This Is What Oil at $40 Means for the U.S. Economy

The price of oil has tumbled 58 percent this year to reach a six-year low earlier this week. Even if prices stay at these levels, chances are they won't impact the Federal Reserve's interest-rate plans. 

Seventy percent of economists in a Bloomberg News survey said crude oil prices around $40 per barrel for the next three months would have no impact on the Fed. Of the 30 percent that said it would influence the central bank, the respondents were evenly split between whether it would cause a delay in the first interest-rate increase or slow the hiking path.

The fed funds rate has been at a range of 0-0.25% since the end of 2008 and officials meet September 16-17 to decide whether an interest rate increase is still warranted. New York Fed President William Dudley said Wednesday that the case for raising rates in September is less compelling after recent market volatility. 

Oil sustained around $40 through the end of the year will only put prices further from the Fed's 2 percent target. The median projection of 24 economists is for a deduction of 0.3 percentage point from average, year-over-year CPI this year, which economists forecast at exactly 0.3 percent in a separate survey.

And don't discount the chance of oil prices, as measured by West Texas Intermediate futures, staying at these lows for at least a while. Economists assigned a 65% probability that crude will stay around $40 per barrel through the end of September. Forty percent said it could stay here until the end of the year. And it could get worse; one in three of the economists said oil will fall to as low as $30 a barrel.

While crude has come down far and fast (prices were as high as $61.43 in June), the drop may actually help U.S. growth. Economists say oil prices sustained at the current levels through the end of the year would boost U.S. GDP by 0.2 percentage point. That scenario would have no impact on U.S. exports and global growth.

How Many Hedge Funds Will Die Next Year?

(Answer: A Ton)

by John Rubino on August 24, 2015

For those who keep hearing about hedge funds but aren’t quite sure what they are: Think mutual fund with no rules. A hedge fund is an investment company that can do pretty much anything, from shorting currencies to betting on biotech takeovers to writing credit default swaps.

This kind of freedom, as you can imagine, requires a fair degree of creativity, if not genius, on the part of fund managers. And therein lies the problem. As the concept has gotten popular the number of hedge funds and the money they manage have soared. There are now 11,000 of them running about $3 trillion.

But have we produced 6,000 new super-genius money managers to handle all the extra money? Of course not. As in any other field, the sudden popularity of a concept just sucks in mediocre people from other niches. The result: Massive amounts of hedge fund money chasing pretty much everything, with an emphasis on what went up last year. The momentum trades are insanely crowded, and hedge fund returns in the aggregate have failed to exceed those of, say, an S&P 500 ETF for the past six years.

Yet the money has kept coming:

The Most Fascinating Investing Paradox

(Bloomberg) – Earlier this week, Greg Zuckerman of the Wall Street Journal pointed out one of the great mysteries of today’s investment landscape: Despite underperforming by a substantial margin, hedge funds keep attracting more investors and assets under management. It is almost as if (to borrow the headline on Zuckerman’s article), “Hedge Funds Keep Winning Despite Losing.” He wrote:

Hedge funds aren’t just underperforming against the S&P 500 and other stock indexes. They’re also losing out to low-cost “balanced” mutual funds that hold a mix of stocks and more-conservative investments, just like many hedge funds, suggesting their poor performance can’t be blamed on a hedged approach.

Consider the data: According to HFR, a firm that created indexes to track hedge-fund performance, the average hedge fund gained a mere 3 percent in 2014 versus an 11 percent rise in the Standard & Poor’s 500 Index. That’s hardly worth paying a hedge fund outsized 2 percent management fees plus a 20 percent cut of the profits.

Simon Lack, in his book “Hedge Fund Mirage,” describes why indexes such as those developed by HFR significantly overstate returns. That 3 percent gain last year, or about 7 percent annually since 2009, likely excludes funds that underperform. Funds don’t have any obligation to report their performance — it’s strictly voluntary. What we see in these indexes is an absence of poor performers that, were they included, might give a more accurate picture of the industry’s results. And that’s before we get to the issue of survivorship bias — funds that have gone belly up and closed due to their dismal results are missing from the index as well.

Perhaps you believe that the S&P 500 is an inappropriate benchmark. Consider a simple 60/40 portfolio of stocks and bonds. According to research from the Vanguard Group, that simple portfolio beat the returns of not only the hedge-fund industry as a whole, but almost all of the individual funds except for the outlying performance stars. And this 60/40 portfolio did it while charging fees of just 0.24 percent. The balanced fund beat the main Bloomberg hedge-fund index in six of the last seven calendar years, according to data compiled by Bloomberg. No wonder there is so much angst in Greenwich, Connecticut, home to many hedge funds.

This would be nothing more than an interesting bit of trivia if not for the fact that so many hedge funds use leverage. That is, they borrow money and toss it at whatever they’re chasing in order to magnify their returns. So when it doesn’t work they lose far more than they would have otherwise.

And now, with everything from energy junk bonds to emerging market currencies to blue chip equities imploding, the carnage in the hedge fund space can’t help but be epic. The question is how systemically dangerous the death of, say 5,000 of these funds will be. To which the likely answer is: Extremely.

The Greatest Psychological Problem Affecting Investors and Traders

The Greatest Psychological Problem Affecting Investors and Traders: 

We plan trades in one state of mind and track risk/reward in another. To adopt the language of Kahneman, we think fast and we think slow. Our slower analytical reasoning helps us develop ideas and our faster pattern recognition alerts us to threats and opportunities. It is when our faster information processing collides with our slower reasoning that we can find ourselves failing to trade our plans, even after we’ve spent considerable time planning those trades.

