Vivek Kaul
Rakesh Roshan made a fairly trashy but super successful movie called Karan Arjun, which was released in 1995. It was a rare occasion when the Khan superstars, Salman and Shah Rukh, shared screen space (They were also seen together in Karan Johar’s Kuch Kuch Hota Hai and K C Bokadia’s Hum Tumhare Hain Sanam).
So, Karan Arjun was a story of reincarnation, where the two heroes(played by Shah Rukh and Salman) are killed by the villain. They are reborn and come back to their original village and take revenge. But before they are reborn, their mother(played by Raakhee) keeps telling everyone, “Mere bete aayenge, mere Karan Arjun aayenge … zameen ki chaati phad ke aayenge, aasman ka seena cheer ke aayenge.”
Despite the ridiculousness of the idea, the sons are reborn and they come back and take revenge. Such confidence in something happening is rarely seen in reel or real life for that matter. A similar confidence seems to have taken over stock market investors in India right now. They firmly believe that Narendra Modi will become the next Prime Minister of the country and clear up all the economic ills that have held back economic growth for a while.
Stuck projects will be cleared. Investment will pick up. Consumption will be back. And happy days will be here again. Or so the logic goes.
The BSE Sensex has been rallying on this possibility and between September 2013 and March 20, 2014, it has rallied by 14.4%. The foreign investors seem to be more taken in by the possibility of Narendra Modi coming in as the knight in the shining armour and rescuing the Indian economy.
Goldman Sachs said in a recent report that “the upcoming parliamentary elections could have an important bearing on policy choices and the progress of structural reforms. Adoption of more decisive and/or pro-growth policies could help boost investment activity and provide impetus to the overall growth cycle, in our view.”
The bank had been a little more direct in a November 2013 report where it had said that “Domestic equity investors tend to view the BJP as business-friendly, and the party’s prime ministerial candidate Narendra Modi (the current chief minister of Gujarat) as an agent of change. BJP and Mr. Modi, in particular, have been focussed on infrastructure and capital spending in the past and a BJP-led government may be beneficial for the investment demand pick up, in our view.”
The foreign institutional investors have bet big time on this possibility. Between September 2013 and March 20, 2014, they have invested Rs 62,271.54 crore into the stock market. During the same period the domestic institutional investors have sold out stocks worth Rs 45,034 crore.
And this investment by the foreign investors is clearly because of the Modi factor. As Geoff Lewis, Global Markets Strategist, JPMorgan AMC told The Economic Times recently “Well, Modi is obviously a very big influence on the stock markets.”
But even Narendra Modi, despite his best intentions, may not be able to do much, if and when he does take over as the Prime Minister of India. And there are several reasons for the same. Let us look at them one by one.
A big hope from a Modi led government is that he will restart the investment cycle. As Neelkanth Mishra and Ravi Shankar of Credit Suisse write in a report titled Elections: Much Ado about Nothing dated March 19, 2014 “Hopes are high among investors that elections can re-start the investment cycle. Even if the electoral verdict is favourable, such misplaced optimism ignores the realities of the business cycle, and overestimates the powers of the central government. Only a fourth of investment projects under implementation are stuck with the central government; the rest are constrained by overcapacity, balance sheets, or state governments.”
They further point out that “two-thirds of the projects awaiting central approval are in Power and Steel sectors, both wracked with massive overcapacity, obviating new investments. True utilisation in thermal power generation is below 60%, near 20-year lows (reported plant load factor is 65%). Of the litany of problems in the sector, two are crucial: SEB[state electricity boards] reforms, and coal availability.”
The reforms for state electricity boards need to happen at the state level. As far as solving the problem of coal availability is concerned that is something that cannot be solved overnight. As Swaminathan S Anklesaria Aiyar pointed out in a recent column in The Economic Times “our systems are now clogged with so many laws and regulations at the central and state level that Cabinet clearance is just the first step in a long obstacle race. It takes 10-12 years and over 100 permits to open a coal mine. India, with the world’s third-largest coal reserves, has become a coal importer.”
