How does the United States export inflation?

Exporting inflation is a very interesting concept, and one that doesn’t get the attention it deserves. It is a very real concept, and occurs mainly because the – dollar – is the reserve currency of the world.

Most countries hold their reserves in dollars, which is a safe – haven of sorts, and that is why the dollar is known as the – reserve currency – of the world.

United States and Domestic Inflation

To counter deflation’s bad effects, and to stimulate the economy – Mr. Obama plans to spend billions of dollars over the next few years.

Since, the US runs a large deficit, it can finance this stimulus in only two ways –

  1. Issuing Debt
  2. Printing Money

As the global recession tightens its grips on countries across the world, the appetite for US debt is getting smaller. The yields on US government debt are already at all time lows, and then there is the small matter of – the stimulus that other countries need.

Countries like China, India, Japan, Russia etc. also need to stimulate their domestic economies. They plan to do this by using their dollar reserves, and buying more debt at this time is hardly feasible.

The other option for US to finance this debt is by printing money. Many countries ranging from Germany to Argentina to Zimbabwe have already done this throughout the history of the world. While, you may not see a 100 billion dollar US banknote, inflation is the natural consequence of printing money or quantitative easing and is unavoidable in the current circumstances.

Domestic Inflation effectively reduces the ability of American consumers to buy Chinese goods, Russian oil and Indian software, among other things. As prices rise, people can afford lesser goods and services.

More importantly, domestic inflation reduces the ability of the Chinese, Indian and Russian exporters to sell their stuff to US, and keep their own domestic economy going.

Inflate or Die

Faced with the increased supply of dollars in the market, other countries have two options:

  1. Let the values of their own currencies rise, relative to the dollar.
  2. Print more domestic currency to match the depreciating dollar.

If the central bankers allow their domestic currencies to rise, then many exporters will lose their competitive edge, and ultimately shut shop.

When the dollar rose to about Rs.39 (Indian rupee) a few months ago (as opposed to above 45 – earlier) a lot of Indian BPOs, that export to US – lost their competitive edge, and began lay-offs. Some of them even closed down. Similar things happened in other countries of the world too.

Faced with such a scenario – the governments across the world will need to print money to adjust themselves with the depreciating dollar.

When countries around the world print domestic currency – it would lead to inflation in those countries, which, is effectively due to the steps of the US, and dependence on it.

What if they let the dollar fall?

Developed countries like Canada who are also major exporters to the US can in fact, let the dollar fall, and allow their domestic currencies to rise. This will contain inflation, although it will impact exports, and slow the growth of their economy. Since, Canada is already a developed and rich country  – it can allow that.

Countries in the developing world can’t allow a hit on their growth – because that will have severe social and political consequences.

So, there you have it, inflation export – from one country to another – due to the tightly integrated financial markets, and the reserve currency of these markets – dollar.

Interesting Reads – 17th Jan 2009

I read a lot of interesting stuff during the week, but most of it was discouraging and sombre. However, such are the times. If nothing, I think – our intellect sharpens during a down-turn. People are in a reflective mood, and do a lot of reading and soul-searching.

Here are some good posts that I read last week:

1. Recession will last till Dec 2009: Nouriel Roubini – Nouriel Roubini’s economic prediction- be prepared to get depressed.

2. Where to find best Auto and Home Insurance Rates by Moolanomy: Great tips to find great prices for insurance.

3. Debt Reduction Technique by No Credit Needed: No Credit Needed talks about Dave Ramsey’s famous debt reduction technique.

4. 50 Tips to Save Money on a Vacation by Money Ning: Money Ning has some great tips on saving money on vacations – both domestic and foreign.

5. The next bubble is in bond markets by Trading Goddess: This is more of a developing story, and I suspect we will hear a lot about a bubble forming in bond markets, as we progress through the year.

6. Good Debt, Bad Debt by The Smarter Wallet: We all have debt in some form or the other, and this great post looks at which debts pay off, and which ones leave you poorer.