How can we align these modes of cognition? The usual answer is that we need to impose discipline and rigorously follow a time-tested “process”. It turns out that is often misguided advice. To solve the greatest psychological problem affecting investors and traders, we need to clearly identify the source of our cognitive/emotional mismatch.

When Psychological Problems Have Non-Psychological Causes

We often assume that when problems manifest themselves with psychological expressions, they must be psychological problems. That is often not the case. I recall a situation a few years ago in which a young woman came to see me about a persistent bout of depression. She had sought therapy, and she had tried medication. None of those things helped her. Most recently she found herself feeling down because her face had broken out in acne and she didn’t like the way she looked. Her history was not remarkable for depression or any other psychological problem and she didn’t have a history of skin problems. I suggested a blood workup and, sure enough, she had a massive endocrine imbalance.  Once the imbalance was corrected, there was no more depression, no more acne. The psychological problem had a purely physiological basis.

Family therapists are all too familiar with situations in which the psychological problems of presenting patients reflect wider dysfunctions within broader, family systems. One woman came to me with persistent anxiety problems and practically begged for counseling and medication to help with her “negative thinking”. As our interview progressed, it became clear that there were emotionally and even physically abusive dynamics in her marriage that she was not acknowledging to herself or others. I encouraged her to take a vacation and visit her sister and, sure enough, the anxiety abated. Her sister shared her own concern about my client’s marriage. That led to a more prolonged separation and a realization that the anxiety was not simply her own psychological 

When investors and traders become anxious or frustrated and make decisions out of impulse rather than planning, they naturally assume that *they* must have the problem; that the problem is one of impulsivity. They keep journals, make checklists, set rules, engage in behavioral exercises, and desperately try to rein in their fast-thinking minds. The problem, however, does not go away, because it is not a psychological problem.

Why Investors And Traders React Emotionally To Financial Markets

A key to understanding the cognitive/emotional mismatch of market participants can be found in an important paper from Easley, Lopez de Prado, and O’Hara. We typically think of markets as trading in chronological time. Look at most any market chart and you’ll find time on the X-axis. When we view markets through the lens of chronological time, every day is the same as every other one, opening and closing at the same time.

Easley, Lopez de Prado, and O’Hara suggest, however, that markets do not actually trade via a chronological clock, but by a volume clock. In other words,Lopez de Prado explains, markets are best captured in event time, not the time captured by the movement of earth around the sun. Because events, including volume, are ever-changing, markets themselves are not stable–and this lays the groundwork for emotional instability.

Recent trading in U.S. stocks provides a powerful example. Consider the chart at the top of this post. It describes the ES (S&P 500) futures contract over a two-day period, Thursday and Friday of August 20th and 21st. The data points on the blue line represent closing prices after every 500 price changes (ticks) in that index. In other words, the X axis of the chart does not reflect uniform time periods; 500 price changes is the event unit being used to capture the market’s clock.

Now as it turns out, there were almost 140 event time units for Friday the 21st alone. The prior Friday, in a much quieter market with about one-third the volume, there were only about 40 event time units. As the red line in the chart above captures, the oscillations from “overbought” to “oversold” and back again were very frequent during the recent two-day period. They were much less frequent just one week previous. For all intents and purposes, the market that traded one week was fundamentally different–in volume, volatility, and directional movement–than the week previous.

Imagine a hearing-impaired couple on a dance floor with one slow dance number playing after another. The DJ suddenly changes the music to hip-hop/dubstep and our couple continues their foxtrots. That is the situation of the trader who is event-time impaired. Failing to recognize that the market’s music has picked up, the trader finds that the trades that had worked earlier are now grossly out of step with market action. Markets blow through the trader’s stop out levels; they continue to move much farther than anticipated after profitable exits.

The hearing-impaired couple, now foxtrotting while others around them are break dancing, feels a complete mismatch. Their sense of being out of step, out of place, leads them to feel uncomfortable and lose any sense of rhythm whatsoever. Similarly, facing far more rapid oscillations between overbought and oversold conditions per the chart above, even the most tone-deaf traders intuit that they are out of step, out of place. They become anxious and stressed, sensing threat. They become frustrated, as what had been working no longer works.

Their problem is not a psychological problem. Rather, it’s a problem of failing to adapt to changing markets, which brings psychological consequences. All the behavioral exercises and positive self-affirmations in the world won’t help our hapless dancing couple and won’t help traders out of step with markets. If you’re calibrated to an unchanging chronological clock and markets shift in event time, you’re going to be left behind–and that will lead to performance-related stresses.

How To Find Greater Cognitive/Emotional Alignment

If our dancing couple were given hearing aids, they would quickly recognize when waltz music had shifted to contemporary urban sounds. They might not choose to try their hand at hip-hop dancing, but at the very least they could get the hell off the dance floor and save themselves considerable discomfort. Similarly, investors who can amplify their hearing of market rhythms in event time have the opportunity to respond constructively to situations as change occurs.

So how can we function more effectively in event time?  Here are a few simple and relevant tools that can be tracked by market participants:

Volatility – The VIX is a measure of volatility implied by options pricing for the S&P 500 stock index. We can also measure realized volatility in terms of average daily price movement for any asset–the percent change from high to low prices. When we shift from one volatility environment to another, this is a clue that markets are changing in ways that will require adaptation on our part. – Volume is often highly correlated with volatility.  Indeed, my back of envelope calculations suggest a massive correlation of .84 between daily volume in SPY and the daily realized volatility of the SPY ETF during 2015. Volume this past Friday was over 340 million shares; it had been averaging about 114 million shares per day before that during 2015. When volatility expands, it means new participants are coming into the marketplace–and that tends to move markets directionally. Our portfolios become far more volatile–and potentially far riskier–when we move to high volume/high volatility regimes.