What about accelerating private coal production in the country? That also is not likely to happen any time soon. As Mishra and Shankar of Credit Suisse point out “Given the controversy around coal block allocations, auctions are the only way forward. These are unlikely till the data on reserves in these mines are updated. The government has been planning to conduct coal block auctions for close to three years now (see link), but despite repeated pronouncements of it being a few weeks/months away, there has been little progress. In our view, the challenge is inadequate prospecting—the ministry may be apprehensive of the winning private bidder in an auction managing to increase reserves estimates within a short time frame. Such a development would create negative press and possibly trigger anti-corruption investigations.”
Hence, coal blocks most likely won’t be auctioned till the reserves have been updated. “Blocks are unlikely to be auctioned till reserves have been updated. This is a time-consuming process, and in our view is unlikely to be completed in less than 1-2 years. From the time the blocks are auctioned to the time coal can start to get mined could be another 3-5 years at least,” write Mishra and Shankar.
What about other infrastructure projects? There are many challenges on this front as well. “Challenges abound elsewhere too: legal challenges are likely to stall the National Highways projects, and matter less for India’s road network; Railways lacks financial muscle, and Private Partnership schemes are yet to take off,” write the Credit Suisse analysts.
What does not help is the fact that the banking sector seems to be headed towards difficult times in the days to come. The stressed asset ratio of the Indian banking sector currently stands at 10.2%. This means that for every Rs 100 of loans given by Indian banks Rs 10.2 worth of loans have either not been repaid or been restructured in some way, where the borrower has been allowed easier terms to repay the loan (which also entails some loss for the bank) by increasing the tenure of the loan or lowering the interest rate on it. Also, nearly 85% of the restructured loans have been restructured over the last two years.
What makes the situation even more dangerous is the fact that the non performing assets are likely to increase in the years to come. The Credit Suisse analysts point out that their banking team has been highlighting that “that there is Rs 8.6 trillion of loans with the top 200 companies with interest cover less than one. Only about 23% or Rs2 trillion has become NPA yet.”
Interest cover is earnings before interest and taxes divided by the total interest expenses of s company. If the interest cover of a company is less than one what it means is that the interest expenses of the company are more than its earnings before interest and taxes. Hence, the company is not in a position to fully repay the interest on the loans that it has taken on. In this situation it has no other option but to default or get the loan restructured. Either ways it means problems for the banking system. Or as John Maynard Keynes once famously said “If you owe your bank a hundred pounds, you have a problem. But if you owe a million, it has.”
If the problems in the banking system erupt that would mean that there would be lesser money to lend. Also, the government will have to come to the rescue of the public sector banks, and that would mean greater expenditure for the government, something it can ill-afford to do at this point of time.
And if all this wasn’t enough, the ability of the next government (irrespective of who leads it) to spend its way through trouble is fairly limited. As I had estimated in this piece, nearly Rs 2,00,000 crore of the government expenditure hasn’t been accounted for in the next financial year’s budget.
As Mishra and Shankar point out “The apparent reduction seen in the last three years has been achieved mostly by pushing expenditure into subsequent years: while earlier the month of March used to see 16% of the full-year expenditure, in the last three years, it has come down to 11-12%.”
Obviously, this trick of pushing expenditure into the next year cannot continue forever and needs to stop at some point of time.
To conclude, Modi will have to work in a coalition, which will severely limit his ability to make decisions as quickly as he is used to. Given these reasons, the foreign investors and everyone else who feels that Narendra Modi will turnaround the Indian economy in a jiffy, need to understand that they might be becoming victims of what I would like to call the Karan-Arjun syndrome. Reel life and real life do not always go together.
The article originally appeared on www.FirstBiz.com on March 21, 2014 with a different headline
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Month: March 2014
Why no one is afraid of tapering any more
Vivek Kaul
The only economic theory that works all the time is that no economic theory works all the time.
Since May 2013, analysts, economists and journalists have fettered over what will happen once the Federal Reserve of the United States, the American central bank, starts to taper.
The Federal Reserve had been printing $85 billion every month to buy bonds. By buying bonds, the Federal Reserve pumped money into the financial system. This was done so as to ensure that there was enough money going around in the financial system leading to low long term interest rates.