7.  Increase Credit Card Savings by The Digerati Life: Smarter Ways to use your credit card in this intensive post.

8. Household expenses through the roof by Vilkri: Vilkri presents an interesting conversation about debt, household expenses, and the recession.

9. Stock Market bottom by My Wealth Builder: My Wealth Builder talks about the signs of stock market bottom. It is an interesting post that talks about the signs that come with a bottoming market.

10. Credit Card losses at Citibank by Plugged In Finance: Plugged in Finance talks about credit card losses at Citibank, and when they are likely to peak. I have been interested in this topic for quite some time now, and this is quite a good discussion at Plugged In Finance.

11. Greed or No Greed by Lazy Man and Money: Lazy Man has this interesting post on Greed, Stock Buyers and our goals. Makes for an intersting reading.

Are you at the same wavelength as your financial advisor?

A friend of mine was kind enough to send me a report by an Investment Bank, that had their top Indian stock picks for 2009.

The report lists out each stock pick, and the rationale behind selecting it.

I present one rationale here – the difference between the price of the stock pick, and another industry bell-weather is greater than 20% (the other one is higher). Traditionally, this difference has always been less than 10%, and so the stock is undervalued.

To take an example – Apple has always been around four times the price of Microsoft, and today Apple is just thrice the price of Microsoft. That makes – Apple – an undervalued stock.

Granted, this is just one of the several reasons they give, but, to me, this is absurd at so many levels – that it made me close the report itself.

The most obvious question is what makes the analyst think – this stock is undervalued? Why isn’t the other stock overvalued? Why not short that stock, instead of buying this one?

All of us take a lot of advice from a lot of different people. We read investment books, watch financial news, read investment journals, watch videos on Youtube, listen to friends who are in the industry, and of course in boom markets – we take stock advice from the postman as well.

While it is easy to dismiss investment advice from the postman, it isn’t always so easy to dismiss advice doled out by “experts”  – who make a living out of trading and investing – day in and day out.

Most of the time, this is because we are not able to question the opinions. For instance, I do not have access to the investment analyst who wrote the report, and ask him why the other stock isn’t overvalued?

If I think about the statement a few times, and start rationalizing it, pretty soon I will understand what he or she is saying, and start agreeing with it. That is primarily because I am overawed by the name of the Investment Bank that is printed on the report, and the analyst attended a B-School that summarily rejected me.

But I will not do that: I have learned from my mistakes, and learnt that the worst thing you can do is to follow advice of people who are not at the same wavelength as you. If you follow such advice – you lose a lot of money at the end of it, and feel like a fool for not listening to your own instinct.

Whoever you take your financial advice – should be at the same wavelength as you. You should clearly understand what he or she is saying, and not buy into their stories because of the logo of their firm, or the brand of the college they graduated out of.

At the end of it, you may well find out there are only two or three people who you listen to – but if you follow your gut, you will not regret it. This doesn’t mean you stop listening to disagreeing opinions, if you do that, then, that is the end of your intellectual growth. But, at some point you have to draw the line, and say – this just doesn’t make sense.

Investing is common sense and patience – and if someone behaves, as if you are too dumb to understand why a butterfly spread is good for your portfolio – you need to replace that someone.

Do not use a Leveraged ETF for Hedging

When I read about a – Leveraged ETF, for the first time – I wondered – who will be interested in such a product?

Leveraged ETF is: too fancy a product for long-term investors, or even other ordinary investors. I think a person who can be interested in an ETF, that is good, only, for a day (and understand that fact) should be sophisticated enough to buy derivative options himself, and create a similar product. This will save a lot of costs, and will certainly be a lot more exciting, than simply buying an ETF.

Hedging with a Leveraged ETF

Then I came across this interesting question in The Dividend Guy’s website – Could you hold 75% of your portfolio in stocks, and buy 3X Leverage Funds that short the market?

So, theoretically, you have 3/4th of your portfolio in common stocks, and 1/4th of your portfolio is invested in a product that shorts the market 3 times.

While, the idea itself is good, the daily nature of Leveraged ETFs do not allow them to be the right tool to execute this strategy.

