Market Behaviour: Irrational Exuberance

When a bull run goes on for too long, it can morph into irrational exuberance.  People tend to think that the market has changed and that stock will continue to go up forever.  In reality, it won't - instead, a stock market bubble is gradually inflating.

Unfortunately, most people get caught in the hype and continue to buy while the bubble continues to inflate.  Then that bubble bursts without warning, sending shares of stock down 50 percent and more.  Asset bubbles have formed repeatedly over time, but most people can't recognize a bubble until after it bursts.

The most recent stock bubble was the Internet stock bubble, which inflated in the 1990s and burst in the early 2000s.  Many people who got caught up in Internet stocks lost 50% to 70% on their portfolio - and some lost as much as 90%.

Value investors such as Warren Buffett didn't play in that market.  Value investors will not buy a stock that doesn't have a proven cash flow.  Internet stocks were losing money every year.  Most hadn't even figured out how they would make a profit.  Yet analysts recommended them based on future earnings projections.

If you can't figure how a company will generate its cash flow, walk away from it.  Don't ever get caught up in promises of future earnings that have not yet materialized.

Related topics:

Market Behaviour: The Least You Need to Know
Market Behaviour: Crowd Impacts on Stock Prices

Market Behaviour: Can You Beat the Market?
Market Behaviour: Bull Runs
Market Behaviour: Bear Stalls
Market Behaviour: Pendulum Swings (Volatility)
Market Behaviour: Irrational Exuberance
Market Behaviour: Unjustifiable Pessimism
Market Behaviour: Control Yourself (Patience)

My Investment Experience: My portfolio depreciated from RM3,000,000 to a mere RM50,000

My Investment Experience
by Gan Hong Leong


“Investment is most intelligent when it is most businesslike.” Benjamin Graham, widely known as the father of value investing, taught Warren Buffet this philosophy. Based on this wisdom, Warren Buffet invested in the stock market. Today he is the second richest man in the world. Learn from him, learn from his success, and you too can become rich.

The stock market was virtually a virgin jungle to me when I bought my first share. That was in 1960, and I was 21. At that time, I was as naïve and ignorant as a schoolboy regarding stocks and shares. So long as the price was low I would call it cheap. Undervalued stocks, fairly-priced stocks, or overvalued stocks are all the same to me. The chaff and the grains have no difference.

However, I was lucky to insist that the stocks which I bought must give good dividend yield. Buying shares o a cum-dividend basis was my preference. I would sell whenever I had a good capital gain of more than 50%. I continued to invest in that manner which turned out to be profitable. Little did I realised, I was actually buying fundamentally sound stocks at fairly low prices. My investment strategy was businesslike.

In April 1993, the Malaysian stock market had a super bull run. From a low of 645 points, the KLSE Composite Index hit its all time high of 1332. Speculation was rampant. Price rise was spectacular. The market was a hive of activities. To get a seat to watch the market in the broker firm, you need to cue up as early as 7:30 a.m.! In every corner of the town, people were talking about the market. There were no losers. Everyone was a winner. I sold at the later stage of the bull market and made a windfall. By February, 1997 the value of my portfolio appreciated to RM3,000,000 from RM48,000 about 20 years ago. However, I was still none the wiser about the stock market.

The years 1997 and 1998 were traumatic. The KLSE Composite Index was at 1279 in February, 1997. I bought the shares of an investment holding company listed on the main board and the share price was around RM15 per share in early 1997. By August 1997, it had declined to RM7.70 per share.

After I bought some at that price, the price kept on declining. Against the principle of wise investing, I started averaging down whenever there was a small decline. By November 1997, it had declined to RM1.83. I thought it would stop there. Alas! It was not to be. The price continued to decline. By August 1998, it reached a low of 40.5 sen per share.

Meanwhile, my portfolio depreciated from RM3,000,000 to a mere RM50,000. Suddenly, I realised that buying in a downtrend and holding on to a falling stock was extreme stupidity. “Never catch a falling dagger!” became my favourite phrase.

After the introduction of capital control in Malaysia in September 1998, the country slowly nursed back to health. By then, I had become smarter, having learned fundamental and technical analysis. My investment was starting to become intelligent and more businesslike.

In April 2001, I started to accumulate some stocks based on fundamentals. I chose company that had excellent management and great potential for growth. If it pays good dividends and the company was undervalued, I held on to the shares. By September 2003, the stocks that I had bought had appreciated and together with the dividends received, I got another windfall.

Words of Advice
For all stock market investors and speculators out there, here is my advice:
Value for money you must insist.
Buying in a downtrend you must resist.
The trend is your friend.
Follow it to the very end.
Holding on to a falling stock is unwise.
Cut your loses quickly is advised.
Never kill the golden goose when you have one.
Never sell prematurely, let it run for once.
Undervalued unpopular stock is never a fancy.
Glamour stock is the choice normally.
Join the crowd; enjoy the ride, if you wish.
Be careful though, lest you fall out and vanish.
The market is most tempting at the top.
Lock in your profit before volume has a good drop.
Sell your stocks when you love them most.
Take your money & let the deal be closed.
Buy when volume traded is at its lowest.
The market will then be at its dullest.
Investors should buy low and sell high.
Traders should buy high and sell higher.
Some day you will know what I mean.
By then, you are a stock market dean.


Success in any field requires your labour. The stock market is no exception. To be successful, ensure that you have the knowledge and wisdom to plan your strategies, the discipline to carry out your plans, the patience to wait, the perseverance and temperament to endure, the capital to implement, and above all, the will to win. Incidentally, these are traits of a successful businessman; hence, the usefulness of Graham’s advice.

Investment in knowledge pays the best dividends. I share this philosophy.

Disclaimer: The views and opinions expressed in this article are strictly those of the author.

Securities Industry Development Corporation (SIDC) organised an essay writing competition titled My Investment Experience with the objective of getting investors to share their investment experience, good or bad. We present you, the winning essay by Gan Hong Leong from Bentong, Pahang.

http://www.min.com.my/index.php?option=com_content&view=article&id=63

Variety of market-shaking bubbles might inflate in 2011

7 JAN, 2011, 12.27PM IST,BLOOMBERG
Variety of market-shaking bubbles might inflate in 2011

TOKYO: Welcome to the year of the bubble. It may seem an odd assertion at a time when many key economies are in, or on the verge of, recession. Yet near-zero interest rates in Washington, Tokyo and Frankfurt have a way of wreaking havoc with markets and human psychology. It's not a reach to say we have a bubble in bubbles. A variety of market-shaking bubbles might inflate before our eyes - some in asset markets, others in flawed perceptions. Here are eight.

Hot money: It's terrific the MSCI AC Asia Pacific Index jumped 14% last year, outpacing MSCI's broader indexes. It would be better, though, if the gains had more to do with fundamentals and less with ultra-low rates. The Bank of Japan's largess has long seeped overseas to boost stock, bond and property prices near and far. The yen-carry trade - borrowing cheaply in yen and using the funds for riskier bets overseas - was the forerunner of a similar dollar trade. Federal Reserve policies sent tidal waves of liquidity toward Asia in 2010. It could reach disastrous proportions, leaving a trail of ruin in its wake.

Decoupling theory: The bubble here is the unsustainable belief that Asia can grow rapidly no matter what happens among the biggest economies. Don't bet on it. It's great China is growing 9.6% and India at 8.9%. But, nothing would serve Asia better than a rebound in growth in the US , euro zone, Japan and the UK, which combined make up $34 trillion in annual output. Developing economies may live for a couple of years without the majors. Good luck keeping up that performance in the years ahead.