Since December 2013, the Federal Reserve has been cutting down on the amount of money that it has been printing to buy bonds. This cut down in the total amount of bonds being bought by the Federal Reserve by printing money, is referred to as tapering.
In a statement released yesterday (i.e. March 19, 2014) the Federal Open Market Committee (FOMC) said that henceforth it would buy bonds worth only $55 billion, every month. At the current pace it is expected that the Federal Reserve will stop printing money to buy bonds by October 2014.
When Ben Bernanke, who was the Chairman of the Federal Reserve till February 3, 2014, had first suggested tapering in May 2013, it spooked financial markets all over the world very badly. Institutional investors had borrowed money at low interest rates prevailing in the United States and invested that money in financial markets all over the world.
This trade referred to as the dollar carry trade wouldn’t be viable any more, if the Federal Reserve started to taper. Tapering would ensure that the amount of money floating around in the financial system would come down and hence, interest rates would start to go up.
And once interest rates started to go up, the dollar carry trade wouldn’t work, that was the fear among institutional investors. This would lead to them selling out of financial markets all over the world and taking their money back to the United States.
In the Indian context it would have meant the foreign institutional investors exiting both the Indian stock and bond market. As they would have converted their rupees into dollars, there would have been pressure on the rupee, and the currency would have depreciated against the dollar.
In fact, between the end of May 2013, when Bernanke suggested tapering for the first time, and August 2013, the rupee fell from 55.5 to a dollar to close to 69 to a dollar. A lot of money was withdrawn from the Indian bond market by foreign institutional investors. Also, between June and August September 2013, the foreign institutional investors sold out stocks worth Rs 19,310.36 crore from the Indian stock market.
But after yesterday’s decision by the FOMC to cut down on bond purchases by $10 billion to $55 billion, the financial markets around the world have barely reacted.
The S&P 500, one of the premier stock market indices in the United States, fell by around 0.61% yesterday. Closer to home, the BSE Sensex, has barely reacted. As I write this it has fallen by around 28 points from yesterday’s closing level and is currently quoting at 21,804.8 points.
So, what has changed between May 2013 and March 2014? Since December 2012, the Federal Reserve had been following the Evans rule (named after Charles Evans, who is the president of the Federal Reserve Bank of Chicago). As per this rule, the Federal Reserve will keep interest rates low till the rate of unemployment fell below 6.5% or the rate of inflation went above 2.5%.
The rate of unemployment in the United States has been falling for a while and currently stands at 6.7%, very close to the 6.5% mandated by the Evans rule. The trouble here is that the unemployment number has not been falling because more people are finding jobs. It has simply been falling because more people have been dropping out of the workforce. The unemployment rate does not take into account people who have dropped out of the workforce. It only takes into account people who are still in the workforce and are not able to find jobs.
In December 2013, nearly 3,47,000 workers left the labour force because they could not find jobs, and hence, were no longer counted as unemployed. This took the number of Americans not working to a record 102 million. As Peter Ferrara puts it on Forbes.com“In fact, all of the decline in the U3 headline unemployment rate since President Obama entered office has been due to workers leaving the work force, and therefore no longer counted as unemployed, rather than to new jobs created…Those 102 million Americans are the human face of an employment-population ratio stuck at a pitiful 58.6%. In fact, more than 100 million Americans were not working in Obama’s workers’ paradise for all of 2013 and 2012.” Interestingly, the labour force participation rate, which is a measure of the proportion of working age population in the labour force, has slipped to 62.8%. This is the lowest since February 1978.
In it’s latest policy statement issued yesterday, the Federal Reserve seems to have junked the Evans rule. As the statement said “In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.” Federal funds rate is the interest rate that banks charge each other to borrow funds overnight, in order to maintain their reserve requirement at the Federal Reserve. This interest rate acts as a benchmark for business and consumer loans.
What this means is that instead of just looking at the rate of unemployment and the rate of inflation, the Federal Reserve will take a look at other factors as well, before deciding to raise the Federal funds rate. What this tells the financial markets all over the world is that the Federal Reserve will continue to ensure low interest rates in the United States, in the time to come, even though it will most likely stop printing money to buy bonds by October 2014.