A Leveraged ETF uses daily leverage and that is what makes all the difference – Daily Leverage. Let me take an example of how this would work:

Suppose, we have an Index and it moves in the following manner:

Day 1, Index Value – 1000

Day 2, Index Value – 1050 (Gain of 5%)

Day 3, Index Value – 1000 (Loss of 4.76%)

An ordinary ETF will give you no profit, no loss – in such a situation.

However a Leveraged ETF, that  needs to lever itself every day will move in a different manner. A 3X fund will gain 15% on the first day, and then lose 14.28% (4.76 x 3) in the second day.

Here is how it will look:

Day 1, Index Fund – 1000

Day 2, Gain of 15% on 1000    – 1150

Day 3, Loss of 14.28% of 1150 – 985.78

So, even though the market didn’t move at all – you stand to lose money on your investment.

When looked at it from a Hedging perspective – your portfolio of stocks has netted you no gain, but, your Leveraged ETF has caused you a loss.

That makes this product really bad for hedging. Unless, of course – you have the time and ability to counter the daily leverage, and balance your ETF investment daily.

What else can you do with a Leveraged ETF?

You can lose a lot of money.

This product is not for any investor – who wants to hold their money in a derivative instrument for more than a week.

I share the same skepticism as Invest Skeptically, when it comes to this new product. The fee is high, tracking error should be high (although I don’t have data on this), it is a leveraged product – so there is a risk that the counter – party will default, and it is too complicated a financial product; to execute it successfully, and without losing a lot of money.

Buying Gold to protect yourself from the Dollar

There has been a lot of discussion about an imminent fall in the value of the dollar. Even I feel that the dollar will fall considerably in value; but not collapse completely.

The only thing that makes me a little unsure about the dollar fall is – that everyone expects it. I have not heard a single person say that the dollar will not fall.

Normally, the markets never do what everyone expects it to do. If you have a link that talks about the dollar remaining strong – please do send it my way.

The other day, I was talking to a friend who is an analyst at a Hedge Fund, and he gave me an interesting idea of betting against the dollar.

Buying – Out of Money Call Options – of Gold Stocks

There is no other currency that can replace the dollar in the current scenario. In such a situation if countries and individuals were to look for safety – they will invariably turn towards gold.

There are a lot of ways of investing in gold, and buying – call options – in gold stocks is one of them. Out of the Money – options are cheap (subject of another post) and so your initial investment will be very less.

In order to play this bet – the call should have an expiry of an year or more than that. If in that time – Gold doesn’t rise considerably – your investment will be reduced to zero. If gold does rise considerably, then you will stand to gain substantially on your investment.

You can play this strategy on the call option of something like – SPDR Gold Shares (Symbol:GLD). This is a link to see the call option prices which expire on Jan 2011 (two years from now).

The things that I like about this strategy:

1. The initial investment is low so even if the widely predicted fall in dollar doesn’t happen, the loss is limited.

2. Gold prices may still go up – even without a fall in dollar prices.

The things that I don’t like about this strategy:

1.  It is not easy to understand the fair value of a option, and, you can always end up paying much more than an option is worth.

2. Options are inherently riskier than most other assets.

3. Everyone is talking about a dollar collapse and a gold rise – so it may not happen at all.

This idea may or may not make me money, but I really like it. The reason for that is that it is an ingenious way of thinking about:

  • Who will incur a loss?
  • Who will profit from this loss?
  • How can I profit from this loss, with the minimum risk?

These three rules are quite simple and provide an excellent framework for thinking about any investment idea.

Note: I am not a financial adviser and you should consider that options investing is inherently dangerous and not meant for most ordinary investors.

What is an Out of The Money Option?

The world of finance is littered with jargon, and can get quite intimidating – even for pros. Most of this jargon stands for very simple concepts.

What makes it so obscure – is that you need to understand at least three or four different terms to make sense out of any one of them.

For this post – I will take a type of Option – Out of the Money Option – to explain what I mean.