Food prices: A January 3 Times of India headline raised a question in many minds: "Can government do nothing legally to check prices?" The answer is: not much. The UN Food and Agriculture Organization predicts the global cost of importing foodstuffs totalled $1.026 trillion in 2010, compared with $893 billion in 2009. Imbalances in supply and demand and regional trade rigidities will accelerate the trend, swamping developing nations with the most basic of problems: Filling the bellies of those powering their economic rise.

Income inequality: The trajectory of everyday prices is a fast-developing setback to Asia's efforts to narrow its gaping rich-poor divide. Rising costs for cooking-oil and rice may mean little to a Goldman Sachs Group Inc staffer. To a family living on $3 a day and already spending two-thirds of income on food, they are devastating. Rising wealth disparities could foreshadow a year of tensions, as failed harvests and inflation cause famines, riots, hoarding and trade wars worldwide. The bubble here would be one in human suffering.

Wacky weather: A few months ago, drought was imperiling Australia's economic outlook. Today floods that some characterise as "biblical" have economists calculating the implications for commodity prices. Forget temperatures and focus on the increasing frequency of freaky weather patterns from Miami to Mumbai.

Currency reserves: Why any economy needs $2.7 trillion of them is beyond me. It's not just China that is trapped into adding to its currency stockpile to keep its existing holdings from losing value. Japan has more than $1 trillion, while Taiwan, South Korea, Hong Kong, Singapore and Thailand have a combined $1.3 trillion. Talk about an unproductive use of wealth - and a risk that's growing by the day with no easy fix in sight.

Geopolitical risks: Leave it to Kim Jong-Il to remind investors that the biggest surprises won't be from economic or corporate reports, but rogue regimes. Expect a bull market in territorial disputes. Faced with growing uncertainty, governments are desperate to placate the masses. The desire to unify the home population may lead to rifts between neighbours. Those seeking shelter from these brewing storms explains why gold is almost $1,400 an ounce.

Group of 20: Any optimism that European officials can avert disaster might be seen as irrational. The same goes for the belief that China can grow 10% annually forever or that Japan's leaders can defeat deflation. The real perceptions bubble is that a disparate grouping of 20 nations can tame out-of-whack markets and imbalances that were decades in the making. The year ahead might turn any, or all, of these accepted wisdoms on their head.

http://economictimes.indiatimes.com/markets/analysis/variety-of-market-shaking-bubbles-might-inflate-in-2011/articleshow/7232817.cms

Will emerging markets be 2011’s great bubble?

INVESTING
Will emerging markets be 2011’s great bubble?

SUJATA RAO
LONDON— Reuters
Published Friday, Dec. 17, 2010 10:01AM EST
Last updated Wednesday, Dec. 22, 2010 5:50PM EST


Emerging markets, the consensus trade for 2011, look set for further heavy inflows of investment dollars, raising questions over how much more new money they can comfortably absorb without igniting an asset bubble.

Most fund managers at a recent Reuters summit picked emerging markets as a top bet for next year, citing double-digit returns, underpinned by rising incomes and fast economic growth.

Equity portfolio flows to emerging markets are set to reach $186-billion (U.S.) this year, and, while they are seen falling a touch to $143-billion next year, according to the Institute for International Finance (IIF), they will still be more than double the $62-billion annual average seen between 2005 and 2009.

Yet, some are starting to ask if investors are getting carried away. Not only do unbridled portfolio flows risk inflating sector valuations into bubble territory, but the flows may be based on unrealistic expectations of long-term returns.

“The bigger bubble risk is the investor expectation of EM, there’s such euphoria,” said Mark Donovan, chief executive officer of Robeco, which manages €146-billion ($194.3-billion). “I’m always wary of these herd moves into certain asset classes, generally they are not well-timed.”

SWEET SPOT HIDES BITTER TRUTH

Mr. Donovan does not question the underlying emerging markets growth story. But he and some others believe new investors may be ignoring potential problems, within and outside the sector.

Emerging markets have been in a sweet spot this past year or two as liquidity unleashed by Western central banks has pumped up the market, fuelling double-digit returns.

A Reuters poll forecasts emerging returns will far outstrip U.S. and UK equity gains in 2011. Excess liquidity, however, is fuelling inflation in developing economies, potentially leading to overheating. Higher U.S. Treasury yields could also become a headwind.

“My central scenario is that in 2011 emerging markets will be okay. Given where valuations are you will still get a positive absolute return,” said John-Paul Smith, chief emerging markets strategist at Deutsche Bank in London.

“But some of the outsize returns forecasts are probably way too high ... I’m concerned that if people become too optimistic we could see a bubble-type situation developing. When the bubble bursts, it has horrible repercussions for the real economy.”

EMERGING MARKETS ARE ... STILL EMERGING

One worry, Mr. Smith says, is that the inflows risk encouraging emerging policymakers’ hubris, removing the pressure for reform.

Some doomsayers note big capital inflow peaks often precede crises. This may be especially true of emerging markets which remains a relatively small, illiquid asset class: the market capitalization of the 37-country MSCI emerging index, is less than a third of the U.S. S&P 500.

That means a large-scale cash influx can quickly inflate asset prices to unsustainable levels, risking a repeat of the familiar boom-bust emerging market cycles.

RBC estimates that a 1 per cent re-allocation of global equity and debt holdings will send $500-billion into emerging markets – more than 10 per cent of the MSCI emerging market cap.

NOT YET A BUBBLE

At present, emerging valuations are not in bubble territory – they trade at a discount to developed markets at around 11.5 times forward earnings.

Valuations are still below 2007 peaks and well off levels during the dot-com bubble in the late 1990s when some stocks were trading at 60-80 times forward earnings. And the volume of securities available for investment is growing.

The MSCI EM’s market capitalisation has grown by around 10 per cent a year in the past decade and emerging markets’ share of the world index has tripled to 14 per cent. The emerging debt universe too has doubled to around $6-trillion over the past five years, JPMorgan says.

Still, with investors piling in, too much cash could in coming years end up chasing too little market cap.

Global equity fund allocations to emerging markets now stand at 16 per cent of assets under management – in dollar terms that is $1.5-trillion, Barclays Capital said, noting bond allocations are at 7.2 per cent. Both are close to pre-crisis highs.

“(Positioning) has reached levels at which investors rightly question the sustainability of the EM flows story going into 2011,” Barclays analysts said in a note.

SIGNS OF NERVOUSNESS

There are signs of wariness. Many investors say that instead of increasing outright EM longs, they prefer multinationals such as Unilever that have exposure to emerging markets.

Another tactic has been to hedge EM exposure via Australian bonds, which are seen making big gains in case of a hard landing in China – a scenario feared by many.

Michael Power, global strategist at Investec Asset Management, says 2011 may well shape up to be the year in which investors learn not to be unequivocally bullish on the sector.

“People are looking at EM as a cake and saying ‘I want a slice,’ without looking at the ingredients of that cake. So some countries that are not born equal are being swept along in the trade along with the deserving ones,” he said.

“When bubbles burst, there is a fallout and the deserving emerging markets will be considered guilty by association.”

Asian bubble watch: shares due for a correction

Asian bubble watch: shares due for a correction
November 17, 2010 - 2:44PM

Asia's booming financial markets are not yet bubbling over, with investors drawing a line at exotic perpetual bonds, but some equity valuations in red-hot South-East Asian bourses appear stretched.

Asia ex-Japan, with its favourable economic fundamentals and stable balance sheets, has been a magnet for foreign capital, one whose attraction have been made all the more powerful by expectations that money will stay cheap in advanced economies for a long time.

A growing number of emerging economies in Asia and elsewhere in the world have been imposing or considering capital controls to keep the influx of speculative money from feeding potentially destabilising bubbles and complicating policymaking even further.

