Get ready for the next Great Crash

DODD-FRANK ACT,IF PASSED,MIGHT HELP AVOID A 2008-LIKE CRISIS,BUT A CRASH SEEMS INEVITABLE

Andrew Ross Sorkin


The next Great Crash is coming.Guaranteed.Maybe not today and maybe not tomorrow.But,in all likelihood,sooner than we think.
How can I be so sure Because the history of modern markets is a story of meltdowns.The stock market crashed in 1987,the bond market in 1994.Mexico tanked in 1994,East Asia in 1997.Long-Term Capital Management blew up in 1998,Russia that same year.Dot-coms dotbombed in 2000.In 2007 well,you know the rest.
And that was just the last 20 years or so.The stagflation of the 1970s,the Depression of the 1930s,the panics in the 1900s ... and back and back and back it goes,all the way to the Dutch and their tulip bulbs.
In those giddy years before the Great Recession,it seemed as if wed grown accustomed to the wild ride.Wall Street certainly had.Jamie Dimon,the chairman and chief executive of JPMorgan Chase likes to say when his daughter came home from school one day and asked what a financial crisis was,he told her: Its the kind of thing that happens every 5-7 years.
No one should be surprised,Dimon insists,that booms go bust.Thats the way markets work.Most Americans probably find that answer unsatisfying,to put it politely.After all,millions have lost their homes,their jobs,their savings.Perhaps something is wrong if CEOs expect the markets to break down every half decade or so.
But now here comes the Dodd-Frank Act,which is supposed to ensure that we never repeat that 2008 finale of Wall Street Gone Wild.The bill,if signed into law,might help us avoid another sorry episode like that.But one thing it wont do is prevent another crisis if only because the next one probably wont be like the last one.
So amid all the back-and-forth over this bill,keep in mind that one of the most important aspects of the act: It would give Washington policy makers a powerful tool to mitigate the next too-big-to-fail blow-up,however that blow-up manifests itself.For the first time,Washington would have what is known as resolution authority,that is,the power to wind down a giant financial institution that runs into trouble.If policymakers had had that power during the tumultuous autumn of 2008,they might have averted the catastrophic failure of Lehman Brothers.They might have placed the teetering American International Group into conservatorship.And they might have taken over Bank of America and Citigroup,and possibly even Goldman Sachs and Morgan Stanley.Senior management would have been tossed out.
We will have a financial crisis again its just a question of the frequency, said the economist Kenneth Rogoff,who,with Carmen M Reinhart,wrote a terrific book titled This Time Is Different: Eight Centuries of Financial Folly.The title says it all.Weve been through this before and will go through it again.
While Dodd-Frank might avert another crisis in the short term,Rogoff says the legislation itself is less important than how regulators implement it and keep on implementing it over the years.Before World War II,banking crises were epidemic, Rogoff said.Then things settled down because regulation had become pretty draconian and laws were actually enforced.
But memories fade.Having a deep financial crisis is the best vaccination for another right away, Rogoff said.Down the road,a lot will depend on the regulators.Ten or 15 years after a crisis,and sometimes a lot less,watchdogs start to doze.Political winds change.Regulators loosen up.
Many on Capitol Hill insist Dodd-Frank means the end of too big to fail,period.Many on Wall Street insist it means the end of American finance.Bankers and their lobbyists argue that American businesses and consumers will ultimately suffer,since all these rules will end up throttling the vital flow of credit through the economy.
Dodd-Frank,whatever its pros and cons,helps prepare us for the next Big One whatever that might be.

Is the stock market a ‘barometer' of the economy?

Is the stock market a ‘barometer' of the economy? Any suggestion to that effect is usually met with howls of protest in India. Some question how the stock market can represent the economy when a good portion of the output originates from activities like agriculture which have nothing to do with listed companies.

Then there is the fact that stock prices gyrate wildly from day to day, when corporate or economic fundamentals certainly don't. This leads cynics to argue that stock prices are purely a function of liquidity and have nothing to do with esoteric notions of ‘fundamentals' or ‘intrinsic worth'.

Nevertheless, a section of economists have over the years made a brave attempt to explain the relationship between stock valuations and the corporate assets they represent. The market capitalisation to GDP ratio, Tobin's q (market value to replacement cost of assets) and price-earnings multiple are usually cited by financial analysts to explain prices. However, they still offer only a partial explanation to the puzzle of stock valuations.

Fresh framework

A recent paper, Indian Equity Markets: Measures of Fundamental Value ( http://www.nber.org/papers/w16061), by Rajnish Mehra, Department of Economics, University of California, offers a fresh and more comprehensive framework to examine if Indian equity valuations are in line with corporate fundamentals. It comes up with the somewhat surprising conclusion that they are!