In fact, in the press conference that followed the FOMC meeting, Janet Yellen, the Chairperson of the Federal Reserve was asked how long did she think would be the gap between the end of bond buying and the Federal Reserve starting to raise interest rates. “It’s hard to define but, you know, probably means something on the order of around six months,” replied Yellen.
This spooked the financial markets briefly because it meant that the Federal Reserve would start raising interest rates by around April next year. But Yellen quickly clarified that any decision to raise interest rates would depend “on what conditions are like”.
So what this means is that the Federal Reserve will ensure that interest rates in the United States continue to stay low. Hence, the dollar carry trade will continue, much to the relief of global institutional investors.
Peter Schiff the Chief Executive of Euro Pacific Capital explained the situation best when he said “The Fed will keep manufacturing excuses as to why rates can’t be raised. Whether it’s a cold winter or a hot summer, a geopolitical crisis, or an unexpected sell-off in stocks or real estate, the Fed will always find a convenient excuse to postpone tightening. That’s because it has built an economy completely dependent on zero percent interest rates. Even the smallest rate shock could be enough to push us into recession. The Fed knows that, and it is hoping to keep the ugly truth hidden.”
To cut a long story short, the easy money party will continue.
The article originally appeared on www.FirstBiz.com on March 20, 2014, with a different headline
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Where is global economy headed? Copper prices will tell you
Vivek Kaul
Copper prices have fallen by a little over 12.1%(in dollar terms) since the beginning of this year. Interestingly, a substantial portion of this fall has come since the beginning of this month. Analysts often refer to copper as Dr Copper, given that the demand for copper is often a reliable indicator of economic health.
How is that? Copper is widely used across different sectors of the economy. It has uses in sectors as varied as electronics, homes, factories and even power generation and transmission. Given this, demand for copper is often a very good lead indicator of the economic health of the global economy. This demand is reflected in the market price of copper.
Hence, rising copper prices indicate strong demand for copper, which in turn indicates a growing global economy. Vice versa, falling copper prices indicate low demand for the metal and hence, an imminent economic slowdown.
As Albert Edwards of Societe Generale writes in a note dated March 13, 2014, titled We are repeating 2008- just backwards? Ignore copper meltdown at your peril “Copper and iron ore prices have slumped almost 10% over the last week. Interpreting this move may prove crucial for global investors who traditionally have looked to Dr Copper specifically, and industrial commodity prices in general, to give an early warning to any changing direction of the global economy.”
In fact, there has been a lot of talk in the recent past about a worldwide economic recovery. But that doesn’t seem to be reflected in the price of copper, or other industrial metals for that matter. As a recent column in The Economist points out “It is not just copper this time; the aluminium price is down 10% over the last 12 months, nickel 7.9% and lead 6.3%. Compared with a year ago, metals prices are down 10.2 per cent. With the important exception of oil, commodity prices in general have been weak over the past year.”
What this tells us is that all the talk about a global economic recovery should not to be taken very seriously. In fact, other data suggests the same. The core personal consumption expenditure deflator, a measure of inflation closely tracked by the Federal Reserve of United States, the American central bank, rose by just 1.1% in January 2014. This is well below the Federal Reserve’s benchmark of 2%.
In fact, if housing is excluded from this index, the inflation comes in at 0.7%. Housing prices in the United States have been rising at a fast pace because of the low interest rates maintained by the Federal Reserve.
What this tells us is that consumer demand is rising at a very slow pace in the United States. And there can be no economic recovery without an up-tick in consumer demand. And how are things in Europe? The inflation in the Euro Zone (18 countries which use euro as their currency) fell to the lowest level of 0.7% in February 2014. It was at 0.8% in January 2014.
What these numbers clearly tell us is that most of the Western world is close to deflation. Deflation is the opposite of inflation and is a scenario where prices are falling. In a scenario where prices are falling (or even in a prospective scenario where people start to believe that prices will fall) people tend to postpone consumption in the hope of getting a better deal. And this lack of consumer demand essentially ends up killing the possibility of economic growth.
In fact, the inflation numbers in China are not looking good either. As Edwards writes “Indeed the widely ignored RPI (retail price index)…is rising by only 0.8% year on year, confirming that China is closer to outright deflation than widely appreciated.”