Visiting bankers from the West have been struck by the boldness of Asia's nouveau riche, who last month bought three bottles of 141-year-old Chateau Lafite Rothschild wine at Sotheby's in Hong Kong for $US232,692 each, nearly triple the highest estimate.

It's no surprise then that some analysts say if any asset bubbles form in Asia, it would be among the most anticipated in modern history. Indeed, the phrase "asset bubble" has appeared in more than 3000 articles so far in 2010, more than any other year in the past decade, Factiva showed.

Below are highlights of the bubble risks traders and investors face in Asia. For now the risks appear relatively low.

Shares

Bubble risks: Low to medium, on South-East Asia valuations, IPO frenzy

- Asia's hottest stock markets this year in the south-east may be due for a correction. Without one, they run the risk of forming a bubble.

- MSCI indexes for Indonesia, the Philippines and Thailand are trading at price-to-12-month forward earnings ratios that are 22 per cent above the five-year average.

- Valuations may contract, with the 30-day mean change in 12-month earnings estimates for the Philippines and Indonesia down 0.1 per cent, according to Starmine data.

- A gaggle of prominent shareholders liquidated nearly $US2 billion worth of equities in Hong Kong, South Korea, Indonesia and Malaysia last week, signalling a possible top of the market because of high valuations.

- Contrast that with Coal India's IPO on November 4, which encapsulated the frenetic year for IPOs. The $US3.5 billion offering drew $US52 billion in orders, and shares surged 40 per cent on the first day of trade.

- "When everyone at large starts talking optimism, that is the time to get cautious. Retail participation has increased a lot. There are plenty of 'tips' floating around. All these are danger signs." said Arun Kejriwal, director of research firm KRIS in Mumbai.

Bonds

Bubble risks: Low. Borrowers want to lock in long-term funding, but investors are asking for higher premiums.

- Risk on trading in the wake of the Federal Reserve's second round of quantitive easing has given way to profit taking in secondary markets as US Treasury yields spike.

- The issuance calendar is still full but upward pressure on yields and unfriendliness toward structures that push boundaries, such as perpetual bonds, may eventually cool primary markets.

- Perpetuals, which have no maturity and had not been issued by an Asian corporate in 13 years, issued by Cheung Kong Infrastructure, Hutchison Whampoa and Noble Group fared poorly in secondary trading after Noble's bond attempted to push through with what was viewed as an aggressive structure.

- Noble's 3-point drop in secondary trading was a reality check for bankers and a curb on bubble behaviour. Likewise, OCBC Bank's Lower Tier 2 bond with a 12-year non-call seven maturity - the first of its kind from an Asian bank - widened as much as 20 basis points two days after it was issued.

- Asia ex-Japan G3 currency bond issuance hit a record $US78 billion so far this year, with nearly six more weeks to go in 2010.

- Investors still are welcoming higher duration in both high-yield and high-grade names, for now. Watch how far down they go on the credit scale.

- Capital curbs have already cooled foreign inflows in some of South-East Asia's hot bond markets. While Indonesia has been hit by duration-cutting trades after posting equity-like returns for the second consecutive year, Thai bond yields have rocketed after Bangkok reimposed a 15 per cent withholding tax for offshore purchases of local bonds on October 13.

- In the Philippines, a US dollar shortage engineered by the central bank dimmed the relative allure of Philippine assets and weakened the peso sharply - one of the top performing Asian currencies so far this year.

Reuters

Jeremy Grantham Interview

Airtime: Thurs. Nov. 11 2010
In an extended interview, Jeremy Grantham, chairman of Grantham Mayo Van Otterloo (GMO), talks to Maria Bartiromo about the markets, the economy, and his investment strategy.

http://www.gmo.com/America/

Bubble

A History of Home Values

http://www.accumulatingmoney.com/real-estate-mania-a-history-of-home-values/

Asians Gird for Bubble Threat, Criticize Fed Move

Bloomberg
Asians Gird for Bubble Threat, Criticize Fed Move
November 04, 2010, 6:08 AM EDT

By Michael Heath

(Updates with comments from Malaysia central bank starting in second paragraph.)

Nov. 4 (Bloomberg) -- Asia-Pacific officials are preparing for stronger currencies and asset-price inflation as they blamed the U.S. Federal Reserve’s expanded monetary stimulus for threatening to escalate an inflow of capital into the region.

Chinese central bank adviser Xia Bin said Fed quantitative easing is “uncontrolled” money printing, and Japan’s Prime Minister Naoto Kan cited the U.S. pursuing a “weak-dollar policy.” The Hong Kong Monetary Authority warned the city’s property prices could surge and Malaysia’s central bank chief said nations are prepared to act jointly on capital flows.

“Extra liquidity due to quantitative easing will spill into Asian markets,” said Patrick Bennett, a Hong Kong-based strategist at Standard Bank Group Ltd. “It will put increased pressure on all currencies to appreciate, the yuan in particular has been appreciating at a slower rate than others.”

The International Monetary Fund last month urged Asia- Pacific nations to withdraw policy stimulus to head off asset- price pressures, as their world-leading economies draw capital because of low interest rates in the U.S. and other advanced countries. Today’s reactions of regional policy makers reflect the international ramifications of the Fed’s decision yesterday to inject $600 billion into the U.S. economy.

Stocks Climb

Most Asian currencies rose against the dollar after the Fed’s move, led by a 0.5 percent climb in the Taiwanese dollar and 0.2 percent gain in the South Korean won. New Zealand’s currency reached a 29-month high, and Australia’s dollar touched its strongest level since 1982. The MSCI Asia Pacific index of stocks advanced to the highest level since July 2008.

People’s Bank of China adviser Xia said U.S. policy makers have a conflict between making policy for the domestic economy and accepting responsibilities that come with being the issuer of the international reserve currency, writing in the Finance News newspaper today.

China should counter the U.S. through regional currency alliances, speeding international use of the yuan and seeking stability in exchange rates through the Group of 20, which holds a summit next week, Xia later told reporters in Beijing.

China Policy

“We may need to moderately tighten monetary policy and should tighten controls on banks’ lending,” He Fan, an economist at the Chinese Academy of Social Sciences, said in an interview in Beijing. “We are worried about asset bubbles in China and the Fed’s new quantitative easing measures will add to the pressure on prices.”

China raised interest rates for the first time since 2007 last month, and has limited the yuan to less than a 2 percent gain versus the dollar since June.

Asian currencies have climbed against the dollar this year as the region’s growth outpaces the rest of the world. Regional central banks from China to India and Australia have raised interest rates to curb inflation pressure, while countries including South Korea and Indonesia have adopted measures to slow the flow of speculative money.

“Our country will actively consider implementing capital control measures to improve the macro-economy,” Kim Ik Joo, a director general of South Korea’s finance ministry, said in a telephone interview today. “Now that the U.S. has announced its plans on quantitative easing, don’t you think there will be an influx of capital going into emerging markets?”

Goldman’s Call

Goldman Sachs Group Inc. this week raised its 12-month target for Hong Kong’s Hang Seng Index of equities, saying the city has the most to gain from extra liquidity released by quantitative easing programs and China’s growth.

The Fed’s move will “definitely add pressure to the asset markets in emerging-market economies,” HKMA chief Norman Chan said at a press briefing in Hong Kong today. The HKMA will “take measures that are specific to the housing market if necessary.”

In contrast, the Philippines central bank said global financial markets will be calmer and the decline of the U.S. dollar will ease after the Fed purchase plan came “in line” with forecasts. Funds may continue to flow to emerging markets because of low U.S. yields, Bangko Sentral ng Pilipinas Governor Amando Tetangco said in a mobile phone text message.