Correlation – In normal times, different investments move differently. For instance, through much of recent months, we’ve seen strength in some stocks (consumer-related) and weakness in others (commodity-related). Similarly, we’ll see different assets track different price paths. When market regimes change, correlations will often rise in response to a dominant theme: quantitative easing abroad will lead to a broad rally of the U.S. dollar against many currencies; economic concerns regarding China will lead to declines across almost all stock sectors. An expansion of positive or negative correlation tells us that our portfolios might become less diversified than we expected–a useful hearing aid.- Broad market weakness typically does not come out of the clear blue. Typically, one or more sectors will display unusual weakness before the weakness infects all shares. In 2000, the weak sector became technology shares, especially those linked to the internet; they bombed well before the broad list of Dow blue chips. In 2007-2008, the weak sector was banking, as related to housing. It started its extended decline well in advance of the other blue chips. Most recently, it’s been emerging markets, high yield credit, and commodities that have been the canaries in the coal mine. When there is unusual weakness in part of the world or part of the stock market, there is the possibility that the infection will spread.Breadth Deterioration – I have yet to see a significant bear market that has not been preceded by protracted deterioration of breadth in the stock market. When the market peaked in March of this year, my stats showed 241 stocks across all exchanges registering fresh annual highs against 20 new lows.  At the May peak, that number declined to 116 highs against 21 lows. At the July peak prior to the recent decline, we showed 97 new highs and 203 lows! When a relative handful of large cap shares keep the averages high even as the broad list of stocks weakens, we have a useful heads up that the rising tide is no longer lifting all boats and may be ready to come in.

When we are open to shifts in event time and accompanying changes in how markets are trading, we no longer have to dance out of step in our investing.Perhaps most important of all, we can come to recognize that our emotional reactions to markets–from frustration to fear–constitute information, not problems. Very often, we first intuit that we’re out of step with markets before we consciously identify the source of our misalignment. That intuition takes the form of a fight-or-flight emotional response: we sense that the environment is no longer as stable or secure as we thought. When awareness of our emotional responses prods us to further and deeper analyses and not impulsive actions–when fast thinking can catalyze better slow thought–we can be as responsive to shifting marketplaces as skilled entrepreneurs are to theirs.

Note: I gratefully acknowledge the contributions of Marcos Lopez de Prado to some of the ideas expressed in this post. His websiteis a veritable treasure trove of ideas for those interested in applications of quantitative finance.

RBI Governor makes case for cut in property prices

Reserve Bank Governor Raghuram Rajan on Thursday made a case for reduction in property prices given the high inventory of unsold flats across the country.

"If real estate developers, who are sitting on unsold stocks, start bringing down prices, that will be a big help to the sector because once there is a sense that the prices have stabilized more people will be willing to buy," Dr Rajan said.

I thing we need the market to clear and with growing unsold stock we need to figure out ways to do it," he added.

The Governor said banks should explore ways to make home loans easier, but quickly added that property prices must fall before rates are brought lower.

"We don't want to create a situation where prices remain high at a level that demand may not pick up to the extent necessary," Dr Rajan said.

The RBI Governor was speaking with State Bank of India boss Arundhati Bhattacharya at an interactive session in Mumbai.

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• If this is a signal to banks to go tough on developers (i.e. not keep rolling over maturing debt via new debt), this could result in sharp correction in property prices.
• Many developers have been borrowing to service the interest on their debt.
• If new debt is frozen, the only way they can avoid default is by cutting prices to push inventory.

HLBB partners Intellect to ramp up Wholesale Banking services

HLBB partners Intellect to ramp up Wholesale Banking services 

i) Local banking group to diversify transaction banking platform 

ii) Large export-oriented corporation and SME clients to benefit from greater availability of digital and realtime financial services from HLBB 

LONDON(UK)/KUALA LUMPUR (Malaysia)/CHENNAI (India), 19 August 2015 – Hong Leong Bank Berhad (HLBB) today announced the appointment of Intellect Design Arena Limited (‘Intellect’), a specialist in applying Digital Technologies across Banking and Insurance, as its partner in the bank’s effort to transform and digitise its wholesale banking offerings. 

The bank’s adoption of Intellect’s multi-award winning Intellect Global Transaction Banking (‘iGTB’) suite is in line with the global Banking 3.0 trend whereby technologies such as mobility and cloud are redefining financial services and payments worldwide. 

YM Raja Teh Maimunah, MD/ CEO, Hong Leong Islamic Bank says, “Following the digitisation of our Personal Financial Services, HLBB is now turning its attention to the corporate banking space with a focus on the development of realtime payment offerings in order to better support its Malaysian corporate clients both domestically and globally. More of our wholesale banking clients have gone global and expect more competitive banking services to facilitate their cross-border businesses. As customers nowadays seek other alternatives apart from the physical branch, this offering provides the ability to access information, select products and make transactions from anywhere and at any time.” 

Manish Maakan, the CEO of iGTB, Intellect Design Arena Limited states, “Digitalisation and mobility has changed the way businesses run. Local banks are seeing more non-banking players crowding into their space as their customers want more flexibility, multiple-channel payment options and the ability to do this all in a secure and fast manner. We are honoured to be chosen by HLBB to help transform its digital transaction banking services platform.” 

HLBB’s purchase of the Intellect iGTB suite will consist of the digital omni-channel delivery platform and related applications in digital Cash Management, Liquidity Management, Domestic and Foreign Payments, Trade Finance and Supply Chain Financing. Via Intellect’s iGTB, HLBB will be equipped to facilitate mass adoption of real-time digital payments amongst its corporate clients. Additionally, the bank can implement straight-through-processing between the bank and local/ international payment gateways, as well as host-to-host integration with its clients’ accounting and back-end systems. With this, HLBB clients will truly be able to adopt modern business processes and transaction management capabilities.

