GalaTime

It’s the end of the world as we know it. Or not.

Both my exit conditions for the Long Sensex/Nifty, Short Gold trade occurred almost on the same day:

Exit the whole position if the Nifty crosses 4600 and/or gold drops below 12000

The US markets jumped almost 3%, Indian markets were up over 2% in the morning, the Nifty crossed 4600 (but gave up most of the gains) and GOLDBEES hit a low of 1206. So, let’s look at the final performance:

• Bought Nifty future @ 3829, sold @ ~ 4600, net +20% profit
• Shorted GoldBeES @ 1361, bought back @ ~1210, net +11% profit (again, this is not executable due to short-sale rules, but you can do the same trade on MCX gold futures instead)
  • On July 16, the MCX September GoldM (mini gold) future closed at 13396, today’s low was 12082.
  • Spot gold prices in India dropped below 12000 per 10 gms, down to ~ 11850.

By most standards, a 31% gain is good even across a year, let alone in 3 weeks! And more importantly, this involved an index (and hence lower risk), not a small/mid cap stock.

The key to such trades:

• Patience
• Keeping your powder dry (i.e. have enough capital ready, know which instruments to trade, and where/how)
• The willingness to bet large sums once such ‘low frequency, high probability trades’ set up
• Exiting the position as soon as the original (entry) logic ceases to apply

There may be another opportunity available soon - will write about it in the next few days.

July 16: Buy Sensex, Sell Gold

Buy Sensex (or Nifty via NIFTYBEES) and sell gold (short GOLDBEES - in theory - or short a gold future).

July 23: Update: Sensex vs. Gold trade, 23% in a week

A long position on the Nifty future would be up 17% (Sensex up 19%). A short position on gold would have made 6.5%. That’s a total return of 23%+ in a week.

Today (Aug 5): Nifty future @ 4530 (up 18% from July 16) and GOLDBEES @ 1214 (down 11% from July 16) - that’s a net return of 29% over 3 weeks.

As for exits, here was my plan:

Book partial profits.

Exit the whole position if the Nifty crosses 4600 and/or gold drops below 12000

Note that with the sharp correction underway in crude oil and industrial metals, gold has also dropped quite a bit, and the GOLDBEES gold ETF is close to breaking below 1200.

This was an example of a ‘low frequency, high probability’ trade; one which does not set up too often, but when it does, has a very good chance of working out (and relatively less risk).

• Reuters: Lehman sounds alarm; commods indices near $300 bln

This year’s explosion in commodity investments suggests investors may be overlooking volatility for performance as they pile into index funds that have amassed almost $300 billion, Lehman Brothers said.

“we also find a potentially alarming degree of past performance-chasing momentum.”

“commodity indices are somewhat peculiar in that they allow investors a long-term view of commodities through short-term rolling instruments.”

The last asset class that was ‘performance-chased’ by investors was emerging equities, in late 2007. We all know what happened afterwards.

• Reuters: Gold options point to $1,200

Heavy bets in deep out-of-the-money calls and other bullish plays in the gold options market indicate bullion has a shot at rallying to an all-time peak of $1,200 an ounce by the end of the year.

. . . many option investors were currently adjusting positions after gold’s sharp fall but he saw recent strong volume of December $1,000 calls, bull call spreads between $1,200 and $1,300, and the selling of put options — all of which are betting that gold will rise further.

. . . gold’s current implied volatility was about 36, sharply above the long-term average in the low 20s.

• Mint: Sensex, Nifty firms surprise analysts who say good run won’t last

. . . adjusted net profit of the Sensex companies rose 15.85% in the June quarter. For the firms that constitute the National Stock Exchange’s broad-based Nifty index, it rose 12.24%.

“The real slowdown began in May as the industrial production data shows. Around the same time, tightening of monetary policy also started. We will see the impact in the next quarter—considerably lower sales and net profit growth,”

Excluding the two oil firms, the earnings growth during June quarter for the Sensex firms would have slumped to 8.87%, lower than 11.20% growth seen in the quarter ended 31 March.