Thai Finance Minister Korn Chatikavanij said central banks in the region are in touch and if needed may act jointly against currency speculators, speaking to reporters in Bangkok. Bank Negara Malaysia Governor Zeti Akhtar Aziz said in an e-mailed statement that “central banks in the region also have sufficient range of instruments to manage this challenge and are willing to act collectively if the need arises to ensure stability.”

Currency Pool

The Association of Southeast Asian Nations, together with Japan, China, and South Korea, last year signed an agreement to create a $120 billion foreign-currency reserve pool. Member nations are able to tap the pool, set up in a framework of bilateral currency swaps, in times of turmoil to defend their exchange rates.

Sri Lanka aims to keep rupee gains “controlled” as the Fed’s action generates an “enormous” amount of credit, the nation’s central bank Governor Ajith Nivard Cabraal said in an interview during an Asian Development Bank forum in Manila today.

Currency policies by Asian central banks have differed in recent months. While Thailand, Japan and South Korea have taken steps to cool an appreciation in their currencies that is threatening exports, Singapore has signaled it will allow faster exchange-rate gains.

‘Two Giants’

New Zealand Finance Minister Bill English said that U.S. and Chinese policies are causing his nation’s currency to soar, endangering export competitiveness.

“We’re caught between the policies of the two giants, both of which puts some pressure on us, with the U.S. depreciating their currency and China not allowing theirs to appreciate as much as would suit us,” English said in a Bloomberg Television interview in Tokyo.

Meantime in Japan, whose currency has risen to the highest level in 15 years versus the dollar, Prime Minister Kan said at parliament today that the strong-yen trend is partly related to “the U.S.’s weak-dollar policy, which prompted the rise of the currencies of many emerging nations.”

U.S. dollar policy is set by the Treasury Department, and Secretary Timothy F. Geithner last month reiterated the long- standing American stance that his nation supports “a strong dollar.”

--With assistance from Belinda Cao and Eva Woo in Beijing, Frances Yoon in Seoul, Tracy Withers in Wellington, Max Estayo in Manila, Suttinee Yuvejwattana in Bangkok, Takashi Hirokawa and Sachiko Sakamaki in Tokyo and Sonja Cheung, Marco Lui and Stephanie Tong in Hong Kong. Editors: Chris Anstey, Lily Nonomiya


http://www.businessweek.com/news/2010-11-04/asians-gird-for-bubble-threat-criticize-fed-move.html

Weeding out over-heated stocks

Avoiding over-priced stocks that could plunge anytime is as critical as picking the right stocks. 

Buying over-heated stocks and losing money in a bubble burst is not an uncommon phenomenon in the markets.

Stocks that have moved up the ladder very quickly are potentially risky. The sudden spurt could be based on a rumour or event not backed by strong fundamentals. 

Good market conditions or bull runs do not last forever. Investors, who believe that good times are here to stay often burn their fingers. 

On a similar note, an over-valued stock has little scope or space for upward movement and could lose its momentum anytime.  

A little bit of research and analysis will help investors make prudent investment choices even in bear market conditions.

http://economictimes.indiatimes.com/features/financial-times/Investment-tips-Pick-the-right-stock-at-right-time-for-returns/articleshow/6759442.cms

Pick the right stock at right time for returns

16 OCT, 2010, 03.54PM IST,

KAVITA SRIRAM,ET BUREAU 

Investment tips: Pick the right stock at right time for returns

Picking the right stock at the right time, and booking profits, is a challenge for many small investors. With hardly any time for research and a desire to reap quick profits, many investors often rely on friends and expert advice. The risks are considerable even if you chase a rising stock, without comprehending the driving forces.   How do you differentiate an overheated stock from one that has truly appreciated in its intrinsic value? 


Identifying an under-valued stock 


An under-valued stock is a great investment pick as it has high intrinsic value. Currently under-valued , it has immense potential to rise higher and make the investor richer. 


A low price-to-earnings (P/E) ratio can be an indicator of an under-valued stock. The P/E is calculated by dividing the share price by the company's earnings per share (EPS). EPS is calculated by dividing a company's net revenues by the outstanding shares. A higher P/E ratio means that investors are paying more for each unit of net income. So, the stock is more expensive and risky compared to one with a lower P/E ratio. 


Trading volume is an indicator 


Trading volumes can help pick stocks quoted at prices below their true value. In case the trading volume for a stock is low, it can be inferred that it has not caught the attention of many investors. It has a long way to ascend before it touches its true value. A higher trading volume indicates the market is already aware and interested in the stock and hence it is priced close to its true value. 


Debt-to-equity ratio 


A company with high debt-to-equity ratio can indicate forthcoming financial hardships. If the ratio is greater than one, it indicates that assets are mainly financed with debt. If the ratio is less than one, it is a scenario where equity provides majority of the financing. Watch out for stocks that have low debt-to-equity ratio. 


Some other pointers 


Historical data of stocks that have performed consistently and yielded good returns are reliable. A higher profit margin indicates a more profitable company that has better control over its costs compared to its contenders in the same sector. 


Weeding out over-heated stocks 


Avoiding over-priced stocks that could plunge anytime is as critical as picking the right stocks. Buying over-heated stocks and losing money in a bubble burst is not an uncommon phenomenon in the markets. Stocks that have moved up the ladder very quickly are potentially risky. The sudden spurt could be based on a rumour or event not backed by strong fundamentals. 


Good market conditions or bull runs do not last forever. Investors, who believe that good times are here to stay often burn their fingers. On a similar note, an over-valued stock has little scope or space for upward movement and could lose its momentum anytime. 


A little bit of research and analysis will help investors make prudent investment choices even in bear market conditions.

http://economictimes.indiatimes.com/features/financial-times/Investment-tips-Pick-the-right-stock-at-right-time-for-returns/articleshow/6759442.cms

Sorry to burst your bubble, your investment is overpriced

Annette Sampson
October 9, 2010

They're frothy and insubstantial. Mere lightweights in the world of solid matter. But bubbles can prove mighty dangerous phenomena, especially in the world of investments.

Investment bubbles have been brought back into focus by the mere uttering of the word by the Reserve Bank head of financial stability, Luci Ellis, in relation to the residential property market at a conference in Brisbane this week.

Let's be quite clear. Despite continuing speculation that Australian house prices are in bubble territory this was not what Ellis was claiming. Rather, Ellis said the market was showing ''welcome signs'' of cooling. But low yields on residential property, she said, limited the potential for price appreciation.

Advertisement: Story continues below ''Buying an asset because you expect the price to rise in the future, well, that is actually the academic definition of a bubble,'' were the attention-grabbing words. ''So that would be undesirable and seen as a problem.''

Never mind that future capital gains have long been the prime motivation for Australian residential property investors. Ellis said recent rises in rental yields and a levelling off in prices were a good thing, but this has not dampened the speculation over whether Australia, like the US and so many other countries, is in danger of a housing bubble burst.

The International Monetary Fund also bought into the housing bubble debate this week cautioning that our house prices may be overvalued and a correction could hit household wealth and consumer confidence.

The arguments on the Australian housing market have been well-documented. Those holding the bubble view point to historically high levels of debt by households, high house prices in relation to incomes, and low rental yields as being unsustainable. The property bulls point to continuing undersupply of housing and strong immigration as putting a floor under house values.

Both have a point. But in the post global financial crisis environment where debt still has the potential to derail the economic recovery, it would certainly be prudent to err on the side of caution.

However the argument raises the broader issue of how investors can shield themselves from the inevitable crashes that follow investment bubbles, while enjoying some of the profits while markets are rising.

As the chief economist of AMP Capital Investors, Shane Oliver, points out, investment asset bubbles are an inevitable outcome of human nature. Investors have a natural inclination to jump onto popular fads by buying into investments that have been star performers - a trend that pushes prices up further and further until they become overpriced and unsustainable.