Using a quantitative model to predict what ‘fundamental values' in the Indian market should be, it finds that actual stock values were broadly in line with them between 1991 and 2008.

The paper builds on the theoretical premise that if markets were fairly valued, the price that investors are willing to pay for firms (market value of their equity plus debt) should be equal to the replacement cost of the assets that firms employ. Both values are pegged to the country's GDP (excluding its agriculture component) to normalise them.

Three aspects are factored into the evaluation of fundamentals: corporate capital stock (assets), after-tax corporate cash flows and net corporate debt. An interesting aspect of the study is its attempt to quantify ‘intangible assets' (brands, research and development, technical know-how and the all-important human capital), drawing on earlier research in the American context (McGrattan and Prescott & Corrado et al). It finds that Indian firms have sharply enhanced their ‘intangible' capital in recent years, aiding stock valuations.

Watershed year

All the above research leads to the comforting conclusion that “in a large measure, Indian equity markets were fairly priced between 1991 and 2008.”

It throws up other observations too that offer food for thought to investors. The paper notes that though corporate values have largely moved in sync with ‘fundamentals' between 1991 and 2008, the markets have become more expensive in recent years. It turns out that 2005 was a watershed year for India's stock market.

Through 1991-2004, stock values hovered in a narrow band around the adjusted GDP. Actual stock values in this period also hovered much below the ‘fundamental values', showing an undervalued market. However, the years from 2005 to 2008 saw stock prices suddenly shift gears, with valuations shooting up relative to adjusted GDP. The proportion of corporate values to adjusted GDP moved up to 1.468 in 2005-08, from 0.78 in 1991-2004.

However, this is not a cause for alarm, as higher stock values were supported by a step-up in private investment and the higher ‘intangibles' employed by companies. Nor did market values move wholly out of range of the ‘fundamental' values modelled. The paper goes on to estimate the current ‘fundamental value' at about 1.2 times and says that it may eventually stabilise at around 1.5 times. A hint that stock markets may have room for upside, if the economy continues to grow?

Qualifiers

The qualifiers to this paper are fairly important, though. The author cautions that “although our framework is well suited to examining secular movements in the value of equity relative to GDP, it is not suitable to address high frequency price movements in the stock market”, adding for good measure that “high frequency volatility remains a puzzle”. The other key effect that the paper has not accounted for is the demand for stocks from foreign institutional investors (FIIs).

However, actual stock price behaviour suggests that these two aspects could well be interrelated. As of today, more of the ‘demand' for Indian shares originates from FIIs, rather than domestic investors (only 6 per cent or so of Indian household savings go into equities). Therefore, whether we like it or not, irrespective of how robust or otherwise India's fundamentals are, it is liquidity from FIIs that decides stock values.

The money that FIIs allocate to the Indian market tends to ebb and flow on a daily basis, depending on global events and the attractiveness of other options in the FII basket. And there may lie the explanation for the unprovoked swings in India's stock market valuations and also its highly volatile stock prices.

Executive Training Swaps Whiteboards for Board Games

-- When NetApp Inc. executive Suresh Padmanabhan signed up for a class on honing management skills, he expected whiteboards and PowerPoint presentations. Instead he found a conference room full of board games.

“It did look a little bit silly,” said Padmanabhan, senior director of the critical accounts program for the Sunnyvale, California-based company, which makes data-storage technology.

His impression changed fast. The games weren’t checkers or Monopoly -- they were complex role-playing exercises where each team ran a fictional company similar to NetApp. His group won the game by increasing operating margins to 19 percent (NetApp’s real operating margin was 15 percent last quarter).

“I’ve been at NetApp for 12 years, and I came back from this more excited and stimulated than any other class I’ve had here,” said Padmanabhan, 51.

NetApp joins Hewlett-Packard Co. and other Silicon Valley giants in relying more on simulations and role play and shifting away from lecture-led training sessions. The companies are looking to avoid costly mistakes, encourage collaboration and help turn pretend profit into actual earnings. Stockholm-based BTS Group AB, which develops the customized simulations, also counts Cisco Systems Inc., Autodesk Inc., Salesforce.com and VMware Inc. among its customers.

More Realism

The programs provide a more realistic and relevant experience for participants than a lecture or reading materials, said Mike Hochleutner, executive director of the Center for Leadership Development and Research at Stanford University’s Graduate School of Business. The risk is that students who thrive in traditional settings may miss the point in cases where lessons aren’t spelled out clearly.

“While the learning may be deeper on average, you could have some participants come out who didn’t grasp what you were after,” Hochleutner said. Stanford itself has used a similar approach in its MBA program’s core curriculum since 2007.

At Autodesk, sales teams use BTS Group’s games to see the world through the eyes of their customers. Most of the company’s clients have different business models, so it helps to understand how they operate.