Full Notice: http://www.bseindia.com/corporates/anndet_new.aspx?newsid=5e0544f7-038e-4b4d-81ac-3fac3eb20d76 

India needs a Gandhi-mukt Congress

After watching the 'tamasha' in parliament (and outside), particularly on the last day (when some semblance of 'debate' took place), this perceptive piece by Jagannathan explains the psyche of the Gandhis.

R. Jagannathan, First Post

There are two reasons why personalised attacks have become so common in recent years. One is generic; the other is specific to one party.

First, all parties - barring the Left and BJP - are run like family businesses or personal fiefs. This automatically lends itself to personal attacks even if the differences are about policy. Thus M Karunanidhi and J Jayalalithaa are not only political rivals, but personal enemies. Mulayam Singh and Mayawati are not only caste warriors, but personal foes. Till Narendra Modi became a threat to everybody, Nitish "Chandan" Kumar was a bitter antagonist to Lalu "Bhujang" Prasad, as Modi evocatively reminded his audience at Gaya a few days ago. The generic cause of personal bitterness lies in the dynastic or individual-based party structures in India - outside the BJP and Left.

The second - and specific - reason relates to the Gandhi family. Personal poison has hit national politics today because the main national party of yesterday, the Congress, has become the long-term personal property of one family. Barring a brief period from 1991-1996, this family has always run the Congress party. The family feels threatened by the rise of another national party whose leader is not a dynast, and this poses a potent threat to the idea of dynasties being inevitable in Indian politics.

The rise of Modi's BJP is a direct threat to the Gandhi family's control of the Congress because it challenges the idea of the party as family property. Modi's unexpected rise, despite the forces ranged against him, demonstrate a simple point: that talented individuals can rise from nowhere to become No 1. Just as in business the Narayana Murthys and Sachin Bansals have challenged the hegemony of family-based businesses, in politics, Modi is the disrupter of family-based politics.

It is no surprise that Modi's tactics and strategies are now being copied by ambitious politicians everywhere - from Arvind Kejriwal, who abandoned his Aam Aadmi avatar to become AAP's sole face, to Nitish Kumar, and even Akhilesh Yadav in UP. All these leaders have realised that the people are looking for new leaders who can solve problems. Family-based parties are fine, as long as they seem to provide talented leaders with new ideas for India. At one point, even Kanshi Ram and Mayawati provided that new idea. This is exactly what the Congress party's First Family is afraid of - that talent will trump political inheritance at some point.

If one were to look back at recent events, it is obvious that it is not the Congress party, but Sonia Gandhi and Rahul who have been at the forefront of aggressive behaviour in parliament and outside. Yesterday, even taciturn Sonia rushed to the well of the house, showing her true nature. The disruptions during Sushma Swaraj's speech were often instigated by Sonia herself, and the sharp personal attacks - whether on Modi or Swaraj - were made by Rahul.

The Sonia-Rahul effort to disrupt parliament is driven by two fears - that if they do not lead the chaos, their party's most ambitious leaders could revolt and break off to form their own regional outfits (as Sharad Pawar and Mamata Banerjee did in the past). It should be more than obvious to anyone that young leaders like Jyotiraditya Scindia and Sachin Pilot are any day more capable than Rahul Gandhi, and the only thing holding them back is the reality that the Congress is currently Gandhi family property, and no one is allowed to outshine them.

The second fear of the Gandhi family is narrow and personal: they suspect that sooner or later, the real estate capers of Robert Vadra and Sonia and Rahul themselves (as evidenced in the National Herald property grab) will make them legally and politically vulnerable.

The "maa-beta" aggression is probably intended as a pre-emptive strike, so that in case the legal situation turns against them, they can claim political vendetta. Rahul Gandhi has already been muttering darkly about vendetta politics.

If Narendra Modi wants to ensure that future sessions of parliament are not washed out, he has rework his slogan of "Congress-mukt Bharat." What India needs is a Gandhi-mukt Congress. His focus must be on strengthening the non-family leaders inside Congress and the non-Congress parties, so that over time the Congress party becomes more regionalised and hence more amenable to rational politics. The Congress has a rightful place in Indian politics; the same cannot be said of the Gandhi family's place in the Congress, leave alone national politics.

Despite fighting a bitter battle in Bengal, Modi and Mamata Banerjee have found a way to work together. Despite calling Sharad Pawar's NCP a "naturally corrupt party," Modi and Pawar are more then willing to schmooze when needed.

Compromise in national and regional politics is possible as long as parties and leaders are able to work out their long-term interests and do deals. The reason why no deal is really possible with the Congress is the Gandhi family whose interests may not be coterminus with even Congress interests. The Congress exists for the Gandhi family rather than the other way round.

Modi would be doing India a big service if he works unceasingly to free the Congress party from the Gandhi family by encouraging the younger leaders to strike out on their own. Sushma Swaraj's highly personalised attack on Sonia and Rahul is a good beginning.

Full speed ahead: How the driverless car could transform cities

Self-driving cars are not just about a hands-free driving experience. Their emergence points to an urban transformation that will change the way people navigate, access information, and interact with one another.

Just like Ford’s Model T, which debuted in 1908, today’s automobiles have four tires, a steering wheel, and seats. Henry Ford would have little trouble behind the wheel, but he would be completely baffled by the technology under the hood. Cars today are, in many ways, high-performance computers that can race at 70-plus miles per hour. Automotive digitization has led to important transformations, but the networked era has only just begun to tap its ultimate potential: the driverless car. Thanks to the advent of ubiquitous computing, various forms of semiautonomous technology, such as adaptive cruise control, automatic parallel parking, and collision warnings, are already widespread.