While you would think investors would be once bitten, twice shy, history also shows that bubbles emerge regularly, often arising from the ashes of the most recent crash. While it's easy to get caught up in bubbles, the fact that we've had so many of them also provides investors with the tools to identify when and where bubbles are emerging. There are always those who will claim each bubble is different, but the reality is that they all follow similar patterns. The signs are there for those prepared to look for them.

Dr Oliver identifies a combination of conditions that tend to lead to bubbles.

• Chief among these is a supply of easy money, though the bubble generally does not start to form until something happens that generates popular interest in the investment, it becomes overvalued, and speculators jump in fearing that if they don't buy now they'll miss out on the next chance to make some fast profits.
• Other commentators have pointed out that bubbles are also characterised by overconfidence. Even when it is obvious that prices are overvalued, pundits come up with arguments to justify why ''this is different'' or why the old rules don't apply to this investment. A classic example was the tech boom of the late 1990s when any company claiming a vague connection to information technology could command a heady price on the sharemarket regardless of its earnings. Indeed, even if it had no earnings.
• Another common feature of bubbles is that they are generally fostered by government policy that encourages speculation to grow.

Oliver says the liquidity that has been generated by governments in response to the global financial crisis and the bursting of the bubble in US house prices has created fertile conditions for the next bubble. Easy money is providing the fuel for investors to jump into something seen as safe, offering a good return, and removed from the assets that caused the last set of problems.

His pick of prime bubble candidates are shares in emerging markets, gold and commodity prices, and resource shares.

However for a bubble to exist, speculation and overvaluation must also be present - and while there is definitely speculation in these markets, and prices have risen strongly, Oliver argues they have not yet reached bubble levels.

His verdict is that we are in the ''foothills'' of the next bubble, which more than likely has several years to run.

It is also important to note that while the most memorable bubbles are those that come to a spectacular end, not all investment bubbles lead to a sudden collapse in prices. Bubbles can end with a bang, or they can simply run out of steam, providing investors with a long period of underperformance rather than overnight losses. Historically this has been the more common trend for less volatile (and less liquid) assets such as direct property investments.

In that respect, a cooling in Australian house prices should indeed be welcomed.


http://www.smh.com.au/business/sorry-to-burst-your-bubble-your-investment-is-overpriced-20101008-16bz5.html

Is a property bubble forming?

Saturday September 18, 2010

By ANGIE NG
angie@thestar.com.my

There has been some concern in recent months over an imminent real estate bubble in Malaysia. How real is this threat or is it merely confi ned to a few hot spots?
CONCERNS over whether the local housing market is overheating and will lead to an asset bubble are raising questions on whether there is a need for more tightening measures to curb speculative buying and ensure the market stays sustainable.

Dr Yeah Kim Leng ... ‘Anything can trigger a collapse. An economic slowdown, for example.’

The local housing market has not “hit the roof” like in some places in the region such as in Hong Kong, Shanghai and Singapore which have recorded sharp price jumps of 40% to 60% since last year.
Nevertheless, prices of landed houses in some popular areas in the Klang Valley, Penang and Johor have appreciated by 10% to 30% over the past six to eight months. Bank Negara is keeping a close watch on the mortgage loan market and is engaging with bankers on whether tightening measures such as capping the loan-to-value ratio (LVR) at 80% should be introduced. It will be unlikely that the central bank will impose the mortgage loan limit across the board but the measure will most likely be targeted at the critical sectors, such as the upper medium to high-end landed residential sector and non-owner occupied houses.
Purchasers who own multiple properties may also be subject to the new loan limit if it is implemented.
The RPGT factor
Industry observers say another measure at the Government’s disposal is raising the quantum of real property gains tax (RPGT), which is currently at 5% for all property sold within the first five years of purchase.
The Government has tweaked the RPGT on various occasions depending on market conditions.
From April 2007 until it was reintroduced in January this year, all gains from property transactions have been exempted from the tax. The exemption was granted as a support measure to reverse the flagging property sales during the market downturn.
Under Budget 2010, the RPGT was brought back in January, albeit at 5% for all property sold within the first five years of purchase.

Tang Chee Meng ... ‘The state of the property market is very much dependent on the state of the country’s economy.’

If the Government decides to reintroduce the RPGT in its entirety, property speculators will get the brunt of the “axe” as gains from property sales within the first five years of purchase will be subjected to a tax of 5% to 30%.
The maximum 30% is for disposal within the first two years; 20% within the third year; 15% within the fourth year and 5% within the fifth year. Profits earned from disposal in the sixth year and beyond will not be taxed.
How far the Government will go on tightening the noose on mortgage loans and the RPGT is still left to be seen. But some changes can be expected in the horizon if price increases become more prevalent and broad-based.
Consumer and industry groups are concerned that if the tightening measures are introduced, they will impact the affordability of property buyers and market sentiment.
Usually if a market is flushed with speculative buying and a bubble is imminent, property prices will spike sharply across the board of a certain market within a short time like what is happening in a number of countries in the region today.
A case in point – a 26-year-old government-built apartment of 420 sq ft in the Sham Shui Po area of Kowloon district was transacted at HK$1.98mil, or HK$4,714 per sq ft.
Fuelled by high liquidity and record low mortgage rates, Hong Kong, China and Singapore have implemented tightening measures to clamp down on property speculators as risk heightens that the sharp escalation of property prices will result in a market collapse if the bubble burst.
Reason for concern?
Is Malaysia facing a similar risk and is there worry of an imminent overheating or bubble?
Real Estate and Housing Developers’ Association (Rehda) president Datuk Michael Yam discounts the possibility of overheating or an asset bubble in the local market.

“We believe the steep price increases are only reported in scattered locations in the Kuala Lumpur City Centre and some landed housing projects in the Greater Kuala Lumpur area. This does not represent a bubble but more of a short-term deviation from fundamentals that are due to isolated speculative activities in some areas.
“Generally, the local property industry is chugging along at an even keel. We believe that prices are already peaking, and we are neither hot nor cold. The recent spurt in prices may be due to the effect of the earlier stimulus package and liquidity but that has stabilised and a plateau has been formed,” he relates to StarBizWeek.
Yam says that unless there are government incentives, there is generally no excitement or broad-based stimulation in property activities. For an increase in activities, the impact of the Economic Transformation Programme, Government Transformation Programme and the NKEAs and even Malaysia Property Incorporated as major catalysts has to come in.

“Landed terrace and semi-detached houses have seen big capital appreciation due to the limited stock available and future supply especially in prime locations. As a consequence, prices of current stock in strategic areas of Medan Damansara, Bangsar, Sri Hartamas, Bandar Utama and even new launches at Desa Park City are at or above the RM1mil mark for a double or 3-storey terrace house.
“However, one must appreciate that the price a house commands (other than its location) is dependent on its built-up, specifications, value added renovation and unique features not normally available in a standard offering,” he points out.
Tackling structural issues
Yam says the industry and the Government need to accelerate supply and also review the causes and hurdles that either impede or slow down the delivery process. Areas that need to be examined include the cost of doing business and the efficiency and subsidies that affect delivery to avoid overheating due to pent-up demand.
He disagrees with new tightening measures. “As it is, the market is not exactly buoyant and is only driven predominantly by owner occupiers. Any additional regulations such as higher RPGT, capping loan amounts and imposing higher deposits, or increasing the cost of housing delivery such as making the build-then-sell system compulsory would be a disincentive to the industry,” he stresses.
Malaysia Property Inc chief executive officer Kumar Tharmalingam says the issue of a bubble is being overblown.

