Tuesday, December 25, 2007

Stock Market 1

I love when people say that putting money in stock market is like gambling. It’s amusing when you know the person in front has very little knowledge about what he is talking about and yet there is so much confidence and conviction. That is way it is rightly said "Little knowledge is dangerous". Well I will present before you the truest picture and it will be up to you to go ahead or drop the idea.

We start with an analogy.

Let’s look at the game of poker. What can be a better example of gambling than poker? I won’t go into trivialities of the game and probability and all the deep stuff. All I will touch is that the fact is poker is a Zero sum game. By Zero sum game I mean that whatever someone wins, someone somewhere loses. So it is a pure competition. Either you are a sucker or either you are a winner. So if a poker game begins where there are 8 players with 1000 each. So there is 8000 rupees on the table. That means there is 8000 rupees to be lost and 8000 to be won. So far it is good. Now let’s introduce a game and we call it “magic poker”. In this game we introduce a magical rule. There will be a magical pot in the centre which will create money somehow and that will be distributed in each round which is played. So say 100 rupees is created in each round. If 40 rounds are played we get 4000 more. One more thing to notice is that this money goes into the center pool where bets are placed. If you are not playing the game and taking the risk, you can’t lay your hands on this created money. Savvy. In this magical wonderful game the longer you stay (i.e. more rounds are played) the more money is created and you can walk out with more of it. There will be 12000 to be won and 8000 of people’s money to be lost. Clearly this is not a zero sum game because there can be a scenario where everyone is a winner. But you will always win more than you lose in the long term. Yeah I know you certainly want to play a game like this. Sadly this type of game doesn’t exist. But that is what most people think, but if you have read my past 3 money posts, you must have figured out what I am talking. This is why I laid so much stress to explain how money is created. Because when I will tell you Stock Market is kind of a magic poker game you won’t raise the eyebrow and shout “Hey! Money is never created”.

Now the question arises how stock market has a central money creation pot. Answer is The Companies. I don’t know that someone has told you this or not but the Companies create money more than anything else. All the companies together form that magical pot which creates the money. The amount of money created is profit which the companies earn. Gross profit or net profit? Answer is somewhere between them. You cannot calculate depreciation of the infrastructure used to produce. So you cannot find the exact figure because depreciation is always estimated based on theory. (We will talk more about this as we go on, role of debt creation, banking and all but right know this is all you need to know). Now another question how this money created in random manner comes back to the central table where bets are placed? Now that is the right question and answer is Savings, Investment and Dividends. A company can do these 3 major things with their profit.
First they can save and put that money in banks. These banks can invest this money back in the stock market(Or the central pool at table of magic poker) and at the same time issue loans equivalent to this amount to people, earning interest from it and returns from the stock market at the same time. (That’s why I love banking stocks).
Secondly, company re-invests this money into Greenfield projects which creates demand for jobs and products. The people earning through these projects save their money in banks, mutual funds, insurance companies, real estate and these in turn invest that money into stock market. You can see real estate and stock market are competitors in drawing the money from people and have their own cycles. We will see that later.

Thirdly, dividends are distributed to people who save those in banks or reinvest in stock market. Thus again the money is driven to stock market.

One important thing you will see that the money saved goes into the stock market. But what about the money spent. Money spending also has a very important role. When this created money is spent on different products, this increases the demand for the companies that are producing it. This additional demand ensures that the profit growth is there so that there is more money created the next year. If this money is not spent through investment and spending on buying products, there will be no profit growth and magical compounding effect will not take place. So you see the role of spending is also very important for the sustainability of the companies that comprises of stock market.
In short the profits (money creation) are life blood of Stock Markets. To be continued……

I hope it was useful. Any questions are most welcome.