Indeed, full-fledged self-driving vehicles already exist. Several manufacturers, including BMW, Ford, GM, Toyota, and Volkswagen, have integrated these systems into their fleets and expect to start selling premium cars with different degrees of autonomy as early as 2016. MIT has worked with local researchers in Singapore on a prototype, while Google is using them in California. While fully self-driving cars cannot be bought off the shelf yet, autonomy is, in a sense, the next step in a continuing evolution of silicon under the hood.

Cars and the city

But what is the point of self-driving cars? Are there substantive benefits beyond sending guiltless text messages on the way to work? The answer lies in broader trends that point toward societal and urban transformations. Over the past 20 years, digital tools have changed the way people meet, access knowledge, and navigate—all built upon networks, sensors, mobile communication, and real-time information. These technologies are only now beginning to enter the urban space. In effect, more and more intelligence is suffusing our cities. It is possible to collect real-time information, seamlessly, on every dimension of urban life. HubCab, for example, is a web-based interactive visualization that looks at how New York’s 170 million annual taxi trips connect the city.

A parallel trend is happening with regard to the automobile: cars collect information about passengers and about the environment. Systems inside the car can detect drivers’ sleepiness, and galvanic skin-response sensors can give a metric for stress. Outside the car, radar, cameras, and laser scanners can “read” the road and then respond. Autonomous cars are at the nexus of these two lines of development, benefiting from advances on board and on the street.

Researchers at the MIT SENSEable City Laboratory are interested in the urban consequences of autonomous technology. Self-driving vehicles will have a dramatic impact on urban life when they begin to blur the distinction between private and public modes of transportation. “Your” car could give you a lift to work in the morning and then give a lift to someone else in your family—or, for that matter, to anyone else: after delivering you to your destination, it doesn’t sit idle in a parking lot for 20-plus hours every day. By combining ride sharing with car sharing—particularly in a city such as New York—MIT research has shown that it would be possible to take every passenger to his or her destination at the time they need to be there, with 80 percent fewer cars.

Clearing the roads of four out of five cars has momentous consequences for cities, by measures such as environment, traffic, efficiency, and even parking. In most cities, for example, designated parking accounts for a huge amount of land, which ends up being useless for most of the day. With fewer cars, much of this space could be freed for other uses. Such reductions in car numbers would also dramatically lower the cost (and related energy consumption) of building and maintaining the roads. One engineering study found that automation could quadruple capacity on any given highway. And, of course, fewer cars also means less noise and a smaller environmental impact.

Driving patterns of individual cars can be algorithmically optimized as well. Because autonomous vehicles don’t get lost, they create less congestion and shorten travel times. More important, self-driving cars would also make for much safer roads; more than 30,000 people a year die in automobile-related deaths in the United States every year and 1.2 million worldwide. One of the key challenges for the driverless future is to address the underlying logistics and legalities. Insurance, specifically, is an open question: When an accident involves a self-driving car, who is liable? Social acceptance is another important component: Are drivers ready to take their hands off of the wheel? Digital security is a third. Computer viruses are all too familiar, but the question is what to do if somebody “hacks” a self-driving car and changes the gas pedal into the brake, or even worse, makes the intersection go haywire.

As it always has, technology will continue to advance, and none of these issues is insurmountable. At this point, the transition is poised to happen, but several things must fall into place over the coming years—specifically outside the car—to pave the way forward. At the moment, fewer than half a dozen US states allow driverless vehicles on the roads, but many more states and countries are beginning to address the question. The federal government is working on creating a national policy to inform future development, but it is moving slowly.

It is likely that autonomous cars will deploy gradually—first, with more semiautonomous functions becoming standard (as GPS already has), then proceeding to systems that let drivers choose to take their hands off the wheel in certain situations (such as traffic jams or parking), and finally, to fully driverless vehicles. According to IHS, a firm that provides automotive forecasts and insights, sales of autonomous cars, including driver control, will begin by 2025 and could reach 11.8 million in 2035; sometime after 2050, says IHS, almost all vehicles will be autonomous.

From a technological point of view, driverless cars have arrived; the bigger task is for cities to integrate them. As autonomous driving matures, one thing is all but certain: the world’s mobility challenges will increasingly be met with silicon rather than asphalt.

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A Lesson in Failure- The Rise of the Mars Candy Company

The legendary Roald Dahl’s book  from 1964 (and its subsequent two film adaptations from 1971 and 2005) told the story of a magical candy factory and its eccentric and mysterious owner Willy Wonka. A chocolate river, gum that is a whole turkey dinner, never-ending gobstoppers, and, of course, the singing and dancing oompa-loompas are just a few of the surprises that waited inside the doors of the famously secretive factory. Of course, in a real life candy empire, there are a lot more failures, hard work, father/son disputes, and an unfortunate lack of oompa-loompas. What follows is the tale of how the Mars candy company went from a small candy business started by a polio stricken teen to one of the largest candy companies in the world.

The story of Mars candy starts in Newport, Minnesota (southeast of St. Paul) with the birth of Franklin Clarence Mars on September 23, 1883. Frank was the son of a gristmill operator (grinding grains into flour) who only moved to Minnesota from Pennsylvania with his wife, Alva, months prior to Frank’s birth. When Frank was little, he battled polio which left him disabled the rest of his life.