“A single swallow does not make a summer. There may be certain projects fetching premium values or prices for their products, but it is not representative of the overall market.
“Our data shows values are rising in the Klang Valley but they are within specific locations and projects sought by a special brand of investors who want exclusivity. The strong buying interest is not across the board but is mainly centred in the high growth markets of the Klang Valley, Penang and Johor,” he adds.
Kumar says concerns that the potential slowdown in the West will affect the local market are also overrated.
“Our banks are strong and have not buckled even during the global financial crisis in 2007/8. We have systems in banks that keep on fine-tuning the loan to equity ratio depending on the earning capacity of the borrower. Bank Negara is watching the situation and will call in loan to value ratios to change if the situation warrants.
“Our property purchase system from a primary developer is probably the most seamless in Asia. All the necessary checks and balances are built into place by the developers, bankers and solicitors to make sure that the developers have the right purchaser who has the necessary finances and affordability to purchase the property,” he says.
An imminent uptrend?
Meanwhile, developers are monitoring the sale of their products daily and any signs of weakness in the market will be felt by them “since they stand to lose the most if the buyer pays a deposit and walks away from the purchase later,” Kumar adds.
According to Mah Sing Group Bhd group managing director and chief executive Tan Sri Leong Hoy Kum, the property market is still in the early to mid-phase of an upcycle.
“We do not see a strong risk of a property bubble happening yet and there is no sign of overheating. The price increase in properties has not been broad-based, but demand driven and rather selectively in prime locations.”
Leong says certain locations and types of products are more resilient in terms of demand, capital appreciation and value preservation.
“A healthy property market is good for the economy and quality properties in prime locations are deemed to provide a good hedge against inflation. Barring any external shocks, we are cautiously optimistic that the property market should continue to do well in the short and medium term,” Leong says.
Kumar concurs with Yam that the Government’s stimulus packages are only filtering into the system now and are creating greater confidence and interest in the property market.
“There are not enough viable investment instruments around and that’s why investors are rushing to buy property. Generally, our financial market still lacks depth such as good financial planners and advisors on investment opportunities. There is still a preference for solid and secure investment instruments like property,” he adds.
Kumar says developers will slow down on their launches as they do not want a property overhang of unsold units.
“Over the next few years we are going to see smaller launches in the Klang Valley as our property market consolidates and developers are going to release property in batches to test the market.
“Developers are venturing into niche products with better quality finishings and designs, as buyers want the least fuss these days. This has driven developers to go into higher value residences,” he concludes.

http://biz.thestar.com.my/news/story.asp?file=/2010/9/18/business/7043925&sec=business

Related Stories:

A leaf from history

Reasons for this perceived bubble

What industry players say

Cooling down the market

5 Steps Of A Bubble

5 Steps Of A Bubble
by Investopedia Staff, (Investopedia.com)

The term "bubble," in the financial context, generally refers to a situation where the price for an asset exceeds its fundamental value by a large margin. During a bubble, prices for a financial asset or asset class are highly inflated, bearing little relation to the intrinsic value of the asset. The terms "asset price bubble," "financial bubble" or "speculative bubble" are interchangeable and are often shortened simply to "bubble." (For a review on the South Sea Bubble, check out Crashes: The South Sea Bubble.)

Bubble Characteristics
A basic characteristic of bubbles is the suspension of disbelief by most participants during the "bubble phase." There is a failure to recognize that regular market participants and other forms of traders are engaged in a speculative exercise which is not supported by previous valuation techniques. Also, bubbles are usually identified only in retrospect, after the bubble has burst.

In most cases, an asset price bubble is followed by a spectacular crash in the price of the securities in question. In addition, the damage caused by the bursting of a bubble depends on the economic sector/s involved, and also whether the extent of participation is widespread or localized. For example, the bursting of the 1980s bubble in Japan led to a prolonged period of stagnation for the Japanese economy. But since the speculation was largely confined to Japan, the damage wrought by the bursting of the bubble did not spread much beyond its shores. On the other hand, the bursting of the U.S. housing bubble triggered record wealth destruction on a global basis in 2008, because most banks and financial institutions in the U.S. and Europe held hundreds of billions of dollars worth of toxic subprime mortgage-backed securities. By the first week of January, 2009, the 12 largest financial institutions in the world had lost half of their value. The economic downturn had caused many other businesses in various industries to either go bankrupt or seek financial assistance. (To learn more about housing bubbles, read Why Housing Market Bubbles Pop.)

The Dutch Tulip Mania
To this day, the Dutch tulip mania remains the yardstick by which speculative bubbles are measured, because of the total disconnect between the fundamental value of a tulip and the price that a prized specimen could fetch in Holland in the 1630s.

The vivid colors of tulips and the seven years it takes to grow them led to their increasing popularity among the Dutch in the 1600s. As demand for them grew, tulip prices rose, and professional growers became willing to pay increasingly higher prices for them. Tulip mania peaked in 1636-37, and tulip contracts were selling for more than 10-times the annual income of skilled craftsmen.

The tulip bubble collapsed from February 1637. Within months, tulips were selling for 1/100th of their peak prices.

Minsky's Theory of Financial Instability

The economist Hyman P. Minsky is certainly no household name. However, thanks to the credit crisis and recession of 2008-09, Minsky's theory of financial instability attracted a great deal of attention and gathered an increasing number of adherents more than a decade after his passing in 1996. Minsky was one of the first economist to explain the development of financial instability and its interaction with the economy. His book, "Stabilizing an Unstable Economy" (1986) was considered a pioneering work on this subject. (To learn more, refer to Riding The Market Bubble: Don't Try This At Home.)

Five Steps of a Bubble

Minsky identified five stages in a typical credit cycle – displacement, boom, euphoria, profit taking and panic. Although there are various interpretations of the cycle, the general pattern of bubble activity remains fairly consistent.

1. Displacement: A displacement occurs when investors get enamored by a new paradigm, such as an innovative new technology or interest rates that are historically low. A classic example of displacement is the decline in the federal funds rate from 6.5% in May, 2000, to 1% in June, 2003. Over this three-year period, the interest rate on 30-year fixed-rate mortgages fell by 2.5 percentage points to a historic lows of 5.21%, sowing the seeds for the housing bubble.

2. Boom: Prices rise slowly at first, following a displacement, but then gain momentum as more and more participants enter the market, setting the stage for the boom phase. During this phase, the asset in question attracts widespread media coverage. Fear of missing out on what could be an once-in-a-lifetime opportunity spurs more speculation, drawing an increasing number of participants into the fold.

3. Euphoria: During this phase,caution is thrown to the wind, as asset prices skyrocket. The "greater fool" theory plays out everywhere.

Valuations reach extreme levels during this phase. For example, at the peak of the Japanese real estate bubble in 1989, land in Tokyo sold for as much as $139,000 per square foot, or more than 350-times the value of Manhattan property. After the bubble burst, real estate lost approximately 80% of its inflated value, while stock prices declined by 70%. Similarly, at the height of the internet bubble in March, 2000, the combined value of all technology stocks on the Nasdaq was higher than the GDP of most nations.

During the euphoric phase, new valuation measures and metrics are touted to justify the relentless rise in asset prices.

4. Profit Taking: By this time, the smart money – heeding the warning signs – is generally selling out positions and taking profits. But estimating the exact time when a bubble is due to collapse can be a difficult exercise and extremely hazardous to one's financial health, because, as John Maynard Keynes put it, "the markets can stay irrational longer than you can stay solvent."

Note that it only takes a relatively minor event to prick a bubble, but once it is pricked, the bubble cannot "inflate" again. In August, 2007, for example, French bank BNP Paribas halted withdrawals from three investment funds with substantial exposure to U.S. subprime mortgages because it could not value their holdings. While this development initially rattled financial markets, it was brushed aside over the next couple months, as global equity markets reached new highs. In retrospect, this relatively minor event was indeed a warning sign of the turbulent times to come.