What is interesting is that falling copper prices also tell us clearly that the demand for the base metal is falling in China. Estimates suggest that Chinese demand comprises 40% of the world’s demand for copper. Nevertheless, the thing is that all the demand for copper in China is not genuine industrial demand.
A lot of copper demand is due to a practice known as “cash for copper”. The way this works is as follows. A Chinese speculator manages to raise money in dollars. These dollars he then uses to buy copper. He then sells the copper and gets Chinese yuan in return. He then invests the Chinese yuan in wealth management products, which promise huge returns. The money invested in wealth management products is typically lent to borrowers like property developers to whom the banks are reluctant to lend.
As Lucy Hornby and Paul J Davies point out in The Financial Times “The trick works best for copper because of the red metal’s liquidity and easy storage. Importers have also tried zinc, rubber, plastics and – least successfully – palm oil, which turned out to be bulky, difficult to store and perishable.”
The cash for copper scheme works as long as the the Chinese yuan remains stable against the dollar or appreciates. As on March 19, 2013, one dollar was worth around 6.21 Chinese yuan. Since then the yuan has gradually appreciated against the dollar and by January 13, 2014, one dollar was worth 6.04 yuan.
But since January 13, 2014, the yuan has started depreciating against the dollar, and one dollar is now worth around 6.15 Chinese yuan. A depreciating yuan makes the cash for copper scheme unviable simply because the speculators need more yuan in order to repay their dollar loan. Given this, as things stand currently, the cash for copper scheme doesn’t really work.
What this means is that a huge section of the Chinese economy which was borrowing through this route has effectively been cut off. As Horny and Davies write “Import financing is one of the few sources of cash flow left for companies that are already cut off from loans by state banks at official interest rates. Many have already exhausted their ability to fund themselves through high interest rate trust products.”
Also, an important part of this trick is that borrowers to whom yuan loans are given return the money. In the second week of March the solar equipment producer Chaori Solar missed a $14.7 million interest payment. This was first case of a Chinese company defaulting on a bond payment. What is interesting here is whether China will allow the yuan to continue to depreciate against the dollar. If it does that then the cash for copper scheme will automatically get killed. Also, it will be a recognition of the fact that the government is taking the deflationary fears in China seriously.
By allowing the yuan to depreciate it will make Chinese exporters more competitive internationally. A Chinese exporter will make much more money when one dollar is worth 6.5 yuan vis a vis when one dollar is worth 6.15 yuan, as it currently is. If this were to happen, Chinese exporters will get more competitive internationally and cut the prices of their products. In order to stay competitive manufacturers from other countries will also have to cut their prices (or source their products from China) and in the process, China can effectively end up exporting deflation to large parts of the world.
The article originally appeared on www.FirstBiz.com on March 20, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Goldman Sachs' Nifty target of 7600 needs to be taken with a pinch of salt
Vivek Kaul
The investment bank Goldman Sachs is at it again. In a report dated March 14, 2014, the bank said that it expects the Nifty index to touch 7600 points during 2014. As I write this (on March 19, 2014, around noon) the Nifty is at around 6526 points.
This means that the Nifty needs to rally by around 16.5% from its current level to touch 7600 points. And if the Sensex rallies by similar levels it will cross 25,000 points during the course of the year.
Goldman Sachs offered a spate of reasons justifying the target of 7600 points for the Nifty (You can read them here). The only trouble here is that similar predictions made by Goldman Sachs in the past have gone majorly wrong.
Blogger and analyst Deepak Shenoy writes about these predictions in a post on his blog www.capitalmind.in. In November 2012, Goldman Sachs predicted that India will grow by 6.5% during 2013. The actual growth came in at less than 5%.
In March 2012, the investment bank predicted that by March 2013, Nifty would touch 6100 points. As on March 28, 2013, the Nifty was way lower at 5682.55 points. In August 2011, the investment bank predicted that by September 2012, the Nifty would touch 6600 points. As on September 28, 2012, the Nifty was at 5730.3 points. It only got anywhere near 6600 points very recently.