Wednesday, December 19, 2007

Money 3

I once went to a guitar lesson to learn a song in my school. But they started with all the strange things like first learn to play Sa Re Ga Ma and all that kind of stuff. I got impatient and left the idea all together. Because I thought why should I learn all the gibberish when I want to just play few songs? In short I gave up, something I do often. Now I know that I went there to learn how to play the song on guitar and not to learn the guitar. What will you do when at later date you unfortunately like more songs. Will you go every time to be coached for a song. Its always wise to make a system that is sustainable. I recalled this incident because the above incident is an analogy of stock market. Learning the song is like Earning Money. Sa Re Ga Ma is all the theoretical knowledge. Yet people never learn the Sa Re Ga Ma of the market and seek advice every time they want to learn a song(Earn Money). That is the reason of their downfall. Advices are free and always be cautious of those things that come free because there is always a huge price attached to it( This Blog is also free but as you see there will be no advice. So everything is up to you to believe or not). You must know how to improvise. when a different/tough song (different/tough situation in stock market) comes up to you, you must be well aware to improvise yourself for that. That is why you must learn the Sa Re Ga Ma of the stock market before we can jump into reality. Trust me, end result will be very satisfying and you will say that this is too simple. But like many things in life, most of the things are simple. It is our non-belief in simplicity which makes life complex.

Continued from Money 2

We start with another example. Let’s assume you and me are trapped on an island (Yeah It will be really depressing if you happen to be a guy. Forget that part please). Now we have 2 rupee each (I am talking about currency). So as Money part 1 says we both start producing something and convert that currency into money. Let’s say that you start climbing trees and bring coconut and I started catching fish. One fine day you bought a fish from me. So now I have 3 rupees and 1 rupee. But you being more intelligent come up with a recipe involving both fish and coconut, call Cocfish. You price it at 3 Rs. I bought it because it is very delicious.
Now you have 4 Rs and I have zero. I start to work hard and produce 3 fish for every CocFish you produce. Of course we are transacting through currency. After five days I sold 15 fish and you sold 5 Cocfish to me. But if you had produced 15 coconut also then you have extra 5 Cocfish, you ate rest 5. That is you have goods worth 15 rupees. Now since I am working hard I start to eat 2 Cocfish everyday. Since we don’t have the currency. So you come up with concept of debt. Next 5 days I bought 10 Cocfish and sold 15 fish. So I am in debt of 15 Rs and you have 15 Rs in account. Ofcourse this is on paper but you know that I am addicted to Cocfish and will pay for it in future or you took from me the CD of Resident Evil as collateral. As you can see you don’t have to work for next 10 days (you used 5 for Cocfish) and live off eating fish and on the other hand I have to work my ass off to pay my debt off. We should halt here and review the whole thing now.
You can see from the above example that we started with currency worth Rs 4 and in the end you had 15 Rs in account. How is this possible? Where this 11 Rs came from? Now you shouldn’t be astonished because you know that you created this money because of your ingenious recipe of Cocfish. You can see value of creation as 1 Rs per Cocfish as fish and coconut was worth 2 rs and you sold it at 3 Rs. Now its is getting ugly but stay with me. You had 15 Rs even when you had 5 Cocfish. But that was hidden form of money. What we say “Net worth”. But when I took the debt from you, you converted that hidden worth into a mathematical figure on the ledger and to enforce it you took my precious Resident Evil CD. This mathematical figure is as good as currency and it exists because we have only 4 Rs in currency form. So you see the money is continually created and converted into mathematical figure and mathematical figure is continually converted into net worth. Mathematical figure can be created into networth when I can’t repay your debt and you keep my precious CD.

Now lets come to real life. It is evident that currency is less than the total mathematical figure we have in our accounts all over the world. So currency is not even close to be equal to money in mathematical form yet alone leave the net worth( in form of real estate and stock market and etc) and since we are able to delink currency from money, it is easy to understand that money is continuously created and stored in the form of net worth and mathematical numbers in the banks which has no physical equivalent but just faith and promise from banks that when you will need the cash you will get it. But if everyone out there ask for their money, banks will not be able to give you the required currency.

In island example you converted Cocfish into currency when you lend money to me and by doing it you converted your net worth of 15Rs in Cocfish form into mathematical number in ledger which can be turned into currency. Think about it, it is sublime and beautiful. These concepts are testimony to the power of thinking. to be continued.....
Go to Money 4 or Go to Money 2

Please leave your comments as it is always better to discuss things rather than one sided conversation.