To understand what – Out of the Money Option – means you need to understand at least the following terms:

  1. Strike Price
  2. Market Price
  3. Call Option
  4. Options and Derivatives

Out of the Money Option

An Out of the Money Option (OTM) is a Call Option whose strike price is greater than the market price, or, a Put Option, whose strike price is less than the market price.

So, the next obvious question is – What is a strike price?

Strike Price

Options are contracts that give the holder of the contract – the option to buy or sell a security. The price at which the holder can buy or sell a security is known as: Strike Price.

For example – If gas at the pump is 4 dollars today (Jan 2009), and I sign a contract with a gas station to let me fill gas at 4 dollars in Jan 2011- 4 dollars is the strike price.

Market Price

Market Price is simply the price of the underlying asset on the date the contract is traded. In our example – the market price is 4 dollars.

Call Option

A Call Option is a derivatives contract that allows the holder of the contract to buy the underlying asset. Our gas example is an example of a Call Option.

So, that means if gas is at 4 dollars today, and I hold a Call Option to buy gas at 5 dollars (strike price) in the future – I hold an – Out of the Money Call Option.

The strike price of the call option is greater than the market price.

Options and Derivatives

Options are simply contracts that give the writer of the contract – an option to either buy or sell a security at a future date. An option to buy a security is a Call Option. An option to sell a security is Put Option.

Options are one form of Derivatives.

Derivatives are a type of contract whose value is based on the value of some other asset. In short the value of the derivative will rise and fall with the value of the underlying asset.

For example – you can get into a contract with your teenage son on the length of his hair and his allowance. If the length of his hair increases – you reduce his allowance and vice-versa.

The allowance will then be a derivative – whose value will be based on the length of teenage son’s hair. Your son’s hair becomes the underlying asset.

The kind of Options that you can write is only limited by your imagination. You can look at the this Yahoo Finance link to see the kind of common Option contracts that are traded.

Decoupling

Decoupling – has different meanings in different contexts.  The term has its origins in Physics, and is used to describe the lack of interaction between two particles.

In the context of Economics; especially emerging economies – Decoupling was the phenomenon, where – the emerging economies were insulated from the slowdown in growth of US and other Western Countries.

When the going was good, everyone talked about how emerging economies, and especially India was decoupled from the US.

A lot of people in India were convinced of this because most of the Indian growth comes out of domestic demand.

India is very different from China, when it comes to its engine of growth. Exports form roughly 40% of China’s GDP, whereas they form only 22% of India’s GDP.

That is the main reason why you hear of a lot of factories closing down in China, but, not so much bad news was coming out of India until recently.

But now – with one of the biggest corporate frauds getting discovered – in India, and the existence of one of its biggest IT companies getting threatened – the news may well start to worsen.

The NYTimes has this great story which clearly outlines what exposed the fraud, and how all the economies are tightly integrated with each other today.

Essentially, as the recession deepened in the US – American hedge funds and other institutional investors sold their assets in India (and the rest of the world) – and so the stock markets came reeling down across the globe.

The Indian stock market is down – more than 60% from its highs. When the stock market came down – the source of funds that was fueling the gap between Satyam’s (the company in the center of the storm) actual and reported numbers was plugged. This source of funds was the promoter’s own money. He had pledged his own stock in the company with banks – against which he was borrowing money, and pumping it in the company.

When the market plunged – the banks that held these shares sold them off, and the promoter was no longer able to pump in the money required to hide the gap.

Thus the global credit crisis brought forth India’s biggest corporate fraud till date.

Decoupled – no more.

Interesting Reads – January 10th 2009

I have just been back from a long vacation in India and did quite a bit of reading this week. As far as I am concerned the main news has been the downfall of Mr. Raju and what is now being called as India’s Enron – The Accounting Fraud at Satyam.

I haven’t ever read any corporate confession, but the letter that Mr. Raju sent in to the Satyam board has got to be one of the most poignant and gripping confession letters of all time. Have a read if you will.

