Rajanomics and its decoding

Prannoy Roy of NDTV discussing overall Indian economic situations like Inflation, Growth (faltering), Sovereign rating and Rupee volatility with RBI governor Raghuram Rajan.  
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Limitations of Dow

When I was reading an article about “Why Google and its $1,000 shares will never crack the Dow”, in Bloomberg business certain thoughts came to my mind, so thought of writing about them.

Often people look at the stock index as it is perceived to be broad representation of overall stock market. Dow Jones Industrial Average is one of the three main indices of U.S. (other two being NASDAQ and S&P 500) and it is the oldest of three. Even though “industrial” word is there in the name of the index, Dow now include non-industrial companies also as over a period of time economic composition of sectors changed. Present constituents and their weights of the Dow are as follows (Source Bloomberg and data is as of 21^st October).

Though Dow changed its constituents of the index over a period of time, but it didn’t change the calculation method of the index. It follows price-weighted index calculation method wherein stock price will decide the index proportion i.e. highest weighting will be given to a highest stock price and vice-versa.

There are certain limitations of this method. For example as mentioned in the above article, it becomes difficult to include a stock in the index if its price is too high as is in the case of Google or Apple. Even though both of these companies are technology sector giants it is difficult for Dow management to include these companies as these companies’ stock prices are substantially high as compared to Dow components’ stock prices. For instance Google trading at $1000+ and Apple at $500+ will fetch almost half of Dow index weighting if included at these present price levels. So because of high price these companies can’t be included in the index calculation.

Second limitation is price of a stock does not represent the size of the company. To be precise, price of the stocks doesn’t reveal the companies’ position in their sector or overall market. For example Visa is a highest-weighted stock in the Dow because of its share value, which is highest among its components. But revenue wise Visa is smallest company (around $11 billion) whereas JP Morgan whose revenue is almost $100 billion (9 times of Visa’s revenue) is at 21^st position in price-weighted stock in the index. Chevron, whose revenue is less than half of the Exxon Mobil, influence Dow more than Exxon as it is the 6^th highest weighted and latter being at 10^th position.

Third limitation or complicated situation is of corporate action. Corporate action may be stock split or reverse split or bonus share issuance. Companies can split their stock prices for various reasons into smaller priced ones by any ratio. Reverse split is nothing but opposite action of stock split, wherein companies merge their stock. Bonus share means companies issues shares in certain ratios for existing share holders. For all above actions stock price will be forced to adjust. So according price-weighting index method company’s position will be changed even though not much change happened to company except its share price.

Fourth would be question of index representing all the shares in it. In price-weighted index it may or may not give due importance to all companies' share, which it has. Means if divergence between heavy and low weighted stock prices increases then index may move in either direction just because of heavily-weighted stocks rather all stock prices in it! For example in above case if Visa, IBM, Goldman Sachs and other top companies share price increases and GE, Intel and Cisco price decreases or remains constant over a period of time then latter ones lose on their weight and earlier ones gain on their weight. If this persists for a long period of time then Dow will majorly move by the top weighted companies. This means index value may not represent exact status quo of its constituents itself! These results in a situation like index regaining its lost value but most companies' stock value still at abysmal level!

Interesting readings on Economics Nobel Prize

The Royal Swedish Academy of Sciences has decided to award The Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel for 2013 to

1. Eugene F. Fama
2. Lars Peter Hansen
3. Robert J. Shiller

Trendspotting in asset markets:
There is no way to predict the price of stocks and bonds over the next few days or weeks. But it is quite possible to foresee the broad course of these prices over longer periods, such as the next three to five years. These findings, which might seem both surprising and contradictory, were made and analyzed by this year’s Laureates, Eugene Fama, Lars Peter Hansen and Robert Shiller.

Nobel Prize winners say markets are irrational, yet efficient
Are stock markets irrational, driven by greed and fear, subject to euphoria and panic? Or are they highly efficient indicators of intrinsic value? Both, says the Nobel Prize Comittee for Economics, with no sense of contradiction.