Thursday, December 6, 2007

MONEY - part 2

This is the continuation of Money part 1 which is two post down. I am assuming that you were not able to grasp the creation concept so I will try to explain it in more plain manner. It is because before I can tell you anything about stock market or anything else this concept should be assimilated completely.

What is it that everyone gives and none takes?.....................ADVICE. So I can safely assume that whatever advice I am going to give you, you are not going to take it. So in all my post I will only give you facts and inferences. No advice. Infact if there are one or two then you can safely ignore it. There are lots of professional out there to give you those. What I will try to tell you is the fundamentals of concept called money. You should notice that I call money a concept. Because it is a concept and it is not physical. Currency is physical incarnation of money. Non-physical incarnation of Money is Idea, Time and few more things. We will take all of them one by one. So you should know the difference. If you are still confused then go to my ‘Money’ post for the difference between currency and money. I know I confused you but just forget the last few sentences and start afresh.

How money is created.? So we start with an example straight away. Lets take the example of Google and a writer. Lets take 2 universe. Universe 1- there is no Google. Universe – 2 there is Google.
Universe-1 – if there was no Google. How a writer can research his book? He will have to go to the library. Take a cab of 30 Rs each and lets assume he takes 50 trips. That’s 1500 Rs. He will then have to find out the books he need to research from and then search through the contents and indexes and then retrieve what all material he needs. A time consuming process.

Universe-2 – There is Google. Now a writer can research about his books on internet only. He doesn’t have to take a cab. And so he can cut short his number of trips by say 25. So he saves 750 Rs. He pays 500 for internet. And overall he saves 250 and of course ‘Time’ than the first case.

Now in both the Universe we get the book (Forget, the time saved for now, we will come back to it later). But in 2nd universe we have 250 Rs more. So in other words Google created 250 Rs. Now our intelligent readers will point out that hey 250 Rs is currency so currency was created not money. Okk now we convert it into money. We go and buy 25 breads for that. Google created the purchasing power (which is same as money) to buy 25 breads extra. Don’t go into trivialities that what happened to cab driver and all. Here we are focusing on the product called book alone. We get that in the second universe with 25 breads worth of purchasing power extra. So :

Extra purchasing power created while producing the same good = money created.

Money Saved while producing a good = money created.

So if on Monday you produced 10 breads at cost of 10 Rs and on Tuesday you produced the same quantity and quality at the cost of 9 Rs, then you created 1 Rs on Tuesday. And Ofcourse if you produce it at 11 Rs you destroyed 1 Rs. Assuming you sold the bread at the same price on both day. Savvy.

Now don’t think that money saved is money created. I never said that. In that case she could have saved whole 1500Rs by just not writing the book. But that is not money created because we never got the good called Book. It’s the amalgamation of production and saving at the same time is what is called creation of money. You must notice that I have taken only production side and I am assuming that you are able to sell a product at a constant price. There is money creation at the selling side also. Something we call a brand. We will talk about later. To be continued.......

If someone reads this then can he/she tell me if my examples are comprehensible or not. Because I am feeling that maybe they are not. Thank you.

Tuesday, August 14, 2007

Is Indian economy overheating?