There have been quite a few other interesting reads, and I list some of them here:

  1. Ten Mortgage Tips from Plugged in Finance: Plugged in Finance writes about ten great tips that have been learnt over the years.
  2. Socially Responsible Investing from Moolanomy: Here is something you don’t hear a lot about – Socially Responsible Investing.
  3. Ten Facts about Bankruptcy from USA in Debt: Times are tough and this advice may be helpful to a few unlucky.
  4. Penny Jobs discusses the Buy and Hold Strategy: Always good to hear the other side of the argument.
  5. Where did the 2008 Losses go by My Wealth Builder: A lot of people have lost a lot of money last year. A discussion on where this money went.
  6. Studying Business Cycles by The Digerati Life: One of my favorite blogs on business cycles.
  7. Investing with small amounts – Stocks or Mutual Funds by Sun: Be sure to read this post and specially the comments on it.
  8. 20 Tips on Being Successful in the New Year by Lazy Man and Money: An interesting read about success tips.
  9. Tips for keeping the auditors away by Invesmint: With the tax season setting in, this post makes a useful read.

And finally, you know you are in a recession: When the porn industry asks for a bailout.

Why, Why, Why?

During my college days, I once asked my English professor – Mr. Pramesh Ratnakar to recommend a book that will help me develop my intellect.

Professor Ratnakar didn’t refer any book, but he did give me the most valuable lesson of my life. He said that there is only one way to develop your intellect, and that is by questioning everything, and getting to the bottom of everything.

Keep asking – Why? – till you understand everything.

At that time – I promptly ignored the advise, went to the library, and picked up – War and Peace. After struggling with the classic for a week – I returned it.

It was easier to ask whys than understand Tolstoy. So I started asking Whys, and the habit developed. It is a great habit, and questioning everything; getting answers, and then questioning those answers is the best advice I ever got.

Unfortunately, for me, I don’t ask enough whys.

As I read about one of the biggest corporate frauds in India, it reminded me, that I hadn’t asked enough whys. There were a lot of symptoms of the trouble that was brewing.

Why did the promoter want to buy a stake in his son’s company – when it was apparent that the whole deal will blow up?

Why did the company have so much cash on low yielding current accounts?

How did the company declare great profits – quarter after quarter – when other companies were struggling?

These are just some questions, among a lot others, and in hindsight – everything falls in place perfectly.

Question everything, find answers, and then question the answers. Better than reading Tolstoy.

What is a Ponzi Scheme?

Charles Ponzi came to US from Italy at the turn of the 20th century and carried out one of the  biggest financial frauds of that time.

His initial scheme revolved around arbitraging international reply coupons and soon evolved into an elaborate financial fraud. More recently the term has been popularised by Bernie Madoff and his investment fraud which amounted to a massive $50 billion dollars!

What is a Ponzi Scheme?

Suppose you are a fund manager and 10 people invest 100 dollars each with you. That means your investment fund has got a 1000 dollars.

You do nothing with these 1000 dollars and at the end of the year – you declare 20% profits, and distribute 200 dollars to your investors.

Lured by your success – 10 more people invest 100 dollars each with you.  Now you have – 1000 dollars more, as well as the remaining 800 dollars.

At the end of the second year – you declare 20% profits again, and distribute 400 dollars to your shareholders.

So now you are left with just 1400 dollars (2000 – 200 – 400).

But that doesn’t matter because you have such a great record – that now twenty more people invest 100 dollars each with you – and you have 2000 new dollars.

So that means you have a total of 40 investors; who have invested 4000 dollars with you. But the money that you really have with you just amounts to 3400 dollars.

You are a total fake, but that won’t be exposed till the time you can raise more money than you have to repay. You can continue raising money because you have such a great track record.

The real problem will occur when all, or at least a majority of your investors need cash at the same time. When that happens – you will have no place to hide. Your scheme will be exposed for what it really is – a scam.

People who have run Ponzi schemes successfully for any length of time are usually very charismatic and appear trustworthy.

This characteristic attracts other people to them, and it takes a while to expose them. Unfortunately, the longer it takes to expose such fraudsters – the bigger the fund grows. The bigger the fund grows – the more pain it causes.