Ignore warning signs at your own peril
Hollywood movies on natural disasters such as volcano eruptions, earthquakes etc. always show that warning signs were ignored by sceptics leading to the disaster hitting cities or towns taking citizens unaware. The same is true with markets. Investors ignore warning signs and then pay for their ignorance with heavy losses on price corrections. The credit bubble bust in 2008 and the euro zone crisis in 2011 where markets corrected significantly had early warning signs, which investors chose to ignore. The unsustainable rise in property prices in the US on the back of lending to sub prime borrowers and the unsustainable rise in sovereign debt of Eurozone nations lead to market collapses, hurting investors. Investors should have listened to sane voices as markets bubbled but they did not and then lost money.
India has had its fair share of bubbles and busts. Investors have lost heavily in stocks in the infrastructure and reality sector since the market bubble burst in 2008. The NSE Infrastructure index has lost 50% since February 2008 till date while the NSE realty index has lost 80% in the same period. Warning signs were flashing for these sectors but were ignored by investors, who went on to pay the price for ignoring the warning signs?
Where to look for the warning signs?
In hindsight it is easy to spot the warning signs but in the present where should investors look for early warning signs for trouble ahead. The warning signs are both macro and micro in nature. Macro signs affect markets as a whole while micro signs will affect sectors or single stocks. Listing out macro and micro warning signs.
Macro warning signs
Macro warning signs can emanate from within a country or from anywhere in the globe. The macro warning signs in India now is the RBI supporting the government’s fiscal deficit by buying government bonds. RBI has been buying government bonds for the last three years and taking up its balance sheet size by 270%. The rising balance sheet size of RBI has impacted inflation, which has trended at over 9% levels for most of 2011. The government too has not committed itself to reforms to bring down the fiscal deficit. Unless the government shows on the ground commitment to fiscal reforms, the Indian economy can flounder.
On the global front, it is again the central banks that are flashing warning signals.
Central banks from the US Federal Reserve to the Bank of Japan have all expanded their balance sheets by buying bonds to provide liquidity. The US Federal Reserve (Fed) has expanded its balance sheet by 277% in the 2008 to 2011 period. The other central banks to expand their balance sheets in the 2008-2011 periods are the European Central Bank (ECB) by 94%, Bank of Japan (BOJ) by 49% and the Bank of England (BOE) by 166%. The total amount of central bank liquidity added in the 2008-2011 period in US Dollar terms in USD 4.5 trillion. The repercussions of the huge liquidity infusion by central banks is positive in the short term but can be catastrophic in the long term if liquidity is withdrawn from markets or if inflation trends higher.
Micro warning signs
Micro warning signs emanate from regulatory action, excessive leverage and growth, poor corporate profitability, and corporates trying to cater to high market expectations. Two recent examples of micro warning signs are Dhanalaxmi Bank and Mannapuram Finance. The two companies had high growth plans and trying to achieve the growth plans saw them falling into trouble. Dhanalxmi Bank saw its financials deteriorate while Mannapuram has been pulled up by the RBI for serious regulatory breaches. Everonn the education company is another example of fraud taking place due to emphasis on growth and market valuations.
Kingfisher Airlines is a good example of poor profitability leading to corporate distress. The Airlines flashed warning signs much before it almost became bankrupt when it was not paying its dues to oil companies, lenders and even its own staff. Investors should watch out for such signs from other companies with poor profitability.
Build up of excessive debt has caused infrastructure and reality companies to sink. High leverage is usually built up in good times and investors should note the build up of leverage when liquidity and interest rates turn negative for borrowers.
On the global front, news such as the world’s largest steel company Arcelor Mittal making losses due to poor business conditions in Europe is a warning sign for domestic steel makers. Tata Steel, which acquired Corus in 2007 by taking on debt, will face issues, as Corus primary market is Europe. Weak economic conditions in Europe affect other steel makers, as prices will remain soft on global oversupply. Exporters of goods and services to Europe will also face issues if economic conditions remain weak there.
Investors must watch for these signs and monitor them closely. Some of these warning signs may remain warning signs while some of them will act up. The best way to react to the warning signs is to either reduce exposure or book profits continuously if markets continue to move up.