• Hindu Business Line: Why the Sensex fall is overdone

Savings in India have risen at a historic rate of 35 per cent on the growing GDP base; 17 per cent of this is in gold, commodities and real-estate while financial savings represent 18 per cent of GDP. Even this is skewed towards deposits — both banking and non-banking, while the percentage of savings in shares and debentures is a mere 6.3 per cent. If this percentage goes to 25 per cent, it would amount to $40 billion of incremental money being diverted to capital markets.

Assuming a GDP growth rate of 8 per cent, earnings growth of 28-30 per cent for Sensex companies and an interest rate of 7.5-8 per cent, the average earnings per share of Sensex companies can be estimated at Rs 1,300 for FY 2009 on a free-float basis. A price-earnings ratio of 18-20 on this EPS gives us a Sensex estimate of 23,400 to 26,000 for FY09.

WTF? There are so many issues built into these assumptions that I don’t even know where to start! All I can say is - good luck if your job depends on it!

• IMF: What Goes Up Must Come Down? House Price Dynamics in the United States

. . . home prices were undervalued in the 1990s, but overshot equilibrium in 2000 and remain overvalued despite recent declines. In our best judgment, single-family home prices as measured by the OFHEO purchase-only index were around 14 percent above equilibrium in the first quarter of 2008, with a plausible range of 8 to 20 percent.

. . . found inventory-to-sales ratio to be the most important driver of changes in property values in the short run. Starts in foreclosures, which obviously add to inventory, seem to also exert additional downward pressure on prices.

. . . with the gap between actual and equilibrium home prices playing only a weak anchoring role, the downward momentum could well take home prices considerably below equilibrium.

Given that we have zero data on home prices, rents, inventory, sales, etc. for India, such analysis is impossible. Rely on your gut to estimate whether housing is a worthwhile investment at this point.

• Financial Sense: What’s behind the Slide in Oil and Commodities?

The ECB’s surprise rate hike to 4.25% is greasing the skids under the Dow Jones AIG Commodity Index, which has tumbled -15% below its historic high set on July 2nd, including an -18% slide in the agricultural sector. Nymex coal has plunged by $40 /ton. Most importantly, the year-over-year change in the DJ Commodity Index in US$ terms has dropped in half to 20% in just the past two weeks.

The Bank of Brazil is the world’s top inflation fighter, and has guided its currency, the real, 16% higher against the US dollar from a year ago. As a result, the Dow Jones Commodity Index is only 4% higher than a year ago, in local currency terms. “Having stable prices is the best path to economic growth,” said Henrique Meirelles, Brazil’s central banker. “It is important that the central bank take timely measures so that the country can continue in its course of growth with low inflation,” he said.

Perhaps it’s not the ECB but the markets telling us that there is a big slowdown coming worldwide that will  reduce demand significantly for most (non-agricultural) commodities in the next few months.

Update on last week’s post: Buy Sensex, Sell Gold

Buy Sensex (or Nifty via NIFTYBEES) and sell gold (short GOLDBEES - in theory - or short a gold future).

July 16:

• Sensex closed at 12576, Nifty future closed at 3829
• GOLDBEES closed at 1361

July 23 (today):

• Sensex closed at 14960, Nifty future closed at 4490
• GOLDBEES closed at 1270

A long position on the Nifty future would be up 17% (Sensex up 19%). A short position on gold would have made 6.5%. That’s a total return of 23%+ in a week.

Now, it doesn’t matter whether I was right or plain lucky; the question is - what would be the right thing to do on this trade, given the unexpectedly large return in such a short time frame?

My thoughts:

• Don’t look a gift horse in the mouth - book partial profits immediately!
• Why not exit completely? Because analysis says that we’ve got some more room to go - on both sides of the trade. But with such fast & furious moves, we must expect to give up some profits in the interim.

This type of (oversold/overbought) trade allows a data-driven approach to identify a good entry point. But the best exit point is difficult to determine - at what point do the Sensex/Nifty no longer count as oversold?