Before I start I would like to tell you that this is a humble attempt to explain to you the latest plague that is eating into our marvelous growth story. The plague's name is overheating and the disease carrier is dollars. How? For that you will have to read and understand what I have to say.
Overheating economy is one which has too much domestic demand. That is, when an economy is growing too fast and its productive ability cannot keep up with demand or in Keynesian economics when its productive ability is unable to keep pace with growing aggregate demand. When this happens the excess demand is met with the over employment of the resources. This can be achieved by employing workers for extra shifts or using machinery beyond their recommended working shifts.
There is a simple way to explain the causes. Growth is a function of savings and investment. Savings invested and output produced for each unit of investment is economy’s growth. This investment creates jobs, puts more money into the hands of more people. An economy rapidly growing overtime run short of workers. Employees bid up wages which leads to even more money in hands of people. Example- 1990s IT boom in US. So, extra money creates greater demands for goods and services. Investments typically take time to bear fruit and increase supply at home, so this demand for goods is serviced by importing them. This distorts the current account. And there is a chain reaction but let’s see all this in the Indian context.
You don’t have to be a genius to figure it by yourself that there are strong signs of overheating in this country. Clearly our productive ability is not able to produce enough goods and has resulted into large increase in imports. So, much so the trade deficit has reached a record level. Just take a look at our classic aviation or shipping industry. The infrastructure is bad, the airports and ports are just trying to fulfill the formality of physical existence. A perfect example of sectoral overheating. Result is heavy loses to airline industry and to our export competitiveness (turn around times at port are in days while it is in hours in Singapore).
Even a blind man can tell you how people are stuffed with money today. Suddenly the middle class income has exploded (if you are into economics then monetary aggregate M2 is measure of that). Why? Well, this is because rupee is pumped into the market for every dollar that is coming into India through foreign investment. This , rupee pumping, is done by the RBI to keep it pegged at a desired level set by RBI. So as not to hit our exports. Remember the hardening of rupee is bad for exports. This is precisely the reason our forex reserves are swelling. And as a topping to the cake, there is a manpower crunch hovering over the horizon in all the tier 1 cities. This has compelled companies to go to tier 2 or tier 3 cities for hiring. But you cannot substitute the teir 1 workers, who all have experience and better skill sets. So as a result there is increase in wages. Wage hike in our country is one of the highest in Asia. Of course only in skilled manpower. Above this we have banks. Which till recently have been distributing loans as if there is no tomorrow. The credit expansion by financial institutions has been phenomenal. But what overheating has to do with money and why am I talking about it. Because as earlier said, this money ends in savings and consumption. Savings in turn are invested and we see India flying and India poised campaigns. What happens next will be clear if I will explain about the goods which this money ends buying.
There are two types of goods. One is tradable and other nontradable among countries. As the word suggest tradable goods can be exported during the glut and imported during the shortage. But nontradable can’t. Like - houses, restaurants, hotels. So all the tradable goods (you can substitute tradable goods by importable goods if you want for simplicity), like- mobile phones are not going up in prices fast. But all the nontradable goods prices are reaching dizzying heights ( so if you are into stock markets then choose companies dealing in nontradable goods, the real profits are there). Take hotels for example, they are costlier than the hotels in New York. Real estate has no parallel and all must know it by now. You go on a date with your girlfriend and you will realize what I am talking about.Now coming back to money. Since the money buildup at the consumer level is massive and the nontradable goods are not matching that growth. The result is people are ready to give more for the same good . So there is a mismatch between the price growth of tradable and nontradable goods and our economic fabric is tearing apart . All this leads to high inflation which is bad. How high inflation? Because the prices of the nontradable goods shoots up. What our esteemed government does? They increase the interest rates. Stops pumping rupee in the forex markets or stops buying the excess dollars. This leads to rupee appreciation, rupee hardening, Infosys bleeding and blah-blah.( by the way if you are thinking of 1-year horizon, Infosys is a good bargain at 2000 levels) But all these are short-term measure. The root of the entire problem is Infrastructure. Why? Well remember the productivity talk. Our infrastructure is proving to be a bottleneck in our productivity and until and unless that improves, our productivity will lag demand. So, now you know the reason behind the “300 billion $ investment in infrastructure” talks by our ministers. Infrastructure building takes time but interest rate hardening has a quick but unhealthy effect on the economy. Government is trying both but it needs to put more money into our infrastructure if it wants to bring down the inflation and at the same time jack up growth rate. (If you are planning to buy a cement stock for a long-term perspective then you can because infrastructure needs cement more than anything, accumulate at dips).

So this disease is affecting the star of the Indian growth story, the IT sector. The profit margins are falling and the exports houses are finding it difficult to bear losses. You should know that this is a short-term measure. If government is an iota serious about our IT and export sector then it has to do something about the rupee (yeah ECB restriction was a positive step in that direction but not enough). It should realize that this is just the starting. India has proven itself as a competitive, professional and economical business destination. Dollar is going to flow like monsoon rains and worst of all this monsoon is going to be perennial. That’s why the great Manmohan Singh has proposed fuller convertibility which India will have to embrace sooner or later. It’s not a cure but it is the best shot we have. There is no running from it. Either we have to accept it or watch the jewel corrode under the acidic influence of the Dollar rain.