So that is how the past predictions of Goldman Sachs have gone. Hence, why take this new prediction seriously?
In fact, truth be told, Goldman Sachs is not the only financial firm making such predictions. They come by the dozen. Here are a few such predictions that were made at the beginning of this year. CLSA has predicted that the Sensex will touch 23,500 points by December 2014. Deutsche Bank Markets Research did better than CLSA and predicted that Sensex will touch 24,000 points by the end of this year. And Goldman Sachs in an earlier report dated November 5, 2013, had predicted that the Nifty would touch 6900 points by the end of 2014. This target has now been upped to 7600 points.
The economist John Kenneth Galbraith termed the entire business of prediction as a fraud. As he writes inThe Economics of Innocent Fraud “The fraud begins with a controlling fact, inescapably evident but universally ignored. It is that the future of economic performance of the economy, the passage from good times to recession or depression and back, cannot be foretold. There are more ample predictions but no firm knowledge.”
And why is that? “There is the variable effect of exports, imports, capital movements and corporate, public and government reaction thereto. Thus the all-too-evident-fact: The combined result of the unknown cannot be known,” writes Galbraith.
Given this, why are such predictions made? For one, making such predictions is a fairly lucrative career option. Also, investors (like most other people) want to know in which direction are the markets headed. In the recent past, there have been a spate of reports which essentially have been telling us that markets will continue to go up, because Narendra Modi will be the next prime minister of India.
The stock market investors are largely supporters of Modi, and any report that links Modi and the stock market going up is music to their ears. Sometime back an Indian stock brokerage predicted that Narendra Modi is likely to win the next elections and even made projections on how many seats the Bhartiya Janata Party is likely to win. This after some of its analysts had travelled six hundred kilometres through fifteen districts.
In a country where the most detailed polls go wrong, how can anyone in their right mind make a prediction on the number of seats a party is likely to win, after travelling through just 15 districts? The report was immediately lapped up by the pink papers and their readers, given that Narendra Modi winning the elections is music to their ears. As Galbraith puts it “The men and women so engaged believe and are believed by others to have knowledge of the unknown; research is thought to create such knowledge. Because what is predicted is what others wish to hear and what they wish to profit or have some return from, hope or need covers reality.”
Also, financial firms need a story to sell stocks to their clients. As the old saying goes, every bull market has a theory behind it. Andy Kessler, who used to be analyst with Morgan Stanley, recalls his experience in Wall Street Meat. As he writes “The market opens for trading five days a week… Companies report earnings once every quarter. But stocks trade about 250 days a year. Something has to make them move up or down the other 246 days [250 days – the four days on which companies declare quarterly results]. Analysts fill that role. They recommend stocks, change recommendations, change earnings estimates, pound the table—whatever it takes for a sales force to go out with a story so someone will trade with the firm and generate commissions.”
Predicting which way the stock market is headed is also a part of this game. Also, revising targets is an important part of this game. As Kessler writes “For some reason, Morgan Stanley was into price targets. I hated them. To me, they were pure marketing fluff. I would recommend Intel at, say $25. The first question I would get is what is my price target. My answer would be $40 for no particularly good reason. It was high enough to interest investors, but I was guaranteed to be wrong. If it hit $38, it was a great call, but I was wrong. If it went to $60, it was an even better call, but I was still wrong. What usually happened was that if the stock hit $35, I was asked to adjust my price target to $50, so that sales force would have a call to go out with.”
Let’s understand this in the context of Goldman Sachs’ Nifty target of 7600. In November 2013, the firm predicted that Nifty would touch 6900 by the end of 2014. Three months into the year the Nifty has already crossed 6500 points and hence, a target of 6900 points doesn’t sound ‘sexy’ enough. The solution, of course, is a new target which is at a much higher 7600 points.
What this also does is that it gives the financial firm a lot of coverage in the media. Every pink paper in the country, along with almost all business news websites have carried the news about Goldman Sachs’ new Nifty target. So, in a way it’s free advertising for Goldman Sachs.
