Dubai debt fears: experts react

Dubai debt fears: experts react
Financial markets have been rattled on fears that Dubai could default on its debts after one of the Government's leading companies asked for a standstill on its debt.

Published: 6:41AM GMT 27 Nov 2009


Asian stocks fell for a second day on Friday, with the Nikkei 225 down almost 3pc and markets in Hong Kong and Australia all weaker. The FTSE 100 fell 3.2pc on Thursday, matching declines across European markets.

Mark Mobius, Chairman of Templeton Asset Management:

Dubai debt worries grip financial markets “If Dubai has to default, that could start a wave of defaults in other areas. This may be the trigger to allow for the market to take a rest and pull back.”

Nader Naeimi, a strategist AMP Capital Investors in Sydney:

“People are worried about the contagion effect from Dubai. Events like this bring back all the bad memories from the global financial crisis.”

Mitul Kotecha, head of global foreign-exchange strategy at Calyon in Hong Kong:

“Dubai has prompted a wave of risk aversion globally. This might prompt a short sell-off in the won but I think that’s what it will be. It’s not going to be a huge fallout because Asia looks more solid in terms of fundamentals.”

Francis Lun, general manager of Fulbright Securities in Hong Kong

"The panic button's been hit again."

Robert Rennie, strategist at Westpac Global Markets Group

"This an important reminder that the credit crisis is forgotten but not gone,"

http://www.telegraph.co.uk/finance/financetopics/financialcrisis/6667415/Dubai-debt-fears-experts-react.html

Dubai default fears rock markets

Dubai default fears rock markets
Global markets had their biggest collective fright since the chaos of the financial crisis as fears that Dubai could default on its debt gripped investors.

By Louise Armitstead
Published: 8:59PM GMT 26 Nov 2009

A metro train passes by Jumairah Lake Towers in Dubai.
Investors are worried that the state could default on its debt
Photo: AP Photo/Kamran Jebreili)

The FTSE 100 suffered its worst one-day fall since March closing down 3.2pc. Companies with big Middle Eastern shareholders led the rout, on the back of concerns that the high-rolling emirate would be forced to sell stakes to raise capital. Barclays Bank tumbled 7.9pc and the London Stock Exchange fell 7.4pc.

There were similar scenes across European stock markets with the French CAC-40 down 3.4pc and the German DAX index down 3.3pc. In America, markets were closed for the Thanksgiving holiday, but electronic trading of the benchmark S&P 500 equity futures contract showed a potential drop on Wall Street of 2.2pc.

On Wednesday, Dubai World, the government investment company behind some of the emirate's most ambitious projects, said it was seeking to delay repayment on a tranche of its debt.

The company has $60bn (£35.9bn) of liabilities from its various companies including Nakheel, the property firm behind the Palm Jumeirah, the world's biggest artificial island, and the Nakheel Tower, the world's tallest building at 1km high. It also owns DP World, the ports operator that bought P&O Ferries. Nakheel is due to make a $3.52bn Islamic bond repayment, plus charges, on December 14. The company also unveiled a restructuring programme, to be headed by Aidan Birkett, Deloitte's managing partner for corporate finance.

Traders feared that the request for a six-month standstill was a sign that the Dubai Government was struggling with its other debts – and that the full impact of the financial crisis globally may not yet be over.

British bank stocks, that are among the most exposed in the world to the Middle East, were hard-hit. Royal Bank of Scotland slumped 7.75pc, Lloyds Banking Group lost 5.75pc and HSBC fell 4.4pc – all three are among nine banks who were bookrunners on an outstanding $5.5bn syndicated loan to Dubai World in June 2008.

HSBC's interim accounts showed that the bank had a $15.9bn exposure to the whole of the United Arab Emirates.

The concerns for UK banks also hit sterling, which fell to its weakest point in a month against the euro and a basket of currencies, while gilt futures leapt to a six-week high, propelled by renewed fears about credit quality.

Property shares fell sharply amid concerns of a fire sale of Dubai's UK assets, which include the Grand Buildings in London. Dubai has also been a major buyer of UK property.

