Understanding the Great Panic of 2008

The Great Panic of 2008 is now seriously over-rated. If you manage to keep a cool head and act logically, then not only will you minimise your losses, you will lay the foundations of making big profits in the future. But if you too panic and become part of the herd, then your losses will become permanent and it will take years for you to get back to getting good returns from your investments. All around us there are investors who have surrendered to a helpless sense of desperation. They aren't even trying to understand what's happening and why it is happening. Suddenly, it's the time to sell and sell at any price.

The Credit Crunch
The Problem: Debt of all kind has become hard (or impossible) to raise. When it's available, interest rates are high. This is choking business activity.
The Prognosis: The complete seizure of the credit markets will ease within days, but finance will be expensive for a long time to come.

The first step to managing the effects of this Great Panic is to understand it. Let us systematically examine different aspects of the crisis and see how they fit together and how they affect us.

As investors who depend on the stock market for earning returns, we are all focussed on collapsing prices. However, out of the various parts of this crisis the stock markets are the least important because they are the result of problems in other areas. For investors, the stock market crash also offers the greatest danger as well as the greatest opportunities.

There are three main parts of the crisis: the Credit Crunch, the Economic Slowdown and the Stock Market Crash.

These three are obviously inter-related. Even if your direct concern is only with the stock markets, you need to understand all aspects of the crisis.

No one seems TO WANT TO lend money to anyone else. This is a big problem, because credit is the life blood of the modern economy. We are not just talking about big-ticket, long-term lending but routine stuff like working capital and suppliers' credit. Over the past month these credit markets have seized up not just in U.S. and Europe but also in the rest of the world, including India. This credit squeeze is a bigger problem today because the past five years have been a period of easy and cheap money. Companies have created their entire business model around the continued availability of easy credit. Suddenly, almost overnight, this credit has vanished.

In India, there have been plenty of rumours about big companies having to raise money at huge interest rates. News stories appearing in the media have pointed fingers at unnamed entities like 'a large private bank', 'a large telecom company', and 'a large real estate company'. The identities are not difficult to guess.

Banks have severely limited fresh loans. Not only are fresh loans not being provided, but banks are also avoiding actual disbursal of loans that have already been approved.

Over the last month, the standard explanation for this drying up of money has been that lenders no longer trust borrowers. In the U.S. and in Europe, a great deal of debt that was once thought to be safe has turned out to be close to worthless. Scared by this, lenders decided to play it safe.

That's the theory. However, we think that the truth is different. There's no great 'toxic debt' in the Indian system. Even then Indian lenders are being over-cautious. For example, the Reserve Bank cut the Cash Reserve Ratio (CRR) by 1.5 per cent over October 9th to 11th. CRR is that part of the deposit base of a bank that has to be kept as a reserve in cash. The cut brought CRR down from 9 per cent to 7.5. Earlier, 9 per cent had to be kept as cash, now 7.5 per cent has to kept as cash. The 1.5 per cent becomes free for lending.

The theory was that this would free up a lot of money (around Rs 60,000 crore) for lending. In practice, many banks seem to have decided to keep the additional amount as cash anyway. In fact, the chairmen of some public sector banks came on TV soon after the CRR cut and proclaimed that they would not use the additional money for lending. They would just keep it, just in case they needed it later.

And that's the root cause of the problem - caution, driven by fear. It's the same the world over. Those who have money are just not willing to put it to any use whatsoever. They'd rather be safe than sorry.

This complete freezing of the various credit markets is a serious problem. However, we think that this is so serious that there's no way that governments around the world will allow it to carry on. Within days, perhaps before this magazine reaches you, we would have seen some drastic action to unclog credit flow. We believe that all cards are on the table including the de facto underwriting of many kinds of credit by governments, especially inter-bank credit.

Even once-unthinkable options like the de facto nationalisation of banks in most of the world is quite possible. The British government has already started down this path by injecting a large dose of capital into eight big banks. The U.S. government has admitted that they may take up some stake in a few banks.

However, just because the complete credit freeze will ease up doesn't mean that money will suddenly become cheap and easy again. For a long-time-perhaps a year or two-lenders will be overcautious and interest rates will be high. Note that high interest rates are not a disaster scenario the way a credit freeze is. The world has been there before. It's bad for growth, but it's a part of the cycle that has to be lived through.

On Friday, October 10, India's Index of Industrial Production (IIP) gave a deep shock to the market. The IIP for August was announced and it was down to just 1.3 per cent from 10.7 per cent. What the numbers mean is that industrial production in August 2007 was 10.9 per cent more than that in August 2006, but August 2008 was just 1.3 per cent higher than August 2007. There are plenty of other indicators that economic growth is slowing down. This is something that's happening the world over and is now clearly recognised.

A few days ago, the chairman of the International Monetary Fund (IMF) said that the world's economy was entering a difficult phase. He predicted that there would be barely any growth. Developed countries' economies would shrink and overall growth would be just 3 per cent. Like any prediction, growth estimates are not sacrosanct. The Government of India seems to persist in the belief that we will grow at close to 8 per cent, although that is probably a fantasy induced by the approaching elections.

It must be noted that before the current crisis took hold, the Indian authorities seemed to have made a clear choice that low growth was a lesser evil than high inflation. For a few months now, the RBI has been raising interest rates and squeezing money out of the economy. This is believed to limit inflation but hinder growth. The current crisis seems to have induced a reversal of that thinking. What will help reverse the anti-growth policy is the receding fear of inflation getting worse. The prices of oil and other commodities were the main drivers of high inflation earlier this year. These are now in full retreat.

However, it is clear that a modest easing of growth of the kind that we've been expecting is not what is playing a role in the Great Panic. The panic-mongers are talking about a far more severe scenario in which the world goes into a severe reversal for many years. There is simply no ground for believing that anything like that will happen.

We've had at least half a decade of robust growth around the globe. The speed of this up-cycle has created imbalances that will have to be worked out for a while. Some sectors have more imbalances than others and these will have to work themselves out over a few years. For example, there have been huge real estate bubbles in most parts of the world. More generally, cheap and easy money has led to over-commitment in many capital-intensive sectors and these will now readjust to reality.

We believe that the stock markets are now in a pure panic phase. Interestingly, this panic is so sharp that it will necessarily have to stop within days. The likeliest scenario is that the crash that is now under way will end soon. After that, there will be a phase when prices will drift along at a low level for some time. Then, quite quickly, larger and larger number of investors will realise the value inherent in the markets and a bull phase will get initiated.

That's the way of the equity markets. Markets oscillate between over-reaction on the positive side and over-reaction on the negative side. Human behaviour being what it is, the negative over-reaction is faster than the positive one.

The credit squeeze is also making the crash more severe. In one way or another, there is a great deal of debt-funded buying in the stock markets. For example, many FIIs are heavily leveraged, some to the tune 10 or 20 times. If they have $10 million of investors' money, they'll borrow 10 times as much and create a $100 million of investments. This leverage now has to be rolled back because of the credit squeeze. Many domestic investors are heavily leveraged too.

Apart from the panic selling of the last few days, the markets have played out almost exactly as they were expected to. A bull market leads to a bear phase, which in turn sets up the next bull market. It doesn't end, and the big money is always made by investors who are planning for the next phase.

To figure out how to do that, read on to the next part of our analysis 'Profiting from the Great Panic of 2008'