“It’s practical learning,” said Ken Bado, executive vice president of sales for San Rafael, California-based Autodesk, the top seller of engineering-design software. “You’re putting emotional energy into it -- it’s not just pure intellect.”

Common Mistakes

Bado said the teams that didn’t perform well tried to do too much without committing enough resources -- say, opening an office in China with only a handful of employees. Seeing the consequences of such actions in the simulation solidifies the lessons, he said. Bado also encourages participants to bet real money on the outcome.

“I say, ‘You think you know what’s going on here, you’re confident? Put $20 in, put $100 in for the team,’” he said.

North American customers bring in the biggest chunk of revenue for BTS, generating 46 percent in the first quarter. Sales for the region increased 9 percent during the period, when adjusted for changes in foreign exchange rates.

Dan Parisi, the director of BTS’s San Francisco office, said companies that stopped spending on employee development during the recession are starting to open their wallets again.

“If you’re in a cost-reduction environment, you can cut some of this stuff,” he said. “You cut back for four or five quarters on development of talent. There’s a point where it’s going to affect a few things -- employee engagement, just general capability of the organization -- if you’re not building it.”

More Cooperation

Life Technologies Corp., a provider of gene-analysis tools for medical research, had 80 of its vice presidents take BTS classes. As a result, collaboration between employees has increased, said Elsa Guynes, the Carlsbad, California-based company’s director of global sales development.

“Even today, two years later, people that were in classrooms together across countries and geographic areas --they still maintain that relationship,” Guynes said. The company plans to use the approach with its sales force too, she said.

NetApp’s Padmanabhan says the simulations were thought- provoking and engaging. He also got free beer out of the experience, thanks to bets he made with a losing team.

“It’s much better than sitting through a 100-page PowerPoint presentation,” he said.

Billionaire College drop outs!

We all would have dropped the line in defense of our mediocrity in school, “You know what? Bill Gates was a college drop-out. I’m better – I just get low grades.” I am totally in the favor of college drop-outs and the underdog making it big, but not of mediocrity. As we all feel and agree, grades just don’t mean anything. I am not totally against formal education. We need schooling at a young age as its a leveler and instills some form of discipline & competitiveness into us. But there’s only so much formal education can do! To strengthen the argument I present to you some of the world’s richest men, all worth in billions who were college drop outs. These extraordinary people are more exception than the rule. Still, don’t be skeptic. And why would you slot yourself amongst the ‘rule’, than the exception?

1) Micheal Dell, founder – Dell

Dropped out of University of Texas, Austin at 19 to business full time. Founded Dell by opening up his Mac and rebuilt to see if he could. Today, he is worth $15.5 bn.

2) Sir Richard Brandson, The Virgin Group

Suffered from dyslexia in school, and dropped out of high school itself to open a music store named ‘Virgin’ in London. From there he expanded into telecom airlines, radio. He is worth $ 2.8 bn and is known for his lavish lifestyle.

3) Steve Jobs, Founder – Apple

Valmiki who wrote the Ramayana was once a thief. Jobs was once a hacker who made a machine that let people make illegal calls. And then, like the former he too drove his energies in the positive direction to do something that is remembered forever. Jobs was a geek who dropped out of Reed College, Portland after one semester to start out in business. Today he is worth over $5 bn

4) Ralph Lauren, Founder – Polo clothing line

Ralph’s surname was Lifshitz which he changed to Lauren to disguise his Jewish roots. He worked after school in the Bronx to earn money to buy suits. Dropped out of the City College of New York after two years. Dint attend fashion school either to start Polo, initially a necktie brand. Today, he is worth $3.5 bn.

5) Ted Turner, founder – CNN, owner – MTV, VH1, Nickelodeon

Dropped out Brown University to join his father’s billboard business. He sold that to fund ‘Cable News Network’, the channel that revolutionized TV viewing with its live coverage of the Gulf war. Turner went ahead to buy over MTV, Nickelodeon and is the head of the broadcasting empire – Time Warner, that he built. He also built ESPN which was later bought over by Disney. The maverick retired young at 67 and is worth $ 4.7bn.

These are just some of the few people from the western world. There are many other lesser known billionaires who quit studying. For every B-school topper who made it big, I can point out three who dint have great formal education. For all these men were not great ‘graduates’, but great ‘learners’ if you know what the difference is. There are many more people who fit into the ‘Drop-outs Hall of Fame’ like Thomas Alva Edison, Abraham Lincoln, Frank Sinatra, Bruce Willis and Woody Allen. But these great men weren’t entrepreneurs while some of them would be worth in billions too. So my fellow men, take pride in our tribe coz we redefined what success is with our failures. And purely co-incidental that there is no famous woman entrepreneur who was a college dropout. Oops!