Till then, invest in the safety of debt instruments.
Behavioural experts say our views are coloured by confirmation bias. This is the tendency to focus upon only information or data that confirms preconceived beliefs. Right now, the global situation is such that both optimistic or pessimistic biases can be ‘confirmed’. The global economy will eventually recover. But it may go through years of turmoil. Or it could make a relatively fast transition out of the recession.
Three important situations could pan out in different ways. In each case, optimists can marshal arguments to suggest relatively quick, favourable resolutions are possible. Pessimists can argue equally strongly in favour of meltdowns.
The first situation is the US economy, which is suffering from high unemployment and massive deficits. There could be a fast US recovery; there could be a slow recovery. There could be a long slide into more trouble.
The second difficult situation is the Eurozone crisis and its potential impact. Right now, the focus is Greek debt. There could be a gradual shoring up of the Euro. There could also be a collapse or disintegration of the currency union if Greece triggers off trouble in Portugal, Italy, Spain, and others.
The third situation is the “Arab Spring”. How the quest for democracy or more representative governments across the Arab nations evolves will impact energy markets. Regime changes in WANA will be reflected by swings in oil and gas prices.
These are unprecedented situations involving multiple variables. I have no clue how any of these will be resolved, and in what timeframes. I’d suspect that none of the policy makers close to the processes has much idea either.
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An optimist will expect relatively fast, favourable resolutions. The perfect scenario would see the US going into accelerating recovery, the Euro stabilising, and the installation of stable democratic regimes in WANA.
A pessimist will expect to see a great deal more trouble before things settle down. Of course, there could be gradual improvement in all three situations at varying pace. Or an improvement in any two, while the third gets worse.
Whether you’re optimistic or pessimistic, one thing is clear. You’ll need to be patient. The current situation will not clarify in the next couple of weeks. It may take months. It may take years. Manage your finances with that in mind.
An optimist will be willing to take risks and buy into depressed assets now, while a pessimist will look for the safest defensive options. On a scale of global risk perception, most investors seem to rate first world hard currency bonds as lowest risk and third world equity as highest risk, with first world equity and third world bonds somewhere in-between.
But there is no consistency of attitude. Most, including global players with deep pockets, are experiencing mood swings. On the sessions when they feel optimistic, they buy into high risk assets such as third-world equity. When they feel pessimistic, they head for safety in the form of hard currency bonds. These mood swing are perhaps, a sign that nobody has much confidence in any future scenario - either optimistic or pessimistic.
In such circumstances, short-term traders should shelve their own beliefs and simply look for ways to exploit the schizophrenic attitude. Every item of news-flow through the next few months will result in price swings that could be traded for profit. Whether you focus on forex, commodities, interest rate instruments or equity is a matter of personal choice.
In the somewhat longer-term, either pessimistic or optimistic attitudes could serve equally well. A pessimist will try and preserve capital by staying in the safest assets he can find. An optimist will expect the worst to be over fairly soon and start investing in more risky assets.
For a rupee investor, the safest assets are money market debt funds. Slightly higher risk would be medium term debt funds, which will give strong returns as and when the rate cycle turns around. Equity is more risky than debt at the moment. In the equity class itself, small and medium sized stocks are more risky than large ones.
An optimist could look to buy equity, during periods of decline. Valuations are too high for blanket “buy the index” strategies. But standard filters like higher than average dividend yields, lower than average PE and so on could offer better safety margins.
Say, for example, an investor looked only at large, liquid stocks trading below 14PE and above a dividend yield of 2 per cent. Stocks that meet those considerations would be well worth buying on further declines.