Land Securities and British Land both shed over 3pc. Similarly construction companies were down including Balfour Beatty and WS Atkins, who are involved in key projects in the Middle East, including the Dubai Metro.

The confidence in emerging markets was hit. Analysts at Merrill Lynch said: "The risk of corporate default in Dubai clearly shows that contagion risks have not disappeared and that perhaps the market has turned a little complacent about risk.

http://www.telegraph.co.uk/finance/businesslatestnews/6664913/Dubai-default-fears-rock-markets.html

Is this bye-bye Dubai?

Is this bye-bye Dubai?
Dubai dazzled the world with its extravagance and excess. Now it wants to defer its debts. What went wrong, asks Richard Spencer.

By Richard Spencer
Published: 7:52AM GMT 27 Nov 2009

The brief statement was short but, in the words of one banker, desperate. "Dubai World intends to ask all providers of financing to Dubai World and Nakheel to 'standstill' and extend maturities until at least 30 May 2010."

In a nutshell, the government was asking banks to let two of Dubai's most famous companies hold off on their mortgage payments. Since they are state-owned, the announcement suggested the city itself was in trouble: governments aren't supposed to default on their debts, and when they do – as Argentina did in 2001 – it causes chaos around the world.

Yesterday, the creditors didn't know whether to laugh or cry. On the one hand, this is an undoubtedly serious situation. Western banks, and the construction firms that built those castles in the sand, are exposed to serious amounts of money. Dubai's total government owings are officially $80 billion, unofficially twice that, and the cash flow to pay that back is a mystery.

More to the point, confidence had returned to the city's dealings, its companies were rehiring, precisely on the same assumptions that have seen rising property prices in London and rising stock markets everywhere. The crisis was over, meltdown averted, and growth was back.

But if Dubai's revival turns out to be fake, perhaps the rest is, too?

Yesterday, share prices around the world fell as the news was absorbed. One analyst asked whether this was the "new Lehman brothers".


http://www.telegraph.co.uk/news/worldnews/middleeast/dubai/6667851/Is-this-bye-bye-Dubai.html

Statement of Retained Earnings

-----

SAMPLE Consolidated Statement of Retained Earnings
For the Year Ending December 31, 2002

December 31, 2002

$2,185,000   Retained Earnings Beginning of Year
$2,188,000   Net Income

$   700,000   Less Cash Dividends
$3,673,000   Balanced Retained Earnings End of Year

-----

The statement of retained earnings indicates the amount of the company's earnings (net income from the current income statement) and adds this amount to the previous retained earnings from the balance sheet.  When a company earns a profit, management must decide either to:

1.  Pay out all or part of the earnings to shareholders as dividends; or
2.  Retain the earnings to

• finance the purchase of assets,
• retire debt, or
• grow the other resources of the company.

The retained earnings on the balance sheet are the sum of undistributed earnings of the company that have accumulated over time. 

The statement of retained earnings indicates the amount of retained earnings accumulated at the beginning of the year, and then adds the net income for the period.  If management declares a cash dividend, it is deducted from retained earnings to arrive at the balance of retained earnings for the end of the year, which is carried forward to the balance sheet.

The statement of retained earnings shows you how much net income the company will retain or pay out in dividends for the year - an important factor when you are focusing on dividend-paying stocks.

Three distinct yield categories of stocks

Income investors should focus their search on dividend stocks that have yields high enough to generate the income they require.  If you need an income stream equal to 4 percent of invested capital, then you should look for stocks with yields int he 4 percent range. 

There are thousands of stocks, so to make your job of finding the right dividend stocks easier, we suggest you mentally group them into three distinct yield categories:

Category 1:  Low-yielding stocks
These are issues that have a dividend yield of less thant he yield of the S&P 500 Index.  The yield on the S&P 500 Index is about 1.5%.

• Although they do pay a dividend, they tend to reinvest most of their earnings to foster growth in value through price appreciation. 
• These stocks are very appropriate for growth investors, but they may fail to meet your income requirement.

Category 2:  Medium-yielding stocks
These are issues with dividend yields that are equivalent to the index's yield or higher and tend to be companies focusing on providing a balanced return from both dividends and price appreciation.