5. Panic: In the panic stage, asset prices reverse course and descend as rapidly as they had ascended. Investors and speculators, faced with margin calls and plunging values of their holdings, now want to liquidate them at any price. As supply overwhelms demand, asset prices slide sharply.

One of the most vivid examples of global panic in financial markets occurred in October 2008, weeks after Lehman Brothers declared bankruptcy and Fannie Mae, Freddie Mac and AIG almost collapsed. The S&P 500 plunged almost 17% that month, its ninth-worst monthly performance. In that single month, global equity markets lost a staggering $9.3 trillion of 22% of their combined market capitalization.

Anatomy of a Stock Bubble
Numerous internet-related companies made their public debut in spectacular fashion in the last 1990s before disappearing into oblivion by 2002. We use the example of eToys to illustrate how a stock bubble typically plays out.

In May, 1999, with the internet revolution in full swing, eToys had a very successful initial public offering, where shares at $20 each escalated to $78 on their first trading day. The company was less than three years old at that point, and had grown sales to $30 million for the year ended March 31, 1999, from $0.7 million in the preceding year. Investors were very enthusiastic about the stock's prospects, with the general thinking being that most toy buyers would buy toys online rather than at retail stores such as Toys "R" Us. This was the displacement phase of the bubble.

As the 8.3 million shares soared in its first day of trading on the Nasdaq, giving it a market value of $6.5 billion, investors were eager to buy the stock. While eToys had posted a net loss of $28.6 million on revenues of $30 million in its most recent fiscal year, investors were expecting for the financial situation of the firm to take a turn for the best. By the time markets closed on May 20, eToys sported a price/sales valuation that was largely exceeding that of rival Toys "R" Us, which had a stronger balance sheet. This marked the boom / euphoria stages of the bubble.

Shortly afterwards, eToys fell 9% on concern that potential sales by company insiders could drag down the stock price, following the expiry of lockup agreements that placed restrictions on insider sales. Trading volume was exceptionally heavy that day, at nine-times the three-month daily average. The day's drop brought the stock's decline from its record high of $86 to 40%, identifying this as the profit-taking phase of the bubble.

By March, 2000, eToys had tumbled 81% from its October peak to about $16 on concerns about its spending. The company was spending an extraordinary $2.27 on advertising costs for every dollar of revenue generated. Although the investors were saying that this was the new economy of the future, such a business model simply is not sustainable.

In July 2000, eToys reported its fiscal first-quarter loss widened to $59.5 million from $20.8 million a year earlier, even as sales tripled over this period to $24.9 million. It added 219,000 new customers during the quarter, but the company was not able to show bottom-line profits. By this time, with the ongoing correction in technology shares, the stock was trading around $5.

Towards the end of the year, with losses continuing to mount, eToys would not meet its fiscal third-quarter sales forecast and had just four months of cash left. The stock, which had already been caught up in the panic selling of internet-related stocks since March and was trading around at slightly over $1, fell 73% to 28 cents by February, 2001. Since the company failed to retain a stable stock price of at least $1, it was delisted from the Nasdaq.

A month after it had reduced its workforce by 70%, eToys let go its remaining 300 workers and was forced to declare bankruptcy. By this time, eToys had lost $493 million over the previous three years, and had $274 million in outstanding debt.

Conclusion
As Minsky and a number of other experts opine, speculative bubbles in some asset or the other are inevitable in a free-market economy. However, becoming familiar with the steps involved in bubble formation may help you to spot the next one and avoid becoming an unwitting participant in it. (Learn how to avoid stocks that deviate from the fundamentals. Read Sorting Out Cult Stocks.)

by Investopedia Staff (Contact Author | Biography)

Investopedia.com believes that individuals can excel at managing their financial affairs. As such, we strive to provide free educational content and tools to empower individual investors, including thousands of original and objective articles and tutorials on a wide variety of financial topics.
Filed Under: Economy, Stocks


http://www.investopedia.com/articles/stocks/10/5-steps-of-a-bubble.asp?partner=ntu6

The Fundamental Mechanics Of Investing

The Fundamental Mechanics Of Investing
by Andrew Beattie (Contact Author | Biography)

In this article, we tell a simple story that demonstrates why stocks and bonds are created.

A Business Is Created
Jack is a farmer, and he is interested in starting up an apple stand for the tourists who pass his place. Since Jack has fairly good credit, he got a business loan to cover the costs of set up, and he now has the ideal land for apple growing. Unfortunately Jack only set aside enough money for getting his land in shape. He forgot all about buying seeds. By a stroke of luck, Jack finds a store that will sell him a magic high-growth, high-yield seed for $100, but Jack only has $50 left.

The Initial Public Offering to Raise Capital for Growth
Our clever farmer goes to five of his closest friends (you're included) and asks if they'll each give him $10 to help his business. However, Jack doesn't know if he can take it in the form of a loan because he may not be able to pay it back if the seed doesn't turn a profit. No worries: Jack promises everyone they'll receive a percentage of the tree's apples that is equal to the percentage they gave. In other words, Jack has given his friends a share in his tree. They agree and the seed is in the ground before you can sing "Johnny Appleseed".

The Distinction Between Being a Partner and Being a Shareholder
This tree, being magic and all, grows rapidly. In the first month, it is five feet tall and there are two apples. Jack keeps one apple because he owns 50% of the business's product, which he paid for with the $50 dollars he put in for the seed. He cuts the other one into five pieces, each of which goes to each of his investors, who can sell or eat it. The investors have a quick meeting and decide they'd rather have Jack sell their portion of the product and give them a percentage of the profit. So Jack makes up little papers saying, "Jack's Apple Company: you have one share guaranteeing you 10% (10/100) of the profits."

Trading Occurs in Jack's Undervalued Stock
So this tree really takes off now - the magic is coursing through the wood and it grows to 10 feet tall! There are 20 apples and Jack sells them all for $10 a piece, keeping $100 for himself and giving his friends $20 each. Jack uses his $100 to buy another seed and plants it. Pretty soon, Jack has two trees producing 40 apples and earning $400 a month.

Some of his neighbors want in on the deal Jack gave his friends, and Tim, Jack's first investor, is interested in selling his 10% of Jack's Apple Company. Judy, Jack's neighbor, wants to buy it and she offers Tim the $10 that he originally paid. However, Tim is not stupid: he realizes that this share is producing $40 a month and Jack is about to buy another seed. So Tim asks for $40 dollars and Judy snaps up the share, which pays for itself immediately.

A Bit of a Bubble Forms
The other original shareholders see how much Tim got and want to sell too, and the other neighbors notice how quickly Judy's investment paid off so they really want to buy in. The offers steadily climb until Jack's shares are being bought for over $100 a piece - more than Jack's trees are producing in a month. Only one original shareholder, Betty, is still in there and holding out on offers like $120 because she is still getting a regular payment that is pure profit for her. Suddenly, Jack's trees (four in total) are ravaged by aphids. The entire month's production is ruined and several shareholders are wondering if they can pay rent since they used their savings to buy shares.

The Bubble Bursts
The shareholders that need the money sell to Betty at a discount ($40), and then the other shareholders notice, all of a sudden, that their $100 shares are worth $40. This is very disconcerting. The remaining shareholders offer their shares to Betty, but she says she's quite content with three shares. The other shareholders are desperate now, so when the town sheriff offers them $20 a piece for the shares, they take their losses and get out.

Meanwhile, the main drive of Jack's business hasn't changed: people still want apples. Jack needs to get rid of these pesky aphids and he needs the money to buy insecticide.