I would exit the whole position if the Nifty crosses 4600 and/or gold drops below 12000 - but this is based more on a hunch than anything else.

I think this is an opportune moment for a pair trade: Buy Sensex (or Nifty via NIFTYBEES) and sell gold (short GOLDBEES - in theory - or short a gold future).

Why?

• Indian equities are way oversold (unusually so for 2002-2008 period, except in May ‘04)
• Gold is overbought (but not drastically)
• There’s fairly high levels of fear in capital markets (NSE VIX has remained above 30 for a while, and spiked to 49 yesterday)
• My historical analysis shows that the performance of the Sensex-Gold pair is close to a turning point
• Because no one else’s crazy enough to do it!

I admit that this may be a bit early (say 5-10% more to go on each side), but if I look at a time frame of ~2 months, this pair trade looks mighty attractive.

• Bloomberg: Vietnam Dong Investors Use Black Market; Traders See 18% Drop

Vietnam’s currency controls are forcing foreign investors into the black market to obtain dollars, aggravating declines in the world’s worst-performing stock market and pushing benchmark bond yields above 20 percent. The dong dropped 5 percent to 16,846 per dollar, its biggest decline since 1998. Traders are pricing in an 18 percent drop in the coming year to 20,600, according to offshore 12- month non-deliverable forwards.

Vietnam may suffer a “currency crisis” similar to the slump in the Thai baht that triggered the regional collapse in 1997, Morgan Stanley analysts said in a report last month. “The central bank is not providing dollars, except to some importers and some working capital for exporters”. The risk is Vietnam exhausts its currency reserves of $22 billion supplying dollars or that “overkill” in cooling growth causes losses at state banks.

With Vietnam & India being thought of in similar (economic) terms, it’s worthwhile to pay attention to what the consequences can be.

• DNA: Sebi nod for big-ticket IPOs lapses

The proposed Rs 1,000 crore-plus initial public offerings by Acme Tele Power, Jaiprakash Hydro Venture and UTI Asset Management Company are shelved for now as these companies have allowed the regulatory approval to lapse. The big three are among the 20 IPOs that have been put on hold owing to the negative sentiment in the stock market.

. . . the lengthened stock market volatility has forced 83 global companies to withdraw their listing plans in the first quarter of 2008. In addition, 24 companies postponed their listings. But some smaller domestic issues of Rs 30-40 crore are still hitting the market.

Note also that most of the IPOs issued in the last 12 months are underwater.

• Mint: Sensex can go below 10,000: Sharma

It was an easy call. In this bull run, India was termed an asset class. We were starting to think of ourselves as very special. I started getting worried when such rubbish started going around. India is not any asset class; it is only one of the markets. This kind of euphoric situation can last only for a while. In 2007, every Tom, Dick and Harry could think of making a billion-dollar personal fortune. Employees across industries were getting salaries which were not justified even at the peak of any cycle in the US. It was getting ridiculous—wage inflation, asset inflation. If one had stepped back and viewed it dispassionately, it was quiet easy to figure out.

The maximum downside one had seen in India was about 35% in a year in 2000. We have breached that already by the middle of the year. Now we are entering a situation where long-held theories can be thrown out of the window. We could be down another 30-40% from here. I would not be surprised at all to find Sensex below 10,000. When we made an initial target (for the index) it was based on other factors and the run-away inflation was not in sight. If we factor it in that, the trouble gets compounded.

When the Sensex was at 21000, we saw people predicting 25000, 27000 and so on. Now, we are talking 10000 and below. Linear extrapolation can lead to sub-par results.

And saying that this big drop was obvious is a bit of 20/20 hindsight - coz the key is timing. Even at 5000, the Nifty could be considered over-valued by historical measures, but it went to 6300!

• New Scientist: ‘Gordon Gekko’ trading bot profits from mood swings

Vytelingum has developed a new trading program that can adjust how aggressively it trades to match market conditions . . .

The new agent responds to market changes in two ways. Firstly, it can change its aggressiveness by monitoring other traders’ behaviour. If other traders are being aggressive – for example, by attempting to undercut others – it raises its game to trade even more aggressively. If trading is less competitive, the software acts less aggressively and calmly aims for the biggest profits available.