• When screening for stocks, we target stocks with yields that are at least 150 percent of the index's yield.  They are committed to their dividend program and pay out from 30 to 50 percent of earnings in dividends. 
• You can shop in this group for income, but remember that the object of your search is to find stocks that meet your income requirement, so you should concentrate on stocks with higher yields.

Category 3:  High-yielding stocks
These are issues with yields today in the 4 to 5 percent range or higher and are companies that are generally in mature industries that focus on providing investors with returns through dividends. 

• They pay out 50 percent or more of their earnings to attract investors to their high dividend yield.
• Mature industries that fit this category are utilities, banks, pharmaceuticals, energy and real estate investment trusts (REITS).  The high yields of REIT stocks can be compelling.
• You will be able to find a fair supply of high-yielding stocks with dividend yields equivalent to most bonds' yields.  It just depends on where you look. 
• You can find stocks with yields in excess of 4 percent from mature companies in certain industries like utilities that focus on attracting investors to their high dividend yields.
• You can also find undervalued stocks with juicy yields that have fallen out of favour with investors.  In many cases, their price has declined while their dividend has remained stable, increasing the stock's yield in the process.  Analyse these situations carefully to determine why the stock has declined in price and if its dividend is secure.  There is often a fundamental business reason why the stock price is declining:  failing to meet earnings expectations, declining revenue, increasing debt levels, etc.  Your job is to determine if the price decline is a temporary setback or part of a larger negative trend.  If you're confident that the pricing adjustment is based on temporary conditions that you see improving, then you may have found a nugget of gold!

Stock versus Cash Dividends

Some firms pay stock dividends in addition to or in lieu of cash dividends.  Stock dividends are a form of recapitalization and do not affect the assets and liabilities of the firm.

There is a misconception that stock dividends increase the ability of the firm to grow.  Many investors believe that stock dividends preserve cash and actually allow the firm to reinvest more for growth.  Because of this belief many stocks trade higher after paying a stock dividend.  However, stock dividends do not increase the earning power of the company.

In the US, if an investor receives additional shares from a stock dividend (and the investor does not have the option to take the dividend in cash), there is no tax consequence until the investor sells the stock.

Evaluating Dividend-Paying Companies

A company should be evaluated on three dividend attributes:

1.  Reliable dividend payment history
2.  A record of increasing dividends
3.  A relatively high dividend yield

A company's dividend history is factored into the company's stock price. 

• One with a superior history of paying and increasing dividends will usually command a higher price than a company that has a poor record. 
• A high dividend yield will often attract more investors to a stock, and this can translate into higher prices as investors buy up shares to lock in a generous stream of dividends.
• A track record of dividend growth is an important indication of the company's ability to grow earnings. 

But beware of company with a high dividend yield that has an eroding earnings outlook.  Remember, a company can only pay dividends from current or accumulated earnings.  Without good earnings, there is good chance that the high dividend you covet may be cut.

What dictates dividend policy?

Management determines if it is going to distribute earnings in the form of a dividend or reinvest all earnings to further the business plan of the company.  The ratio of dividends paid out to investors versus the amount of earnings retained is called the payout ratio.  Changes in tax law and investor preference can influence decisions in the corporate boardroom regarding how much profit to retain or to pay out to investors in the form of dividends.  However, dividend increases often lag behind an increase in earnings because management will want to be certain that a new higher dividend payment will be sustainable going forward.

Looking back over market history, we can see that dividend policy and payouts have remained relatively steady and that any change in dividend yield has had a lot more to do with the change in stock prices than with changes to dividend policy made by corporate directors.  (Note:  You can 'price' your stocks by looking at historical dividend yields.)

Management is usually very reluctant to reduce dividends because a cut is often perceived as a sign of financial weakness.  Even during the Great Depression, companies were loath to cut dividends.  From 1929 to 1932, dividend yields soared because most companies maintained their dividends as stock prices collapsed in the crash.  But, as stock prices rose from 1933 to 1936, dividend yields fell - even though companies were actually increasing the dividends they paid.