As you might imagine from this, he was rather immobile as a kid, so he spent a lot of time watching his mother bake and cook, including watching her go through the difficult and tedious process of making fresh chocolates. He got so into candy, that he began selling Taylor’s Molasses Chips and creating his own candy recipes while still in high school. By the time, he graduated, he had a pretty successful career going selling candy wholesale to stores in the Minneapolis/St. Paul area.

In 1902, he married Ethel G. Kissack, a schoolteacher. About a year later, Frank’s first son – Forrest – was born. It was also around this time that the candy market became oversaturated. With the Hershey Bar having been first introduced in 1900, the United States’ first mass produced candy bar, a host of other locally owned candy chains popped up. The competition was fierce, especially in the Minneapolis area. Brands like Chick-O-Stick, Pearson’s, and Cherry Hump started in Minnesota and all are still around today. So, it wasn’t a huge surprise when Frank’s wholesale business went under.

To add a little lemon juice to his fresh wound, in 1910, Ethel divorced Frank for being unable to support her. She also won sole custody of Forest, who she promptly sent to live with her parents in Saskatchewan, Canada. The ugliness of the divorce wasn’t a good omen for Frank and Forrest’s future relationship. They would rarely see each other until years later, with tensions still running high.

Frank, never a man to get too down, tried again, this time marrying another Ethel – Ethel V. Healy – and moving to Seattle, Washington to go back into the candy business. He failed again with wholesaling and creditors started taking his stuff.

He moved thirty miles south to Tacoma and again struggled.

In 1920, Frank and Ethel the second moved back to Minnesota to be closer to their families. At this time, Frank had only four hundred dollars to his name. But despite his constant struggles with candy, he continued to try, this time making his own at three am every morning with his wife doing the selling. The candy bar was the Mar-O-Bar, made out of chocolate, nuts and caramel. It was tough, but they started to make a little money and then a good amount more. After years of trying, Franks Mars had finally carved out a somewhat lucrative career in candy. They were even able to buy a house and would have been comfortable being local candy suppliers. But the invention of the Milky Way changed all of that.

It was also around this time that Frank’s son, Forrest, was establishing a mighty fine business sense. After attending college at Berkeley and, later, Yale, he became a traveling salesmen for Camel cigarettes. As the legend goes, in Chicago one night Forrest went a little overboard plastering ads across the city for Camel. He was arrested, but his estranged father bailed him out. While at a soda counter, Forrest looked into his chocolate malt glass and said, “’Why don’t you put a chocolate-malted drink in a candy bar?’”

Nougat had been invented in Italy in the 15th century but a variation of whipped egg whites and sugar syrup (instead of the normal honey) was invented by the Pendergast Candy Company in the early 20th century. They were based in, yes, Minneapolis and the nougat became known as “Minneapolis Nougat.” Frank Mars had started using nougat in his candies in 1920. In fact, he called his company “the Nougat House” for a time. But this time, in 1923, he mixed it with chocolate and put caramel on top of it. Using his cosmic name as inspiration, he called it a “Milky Way.” It was introduced in that same year. Within a year, Mars’ sales jumped by ten-fold, grossing about $800,000 (about $11 million today). Said Forrest later, “that damn thing sold with no advertising.”

Mars Company quickly launched into orbit. They moved their headquarters to near Chicago and by 1928, just five years after introducing the Milky Way, they were making $20 million in gross revenue (about $273 million today). In 1930, they introduced the Snickers bar () and, soon after, the Three Musketeers.

Frank started living in grand fashion, buying fast cars, big houses, and a horse farm for his wife. Meanwhile, Forrest didn’t like what he saw. Knowing that there was more profit, and security, to be had by cutting costs and expanding the business into other areas, he tried to convince his father to give him a third of the company and let him expand to Canada (Forrest’s home country). Frank refused and Forrest, later recounting a conversation with his father, ”I told my dad to stick his business up his ass. If he didn’t want to give me a third right then, I said, I’m leaving.”

In the end, Frank gave Forrest $50,000 and foreign rights to the Milky Way to basically leave his company alone and move to Europe. Fortunately for the company, that is exactly what Forrest did.

While in Europe, Forrest learned from Switzerland’s Nestle chocolate company about how to make good, sweet, European-style candy. He tweaked the recipe of the Milky Way to make it more sweet. He called it the “Mars Bar.” It sold even better than the Milky Way in Europe, amassing Forrest his own considerable fortune.

Frank passed away in 1934, at the young age of fifty. His wife, Ethel, took over the company, then Frank’s half-brother , William L. (Slip) Kruppenbacher when Ethel was too ill to run it. In 1945, Ethel passed away. The company moved to the next of kin, the business savvy Forrest.

Forrest took over the company and immediately diversified, turning Mars into more than a candy company. He worked with a European pet food supplier and, eventually, created Whiskas Catfood. He worked with a Texas salesmen to create ready-to-make rice. That became Uncle Ben’s Rice. Besides being a brilliant money-making business man, he was known to have a violent temper and a demand for perfection. For example, he was known to throw chocolate bars out of windows if he felt they didn’t meet his quality expectations. Remarkably quickly, he turned a regional candy maker into a world-wide food empire.

Today, it is his three kids who are reaping the benefits. John, Forrest Jr., and Jacqueline. They are among the richest people in the world, each owning a third of Mars, Inc, which currently employs over 75,000 people and is valued at around $70 billion, making it approximately the sixth largest privately held company in the world.

The World Of PC Sorcar

Why businesses and financial markets have become a hotbed of illusion.