Secondly, the software can also use past market trends to try to forecast future conditions. If a period of volatility seems likely, the software changes its behaviour more frequently, meaning it is more likely to be ready to exploit any sudden switches in conditions.

• Business Standard: Rupee plunges on capital outflows

While most dealers said they did not see a compelling reason for RBI to move to the fringes, a few of them said RBI did not want to supply dollars because the fall was mostly because of offshore-onshore arbitrage. It is likely that the central bank may be expecting rupee to climb back once the arbitrage window shrinks.

“Most foreign banks were buying dollars in spot market and selling it offshore. The one-month spread was about 25 paise in the NDF (non-deliverable forward) market,” said a dealer with a European bank. According to dealers, very large UK and US banks were major buyers of dollars today.

Note that FIIs were net buyers in equities yesterday. As were DIIs. Was it the retail guy throwing in the towel?

• DNA: The end — or the beginning — for the markets?

One pink paper has stopped publishing pictures of good looking models on the front pages which are totally irrelevant to their articles. Sadly, they no longer write those humorous articles about how market capitalisation has made India such a powerful nation.

TV channels no longer have cheerleaders waving each time the Sensex surges by 1,000 points —- there is no surge left in the market. The market is heading the other way —-solidly south. Ladies and gentlemen, I am sorry to announce the death of ‘India Resurgent’.The one billion people living in this country seemed to have rolled over and died. All of them.No one is buying any more cars, two-wheelers, mobile phones, TVs, homes, clothes, food or medicine.The 1 billion people have frozen.There is no global warming here —- we are in the Ice Age.

FWIW, I think we are way oversold and overdue for a fast & furious ‘clearing rally’. Have bought some Nifty futures to put some skin in the game. Net short though, via naked calls.

• Business Standard: FCCB shadow looms over corporate profits

Several companies that have issued foreign currency convertible bonds (FCCBs) face the prospect of not having these bonds converted into equity unless the stock markets stage a strong comeback. This implies that these corporations may have to pay back the amounts they borrowed together with the interest.

What could compound the problem is that many of these firms do not account for the debt. In other words, they are not providing for the borrowings on an annual basis over the life of the instrument. According to a study by a leading brokerage, accounting for the loan and the interest would, on an average, knock off at least 12% of the profits in FY09 and about 10% in FY10.

It was less than 6 months ago that FCCBs were helping these fine folks make a bunch of moolah. So, make profits on the way up, and dont account for it on the way down. Nice deal if you can get it!

• Mint: Companies shelve capital market plans

The meltdown in the equity markets has taken its toll on the capital raising plans of Indian firms. Investment bankers estimate that at least 13 Indian companies have stalled plans of raising nearly Rs25,000 crore from the equity markets and say this could just be the beginning of the trend.”

Most of the Indian firms that have scrapped their plans were planning qualified institutional placement (QIP)—a kind of private placement that listed companies can make to a set of institutional buyers such as banks, mutual funds, insurance companies, foreign investors and venture capital funds.

The cost of borrowing for Indian firms has gone up from 100 basis points over the six-month London inter-bank offered rate (Libor) to 400-500 basis points over Libor over the past six months.

• Economic Times: Nifty at 6950, Sensex 22880 by July 2008

There is a clear-cut demarcation in the earlier bull phases of 1992 and 2000 and the current bull phase. The earlier bull phases were more or less driven by a handful of market operators who eventually got crushed under their huge outstanding positions.

The age-old concepts of stock valuation have become more or less redundant in view of the structural changes in the market mechanism. As long as the flow of funds remains intact and the settlement in derivative segment continues to be “cash settled”, there is no threat whatsoever to the ongoing bull phase.

This time, its different. Cash flows don’t matter. Valuations dont matter. Common sense is useless!

This would be a good time to do a reality check on stock market predictions. As of market open, the Sensex is at 15200 and the Nifty is at 4550. What is the probability of them meeting these July ‘08 targets?