is that relating to business and financial services.
While undoubtedly there was an increase in economic activity (considering the fact that we had
the elections, and lot of pent up demand) it is clear that this is largely due to some loans and
other disbursals by the banks in the first quarter of the new financial year.

A clear ominous sign is the substantial fall in the Industrial investment proposals. The RBI
announced that the proposed investment until May 2009 amounted to Rs.4,04,380 crores, while
in 2008 they were 15,22,566 crores. Even if we were to double the proposed investment for the
whole year (there is no specific reason why we are only doubling) then it would be about the
same as 2007 (when there were proposed investment to the tune of Rs.827,500 crores27 .

As it is the recession has dramatically hurt India –far greater than what Indian policy makers are
willing to admit. Despite the recent rains, about half of India’s districts have been declared as
drought hit. Various estimates have pointed out that this could reduce the GDP by 3-5 percent.
The recent theory (actually extravagant claims) that rural demand will replace lost demand due to
global crisis seems to have run aground. The next couple of months should see the decoupling
theory sink. India, China as well as other emerging economies are dependent on the OCED
countries for their survival and that is not about to change in the next 5 years. This is to be seen
in the context of two important factors: (a) exports comprise about 15 percent of the GDP, and
(b) India is a capital deficit country. The problem of availability of capital has become more
severe due to the huge government borrowing via the deficit spending route in a case of classic
Keynesian pattern. Unfortunately, India is not in a face to effectively overcome the crisis as it is
often perceived. This is because of the consumption profile of the country.

India is now largely a country dominated by the service sector (which comprises about 57% of
the GDP) meaning that those dependent on the sector are at the bottom of the job market, where
the incomes are relatively low. This would mean that the cushion that they have in difficult times
would vanish if the troubles were to go beyond a certain period of time. However, it is difficult
to quantify the precise tipping point. The problem of rising food prices only aggravates the
situation for those at the bottom of the pyramid, the class of consumers who the world believes
will rescue the Indian economy. Rising in prices of everyday consumption related items is
essentially like a tax, only more efficient in burning a hole in the pocket of the consumers. This
will invariably lead to consumers postponing consumption of non-essential items over a period
of time. This is precisely what is happening over the past six months. Since this is a slow
process, it is less visible on a monthly basis. Anecdotal evidence of consumption of items like
furniture is clearly indicative of this trend of downtrading or searching for cheaper replacements
in nearly all items.
The Financial Express, 29 August 2009, p.7.
The boom till 2008 was largely built on empire built on debt. The recent bout of tightening or the
impact of the recession now means that nearly Rs.382,000 crores of money has vanished from
the system. The government borrowing programme now risks crowding out the private sector.
India faces a peculiar problem. Money supply will continue to tighten (as in the rest of the world)
even if there is an economic recovery as businesses would require huge amounts of capital.
Moreover unlike in other countries a large component of the government spending is on the
infrastructure projects which take time to build. Hence the government will find that it will not
be able to complete them even if it finds that the economy is truly recovering. This would create
a greater credit crunch (though may not lead to a credit crisis).

India’s manufacturing (which is often claimed to be more dependent on internal consumption) is

clearly dependent on the helping of the government, due to the large scale presence of the
government in the business arena. However, India’s fiscal position is on more shaky ground vis-
à-vis other countries. While the domestic savings do provide the scare capital needed over the
next 12-18 months, it would be difficult to sustain growth over the long-term. A drought would
have disastrous consequences to an already fragile economy which was witness to fiscal
profligacy due to the exigencies of the recently concluded elections. The drought would
impacting India at a time when it is most susceptible. There is however, one advantage that
Indian companies may witness. In those industries, where India does have a major competitive
advantage (like Auto), the country may witness some increased interest, especially in the form of
outsourcing. Hopefully, this should reduce the impact of the crisis for those industries positive
affected. The rest of the industries, especially that depend on exports for more than 50 percent of
their turnover are likely to be in deep trouble.

An important aspect of this crisis which most of the countries seem to have missed is a change
that is gradually taking place and that change is what actually aggravated the Great Depression.
At that point of time we had countries that put up protectionist trade barriers in the form of
tariffs. However, in the present times the presence of WTO has led to less of such a direct
measure. Instead, we have system wherein all countries increasingly trying to encourage their
domestic industry, which has to be come only at the cost of another country’s industry. Only that
this may take longer to make its impact felt.

There are obvious advantages for India over the medium term. Since only about 15 percent of the
GDP is dependent on exports, the economy will be able to weather the storm over a short period
of time. However a prolonged sideways trend in the economy could end of creating havoc on the
Indian economy.

Future Prospects for India (personal views)

 India’s growth will stall. The government will have the ability to spend money only for
another couple of quarters and hopefully the intensity of the drought will reduce this year
and the next year will be a normal monsoon.
 As India’s growth stalls, the government will be forced to spend more money thereby
pressurising its fiscal position. This will invariably lead to pressure on their currency.

 The longer the above two processes drag on, the more the pressure on the corporate
sector, whose balance sheet is already burdened with excessive borrowing at a time when
their revenues are being pressurised. The recent crisis has only forced all the major
companies to increase their borrowing. Further leverage will only hurt them more.
 The prospect of rising prices will only aggravate the situation. With major state assembly
elections in every year from now, the government will be forced to maintain the
momentum of its spending programmes, infact it will have to increase spending and not
the other way round.
 Demand is unlikely to rise due to the lack of expendable surplus among the consumers
 Manufacturing growth will continue as long as the government has the ability to spend
 Tax revenues are bound to decline
 Globally we are bound to see an exponential rise in volatility. It is likely that the
corporate sector will be caught on the wrong side of the currency and commodity price
volatility. So unless the government relaxes

Increasingly the government will have to accept that there is a problem (which could lead to
panic) or they could simply relax all the rules so that accounting for the problems could be
postponed for a longer period of time.

What to Do in the era of One step Forward, three steps backward.

 The simplest answer would be cautious.

 Most importantly, one has to realise that we are in an era of one step forward (thanks to
the government) and three steps forward.
 As of now (and probably so in the next three months) deflation will continue to be the
major threat, and not inflation.
 Load up on cash, especially if deflationary pressures are back as they seem to be as seen
from the continuous fall in the producer prices. However, since this is blamed on base
effect, it would be interesting to see how the prices behave after October.
 Remember cash is best only in times of deflation.
 Cash would be of great use as we are bound to witness volatility as the future is like a
minefield where now sovereign ratings are bound to down-graded leading to a
progressive downward lurch.
 The case of Japan clearly seems to show that the best opportunities will be there for
traders. Rallies will continue to be extremely sharp as in the case of Japan and the Great