Illusion is the gap between what is supposed to be and what appears to be. Illusions galore in all walks of life, including our own body. When a body part doesn’t play its role, another body part takes over and in the process dupes our mind into believing that all is well. It is only over the years that diagnosis reveals that both body parts have deteriorated, sometimes irreversibly. Similarly, when an ostrich perceives a threat, it digs its head into the sand, giving it a false sense of comfort that the danger has been averted. Boiling-frog syndrome is another example of how an illusion can be fatal. A mirage, a rainbow and Aurora Borealis are all illusions of nature. The movies we watch are an illusion. All facial creams create the illusion of becoming a timeless wonder, more like a mannequin. Most advertisements for consumer products are as such (Maggi is, sorry was, supposedly healthy!). Come to think of it, even money is also an illusion since on its own, it doesn’t have any utility. Its utility is derived from its ability to buy other things which satisfy a want. But that, too, is restricted to the things money can buy. Some money in the bank acts as insurance which also satisfies a security need. But beyond a point, it is an illusion – because it derives no worthwhile benefit – which makes the world go round. So an inherent dichotomy about illusion is that even though it is not reality, it still makes people happy, at least momentarily.

Illusions in capitalism

Businesses and financial markets are the hotbed of illusions. Policymakers in the US have been trying to talk up a V-shaped recovery in their economy for the past five-six years. Many promoters have this illusion of building empires/creating assets though essentially they are the ultimate examples of massive capital destruction. Some other promoters live in the illusion of creating value/wealth without looking to make worthwhile profits well into the foreseeable future (Eg. Amazon). We also have top companies which churn out loads of cash, only to deploy it in some form of grandeur such as an acquisition which is written-off in subsequent years. Many financial market participants have the weirdest of strategies which don’t add even an iota to the economy or to humanity, and is also not connected to any fundamentals of demand and supply of any good or service. Herding is rampant, and the desire to make a quick buck is strong enough reason for illusions to sustain and thrive, though not necessarily for the same set of participants at all times. It’s hilarious to believe that you can get some stock tips on TV and consistently make money out of it. Its only illusions, or misplaced assumptions/expectations, that lull the market into its ‘irrationally exuberant’ or ‘manic depressive’ moods, which in turn throw up price quotes far away from the range of their rational intrinsic value.

Illusions in financial theory

Let’s take a hypothetical company which has a 100% payout (simplistically assuming no dividend distribution tax), but no growth in earnings. Such a company should, at any point in time, quote at a price that generates a dividend yield equal to the YTM on a G-Sec. Given the 10-year G-Sec YTM of approximately 8% currently in India, the P/E for such a company should be 12.5X. It should not matter what the return on equity (RoE) of such a business is. In terms of P/B however, it shall be 12.5X for a 100% RoE business and 1.25X for a 10% RoE business. But this is the inception of illusion. Most market participants get excited about higher RoE businesses because its hip to own shares of a big known company than a little local company in some random industry (akin to the excitement one gets shopping for an ostentatious good as compared to a Giffen good). The illusions in this case could be two. First, they assume they are getting such a business at book value. Second illusion is the overestimation of future growth rates. The only other criteria which may determine P/E is, well illusion itself.

Let us examine the first illusion: Investor fondness for high RoE businesses and the act of becoming part-owners by buying shares in those very businesses. If we were to extend this logic to buying out the whole company, then the economics for the acquirer at a fancy price is quite damaging. In the above example, if the acquirer buys out the company at 12.5X P/B, its own RoE shall instantly fall to 10%. So the buyer of a share (or company as a whole) should be indifferent to buying a 100% RoE business at 12.5X P/B and a 10% RoE business at 1.25X P/B. But, factually, investors in India pay a far higher differential for the former. So, presumably this must be justified on the basis of future growth expectations. This gets us to our second illusion.

If the expected foreseeable future growth in profit is 15%, the P/E on a very rough basis could be double of that in the earlier example. And if the expected foreseeable future growth in profit is 25%, the P/E on a very rough basis could be triple of that in the previous example. It is such assumptions that make some of the current stock quotes a little more justifiable. However, the question is if these assumptions are realistic or illusory. It’s surely hard to forecast accurately, but to assume that any company shall continue to grow at 25% compounded for five-six years or even 15% indefinitely is the equivalent of believing in Jack and the Beanstalk.

Create, then justify

The catalysts adding fuel to the fire are the intermediaries and the media. The former make money when gullible lay speculators (it’s a travesty to call them investors) ‘buy and sell’ shares. They bring out reports which exaggerate the reality or create the illusion of an exaggerated future, which makes the shares gyrate wildly. Their business would be severely affected if people just ‘buy and hold’; even though there is enough empirical evidence to suggest that a fortune can be made if you ‘buy and hold’ the right stocks while trading is a zero-sum-game. Yes, some traders have made fortunes, but then it’s an illusion (overconfidence bias) to assume that you are as nimble and unemotional as them. The illusion of high growth companies is tailored to fit only the next few quarters/years by analysts and TV talking heads, even though any company worth investing in has a life far greater than that. During this high achievement phase, another round of high octane is infused by the media which loses no chance to trumpet new found heroes and then heaps awards on these high flyers and their companies.

Illusions are also created sometimes owing to the inability of Mr Market to distinguish between high quality companies (let’s call them ‘Great’) and the also-rans. And once people miss out on great companies, they shoot in the dark with the hope of getting lucky with the ‘next’ great company. Then there are certain others who want to own existing great companies at any price because while they can’t find anything else, they are still mandated to stay invested in something/anything. Finally, many people mistake expansion for growth.