The economics Nobel matters for India
The recent announcement of the Sveriges Riksbank Prize in Economic Sciences in Memory of Alfred Nobel has gone to three extremely deserving recipients. The combination of deep economic insight and clever methodological contributions that Eugene Fama, Lars Hansen and Robert Shiller have brought to this field has revolutionized our understanding of the determinants of asset prices.

Split Nobel prize shows bubbles are worth watching
Economics is the only field in which two people can share a Nobel prize for saying opposing things.

Economists Clash on Theory, but Will Still Share the Nobel

Nobel Prize U.S. winner warns of 'bubbly' global home prices

Fama, Shiller, Hansen Win Nobel Prize for Asset-Price Work

What is happening in U.S.?

When one of my friends asked me what’s happening in U.S., so I thought of writing about it in a layman terminology, so that non-finance guys like many of my friends can understand.

Most of you might have already read or heard about American government being shut down from last one week or so. You might be wondering, what is this shut down. Why it happened and what is the impact of it?

To start with America follows the financial year from 1^st October to 30^th September just like our financial year, 1^stApril to 30^th March. For every new financial year a new budget is prepared and once it is passed, fund can be transferred to various departmental activities. Means funds allocated for each department can be utilized according to their plan of expenditure.

But if Congress (Parliament in Indian context) does not pass the new budget presented then Congress needs to come up with contingent bill, which allocates funds as per previous year allocation, to work around for time being. If that is also not passed by the majority in the both the houses of the Congress (Senate and House of Representatives) then government needs to shut down some departments which are not exempted from Anti-Deficiency Act (ADA). ADA is legislation, which prevents some government departments spending beyond their allocated funds.

You might be wondering why Congress didn’t pass the budget or contingent bill. Bill is implemented only when both the houses of Congress pass the bill by 2/3 majority or more. Senate, the upper house of the Congress is led by Democrats (52/100) and House of Representatives; the lower house of the Congress is led by Republicans (232/435). So bill should be satisfactory to both the parties.

President Barrack Obama is trying reform the healthcare (bill is also known as Obamacare) by reducing the cost of insurance and increasing the coverage of uninsured Americans (Around 15% of the population is not insured in America). But Republicans are opposing it for obvious political reasons and burden on expenditure, so not ready to negotiate in House of Representatives. President and Democrats are not ready to negotiate the budget without Obamacare. So because of the deadlock and new financial year U.S. government needs to shut down some of the departments until deadlock is resolved and pass the budget.

Now question is what is the impact of the government shut down? Immediate effect is around 8 lack government employees are on forced temporary leaves without pay and around 13 lack government employees need to work without pay. Major tourism spots like historical places, libraries and museums will be closed. And economic impact is different as per different estimations. According to Goldman Sachs estimates 5-6 days shut would shave off around 0.2% of GDP, 10-12 days shut would cost around 0.5% of GDP and 20-24 days will be of 1% of GDP.

So ultimate question would be what is the way going forward?  How long deadlock can continue? As long as both parties come to table with some amendments from both of their demands deadlock can continue. Historically the longest deadlock has been for 21 days in 1995-96. So what if present deadlock continues for more than 2-3 weeks like one in 1995-96? That’s the worst thing to happen to U.S. as it will be facing debt ceiling negotiation on October 17. Debt ceiling means, the limit on the amount of debt America can issue. If this deadlock continues till October 17 then there is possibility that debt ceiling may not able to increase. If that happens then treasury department may not able to repay the amount on debt maturities beyond a point, where it runs out of its reserves. After this treasury department needs to prioritise its debt service obligations and there might be partial defaults or in worst case full default, which is unthinkable and unprecedented! Because of the debt ceiling issue and the way it was handled in 2011, Standard & Poors downgraded U.S. from AAA rating.

Conclusion: Hope American politicians realise and recall the phrase “it’s the economy, stupid” and resolve the issues as early as possible.