Jack Issues a Bond
Jack's not too keen on issuing more stock after the fiasco with his neighbors, so he decides to go for a loan instead. Unfortunately, Jack used up his credit with the land preparation so he is once again looking for divine inspiration. He's looking at his equipment to see what he can sell and what he can't, and then it hits him: he'll try to sell his apple crates without actually selling them. The crates are useless without aphid-free product to fill them, but as soon as the aphids are gone he'll need them back.

So Jack calls up Judy (in hopes of making amends) and offers her a deal, "Judy, my good friend, I have an offer for you. I'll sell you my apple crates, which are worth $100 total, for a mere $60 and then buy them back next week for the full $100." Judy thinks about this and sees that in the worst case scenario, she can just sell the crates… sounds good. And a deal is made.

"But Judy," Jack adds, "I don't want to run my crates down there and pick them up again. Can I just write up a piece of paper? It'll save my back."

"I don't know - can we call it a promissory note?" Judy asks enthusiastically.

"Sure can, but I was thinking more of calling it a bond or a certificate," says Jack.

And lo and behold, Jack eliminates the aphids, pays Judy back, and turns a healthy profit that month and every month thereafter.

What Did We Learn?
This story will not explain everything about investing in stocks, but it does highlight one very important point: the price of Jack's stock followed investors' opinion of the stock's value rather than just the performance of Jack's company. Because the stock market is an auction, there is no set price for a certain stock, there is a concept that derails most people's trains of thought: the price paid for a stock is what it's "worth" until a lower or higher price is offered.

This fluctuation of worth is good and bad for investors because it allows for profit (when you buy an undervalued stock) but also makes losses possible (when you pay too much for a stock). If you would like to advance your understanding of stocks, please check out this Stock Basics.

For more on bonds, see the Bond Basics.
by Andrew Beattie (Contact Author | Biography)

http://www.investopedia.com/articles/basics/03/062703.asp?partner=basics5

Greece, the Latest and Greatest Bubble

MARCH 11, 2010, 6:44 AM
Greece, the Latest and Greatest Bubble

By PETER BOONE AND SIMON JOHNSON

Bubbles are back as a topic of serious discussion, as they were before the financial crisis. The questions today are:
(1) Can you spot bubbles?
(2) Can policy makers do anything to deflate them gently?
(3) Can anyone make money when bubbles get out of control?

Our answers are:
(1) Spotting pure equity bubbles may sometimes be hard, but we can always see unsustainable finances supported by cheap credit. 
(2) Policy makers will not act because all great (and dangerous) bubbles build their own political support; bubbles are invincible, until they collapse. 
 (3) A few investors can do well by betting against such bubbles, but it’s harder than you might think because you have to get the timing right — and that’s much more about luck than skill.

Bubbles are usually associated with runaway real estate prices or emerging market booms or just the stock market gone mad (remember Pets.com?). But they are a much more general phenomenon — any time the actual market value for any asset diverges from a reasonable estimate of its “fundamental” value.

To think about this more specifically, consider the case of Greece today. It might seem odd to suggest there is a bubble in a country so evidently under financial pressure, and working so hard to stave off collapse with the help of its neighbors.

But the important thing about bubbles is: Don’t listen to the “market color” (otherwise known as ex-post rationalization); just look at the numbers.

By the end of 2011 Greece’s debt will be around 150 percent of its gross domestic product. (The numbers here are based on the 2009 International Monetary Fund Article IV assessment.) About 80 percent of this debt is foreign-owned, and a large part of this is thought held by residents of France and Germany. Every 1 percentage point rise in interest rates means Greece needs to send an additional 1.2 percent of G.D.P. abroad to those bondholders.

Imagine if Greek interest rates rise to, say, 10 percent. This would be a modest premium for a country with the highest external public debt/G.D.P. ratio in the world, a country that continues (under the so-called austerity program) to refinance even the interest on that debt without actually paying a centime out of its own pocket, while struggling to establish any backing from the rest of Europe. At such interest rates, Greece would need to send at total of 12 percent of G.D.P. abroad per year, once it rolls over the existing stock of debt to these new rates (nearly half of Greek debt will roll over within three years).

This is simply impossible and unheard of for any long period of history.

German reparation payments were 2.4 percent of gross national product from 1925 to 1932, and in the years immediately after 1982 the net transfer of resources from Latin America was 3.5 percent of G.D.P. (a fifth of its export earnings). Neither of these were good experiences.

On top of all this, Greece’s debt, even under the International Monetary Fund’s mild assumptions, is on a non-convergent path even with the perceived “austerity” measures. Bubble math is easy. Hide all the names and just look at the numbers. If debt looks as if it will explode as a percent of G.D.P., then a spectacular collapse is in the cards.

Seen in this comparative perspective, Greece is still going bankrupt unless it gets a great deal more European assistance or puts a much more drastic austerity program in place. Probably it needs both.

Given that there’s a definite bubble in Greek debt, should we expect European politicians to help deflate this gradually?

Definitely not. In fact, it is their misleading statements, supported in recent days (astonishingly) by the head of the International Monetary Fund, that keep the debt bubble going and set us all up for a greater crash later.

The French and Germans are apparently actually encouraging banks, pension funds and individuals to buy these Greek bonds — despite the fact senior politicians must surely know this is a Ponzi scheme (i.e., people can get out of Greek bonds only to the extent that new investors come in).

At best, this does nothing more than postpone the crisis. In the business, it is known as “kicking the can down the road.” At worst, it encourages less informed people (including perhaps pension funds) to buy bonds as smarter people (and big banks, surely) take the opportunity to exit.

While French and German leaders make a great spectacle of wanting to end speculation, in fact they are encouraging it. The hypocrisy is horrifying. President Nicolas Sarkozy of France and Chancellor Angela Merkel of Germany are helping realistic speculators make money on the backs of those who take misleading statements by European politicians seriously. This is irresponsible.

What should be done? In three steps:

1. The Greeks and the Europeans must decide: Do they want to maintain the euro as Greece’s currency, or not?

2. If they want to keep the euro in Greece, the Greeks need to come up with realistic plan to start repaying debt soon. Any Greek plan will not be credible for the first few years, so the Europeans must finance the Greeks fully. This does not mean spending 20 billion euros; rather, it means making available around 180 billion euros, that is, the full amount of refinancing that Greece needs during this period.

3. If they don’t want to keep the euro, then they should start working now on a plan for Greece’s withdrawal. The northern Europeans will need to bail out their own banks, because Greek debt must fall substantially in value. Euro-denominated debt will need to be written down substantially or converted to drachmas so it will be partially inflated away. The Greeks can convert local contracts, and deposits at banks, to drachmas. It will be a very messy, difficult transition, but the more the debt bubble persists, the more attractive this becomes as a “least awful” solution.

Regardless of the decision on whether Greece will keep the drachma or give it up, the I.M.F. should be brought in to conduct the monitoring and burden share.

The flagrant deception that we now observe — as the Europeans claim that the Greeks have taken a big step forward, and encourage people to buy Greek bonds — proves they do not have the political capacity to be realistic about this situation. Who can now be believed when it comes to discussing needs for Greek financial reform and formulating a credible response?

The only credible voice left with the capacity to act is the I.M.F. — and even that body risks being compromised by the indiscreet statements of its top leadership as the bubble continues.

If such measures are not taken, we are clearly heading for a train wreck. The European politicians have been tested, and now we know the results: They are not careful. They are reckless.

Peter Boone is chairman of the charity Effective Intervention and a research associate at the Center for Economic Performance at the London School of Economics. He is also a principal in Salute Capital Management Ltd. Simon Johnson, a senior fellow at the Peterson Institute for International Economics, is the former chief economist at the International Monetary Fund.


http://economix.blogs.nytimes.com/2010/03/11/greece-the-latest-and-greatest-bubble/