A fool & his money…

In any company’s lifecycle, there are periods of par growth and supernormal growth. But over long periods (more than seven-eight years), the average growth of most companies tend to mean-revert. But it’s the period of change in growth from par to super-normal when the intermediaries and media cook up stories to pull in the crowd. I remember before the turn of the century, many of the IT companies, though top-notch, made it to this list. Then it was FMCG and pharma companies, then steel. Thereafter there was a phase when PSU banks graced this list. Then it was the turn of textiles, and sugar and then real estate, followed by infrastructure. And we have come full circle now with FMCG and pharma dominating the list again, though private sector banks have replaced IT on the list. The illusion in each case was that the two-three-year period of supernormal growth was extrapolated as if it would continue for many years, and, hence, over-exuberant valuation was accorded to those companies by Mr Market.

The illusion is so lifelike that even the most experienced and levelheaded sometimes lose their heads. The first-movers in such an upmove surely make money, undoubtedly a lot of it. But the majority isn’t as lucky, and end up getting sucked-in. The lure of illusion is too strong to resist and they eventually end up in a suckers rally. And this happens not only in stocks of companies who don’t have meaningful operations or are run by fly-by-night operators, but also companies which are the best in class and scale. The people who bought Infosys at 200 P/E took nine years to barely recover their opportunity cost even though its average RoE in the interim period was 39% and its PAT grew at 26% compounded annually. People who bought HUL at 64 P/E took even longer – 16 years even though its average RoE in the interim period was 76% and it’s PAT grew at 12% compounded annually. In an extreme case, people who bought Zee at 500 P/E are still way under water even after 15 years. There are enough horror stories across sectors. This is illustrated in Insomnia guaranteed. Although peak prices have been taken as entry points, even if we moderate it, the main point still holds that ‘great companies’ create an illusion of safety for an investor who has paid a premium price.

Insomnia guaranteed

Wrong entry price ensures a prolonged period of agony even in great companies...

...while in mediocre companies, this mistake ensures a lifetime of agony

Note: 1) In table 1, entry date is the date when the stocks were most pricey (in terms of valuation) since 1991, and thereafter how many years it took for them to recover their opportunity cost, including dividends. For both table 1 and table 2, June 30, 2015 is taken as the exit date. 

2) Entry and exit prices have been taken on a monthly average basis (to weed out intra-day abnormalities, as also ease of exiting). 

3) PAT and ROE (average) calculated for each stock from year of entry until exit year. 

4) Average ROE = five-year PAT (FY11-FY15)/average net worth (Op FY10 + Cl FY15)/two)/five-year. 

5) Adjusted for dividend, bonus, rights issue, split, merger and demerger.

 Now showing

At present, we have illusions being personified in three spaces. One, in certain pockets in the public market; here there are a bunch of great companies with excellent return ratios accompanied by sustained super-normal growth. They perhaps deservedly quote at a rich valuation. But even here, it is being implicitly assumed that these companies will repeat their chequered history well into the future; and the probability of this happening maybe lower than in the past (see: Great expectations).

Great expectations

The following companies are richly priced and investors are expecting an growth encore

 

There is another pocket, where the quality of the businesses is not exactly commensurate with their growth rates. It’s in this case that it becomes a little harder to justify the valuation at which they are currently quoting. This category may turn out to be a graveyard for investors (see: Much ado about nothing).  Then there is a bunch of businesses that are not extraordinary, nor are they growing at any scorching pace, but still quote at price that seem absurd. The stocks in this category are an accident waiting to happen. This is depicted inMirage of glory. It can be inferred that neither a high RoE nor growth in profit justify such a valuation, but still the halo around such companies showered by Mr Market is nothing but an illusion.

Much ado about nothing

Keynes' beauty contest winner who have a halo around them for seemingly no good reason

 

 Mirage of glory

These are the pinnacle of illusion; mediocre businesses, low growth or both still richly priced 

*Compounded annual profit growth from FY11 to FY15 

Note: Price used for calculation is as on July 15, 2015. 

1) Cut-off market cap > Rs.100 crore to weed out micro-caps prone to manipulation. 

2) D/E > 2.5X (except banking and finance companies) removed from the list to weed out companies with serious balance sheet issues. 

3) Average RoE = five-year PAT (FY11-FY15)/average net worth (Op FY10+ Cl FY15)/two)/five-year. 

4) Adjusted for bonus, rights issue, split, merger and demerger. 

5) Limitations include: using P/E for cyclical businesses, an abnormally small or high base distorting the inferences, not accounting/adjusting for fluctuating PAT across years and assuming them to be linear and an assumption that the audited figures give a true and fair view. 

Source for all data: Capitaline

Second, in certain specific businesses, many promoters or CEOs of big companies are continuing with their zeal to build grandiose empires. It is only years later that many wake up to the reality of a write-off, (see: Acquire now, repent later). 

Acquire now, repent later

Destroying capital is a global phenomena and not just in commodity companies  

The third frenzy is in the startup space. Here, I don’t have a lot of insight, but anecdotal evidence suggests we might be going back to the ‘eyeballs’ days. A few Google clicks should tell anyone interested how it all ended. But right now, everybody is in cruise mode (see:Unicorn club).

Unicorn club

That is the exalted title for startups that have a

valuation upwards of a billion dollars 

Source: CB Insights, figures in $ billion

Watch this space

The illusions are such that people can’t resist hiding their discomfort in them, and this is never going to change. Most people don’t learn from mistakes, neither others’, or their own. This is the cardinal sin which most market players commit, which creates opportunities for players who can resist the lure, and stay focused on hard facts even if it means standing alone in a corner while the rest of the world is going nuts. That’s what it takes to be a winner over long periods in this world of PC Sorcar. But even if one turns a winner in this game of illusion, he is still a rat. As the mighty John Maynard Keynes famously proclaimed, “In the long run, we are all dead”. To play the bigger game, one needs to step out from the world of capitalism and into the world of philosophy and spiritualism. But that is for another day.