Interestingly, when the stock market hit an all time high in January 2008, a stock brokerage which was looking to go public, released a report saying that the Sensex will touch 25,000 points before the end of the year. The report was covered comprehensively through the day across all business news channels. The next day the pink papers also splashed the news big time. So, the stock brokerage got the publicity that it needed. Of course, the Sensex still hasn’t touched 25,000 points, more than six years later.
This is not to say that the Sensex will not cross 25,000 by the end of the year or the Nifty will not touch 7600 points, as predicted by Goldman Sachs. For you all we know that might turn out to be the case. And the analysts at Goldman will then be termed as visionary. But when it comes to markets, it is always worth remembering what John Maynard Keynes, the great man that he was, once said: “Markets can remain irrational longer than you can remain solvent.”
The article originally appeared on www.FirstBiz.com on March 19, 2014
(Vivek Kaul is a writer. He tweets @kaul_vivek)
What is the right price of anything?
Vivek Kaul
A few years back when I went to get a new pair of spectacles made, I was given an estimate of Rs 5,700. “Chashma khareedna hai, dukan nahi (I want to buy a pair of spectacles, not the shop),” I quipped immediately.
The shopkeeper heard this and quickly moved into damage control mode. He showed me a new frame and we finally agreed on a price of Rs 2,700. The frame I ended up buying was not very different from the one that I had originally chosen. The shopkeeper tried to tell me that the earlier one was more sturdy, easy on the eyes, etc.
But to me both the frames looked the same. I have thought about this incident a few times since it happened, and come to the conclusion, that the shopkeeper was essentially trying to figure out the upper end of what I was ready to pay. In the end he sold me more or less the same product for Rs 2,700 even though he had started at Rs 5,700. He was playing mind games.
Was he successful at it? Prima facie it might seem that I saved Rs 3,000. (Rs 5,700 minus Rs 2,700). But is that the case? One of the selling tricks involves making the customer feel that he has got a good deal. Barry Schwartz provides a excellent example of this phenomenon in his book The Paradox of Choice: Why More is Less.
He gives the example of a high-end catalog seller who largely sold kitchen equipment. The seller offered an automatic bread maker for $279. “Sometime later, the catalog seller began to offer a large capacity, deluxe version for $429. They didn’t sell too many of these expensive bread makers, but sales of the less expensive one almost doubled! With the expensive bread maker serving as anchor, the $279 machine had become a bargain,” writes Scwartz.
Now compare this situation to what I went through. Before you do that, let me give you one more piece of information. When I went to the shop looking to buy a pair of spectacles, I had thought that I won’t spent more than Rs 2,000 on it. But I ended up spending Rs 2,700.
The shopkeeper’s first prize of Rs 5,700 gamed me into thinking that I was getting a good price. Thus, I ended up spending Rs 700 more than what I had initially thought. Behavioural economists refer to this as the “anchoring effect”. As John Allen Paulos writes in A Mathematician Plays the Stock Market “Most of us suffer from a common psychological failing. We credit and easily become attached to any number we hear. This tendency is called “anchoring effect”.”
Marketers use “anchoring” very well to make people buy things that they normally won’t. As Schwartz points out “When we see outdoor gas grills on the market for $8,000, it seems quite reasonable to buy one for $1,200. When a wristwatch that is no more accurate than one you can buy for $50 sells for $20,000, it seems reasonable to buy one for $2,000. Even if companies sell almost none of their highest-priced models, they can reap enormous benefits from producing such models because they help induce people to buy cheaper ( but still extremely expensive) ones.”
Anchoring is used by insurance agents as well to get prospective customers to pay higher premiums than they normally would. As Gary Belsky and Thomas Gilovich write in Why Smart People Make Big Money Mistakes and How to Correct Them “If you’re on the “buy side” purchasing life insurance, for example you’ll be susceptible to any suggestions about normal levels of coverage and premiums. All that an enterprising agent need to tell you is that most of people at your age have, say, $2 million worth of coverage, which needs $4,000 a year and that will likely become your starting point of negotiations.”
Hence, it is important for consumers seeking a good deal to keep this in mind, whenever they are thinking of buying something.
The column originally appeared in the Mutual Fund Insight magazine, March 2014
(Vivek Kaul is the author of Easy Money. He can be reached at [email protected])