This inverse relationship between dividend yield and price was really evident during the huge bull market run from 1982 to 1999.  Companies increased dividends steadily over the period, actually increasing dividends paid by almost 400 percent.  Yet the dividend yield collapsed to historic lows because stock prices increased by 1,500 per cent.

Some companies do run into trouble and cut or omit their dividend payments, but this is the exception rather than the rule. 

• The typical dividend-paying company not only maintains the dividend payout it establishes, but follows a policy of steadily increasing its dividend as earnings increase. 
• Some companies increase their dividend payments every quarter, some once per year, and others only as profits allow. 
• Some companies will even pay extra or special dividends if earnings have been quite good for a number of years.

Many established public companies pay cash dividends and have a dividend policy that is well known to their investors.  Some of them have been paying cash dividends for a very long time.

Twelve of the companies in the S&P 500 today started paying dividends more than a century ago.

S&P 500 Century Dividend Payers

Company ----  Cash Dividends Paid Each Year Since
Stanley Works ----1877
Consolidated Edison ---- 1885
Lilly (Eli) ---- 1885
Johnson Controls ---- 1887
Procter & Gamble ----1891
Coca-Cola Co ---- 1893
First Tennessee National ---- 1895
General Electric ---- 1899
PPG Industries ---- 1899
TECO Energy ---- 1900
Pfizer. Inc. ---- 1901
Chubb Corp ---- 1902
Bank of America ---- 1903

Business and Dividend Life Cycles

Business life cycles are most influenced by access to resources and capital. 

A company's success and development are also affected by a host of outside factors - competition from companies in the same industry, economic conditions, even changing consumer preferences.

There are 6 phases in a company's development that influence its dividend policy:

1. The Start-Up Phase:   In the start-up phase, someone invest cash for stock in the business to develop products, hire employees, pay for equipment, and rent space.  It is not unusual for a company to raise seed money from professional investors and enter the start-up phase with a hundred or more employees.  A small company needs to plow all profits back into growing and perfecting its business model to survive.

2.  The Early Growth Phase:  If the company launch is successful, it will enter the early growth phase.  As the demand for its products and services increases, sales and profits increase.  The company will need to reinvest all cash flow and profit to achieve competitive scale.

3.  The Late Stage Growth Phase:  In the late stage growth phase, the company continues to grow and may begin to pay a small dividend, usually 10 to 15% of earnings.  This is a clear signal to investors that the company has reached a level of stability in profits and cash flow necessary to support a dividend.

4.  The Expansion Phase:  If the company is well run, it will enter the expansion phase.  Its rate of growth may slow as competitors take some of the company's market share.  Companies at this stage generally increase their dividend payout ratio to approximately 30 to 40% of earnings.

5.  The Maturity Phase:  Companies can continue to expand even as they reach their maturity phase, but their growth rate usually slows measurably.   Well-run mature companies can continue to be a competitive force in their respective industries for decades or even several generations.  Many of the companies in this group are mature companies, a few over a century old.  It is during this stage that companies tend to increase their dividend payout ratios to 50 to 60% of earnings, which provides investors with generous dividend income.

6.  The Decline Phase:  In the later stages, many companies fail to innovate - to keep their competitive advantage.  These companies will enter the decline phase, and unless they reinvent themselves, they will eventually cease to exist.  In this phase, as sales and profits decline, they will eventually reduce or eliminate their dividend payouts. 

Beware of attempting to buy or hold the stock of a company in the final stages of its business life cycle.

Business and Dividend Life Cycles
Start Up

Growth Rate 20%
Dividend Payout Ratio 0%

Early Growth
Growth Rate 30%
Dividend Payout Ratio 0%

Late Stage Growth
Growth Rate 35%
Dividend Payout Ratio 15%

Expansion
Growth Rate 25%
Dividend Payout Ratio 30%

Maturity
Growth Rate 20%
Dividend Payout Ratio 55%

Decline
Growth Rate < 5% and declining
Dividend Payout Ratio < 20%


AT&T is a great example of a company currently in decline, possibly on its way to extinction. 

Beware of attempting to buy or hold the stock of a company in the final stages of its business life cycle.

At one time, AT&T was the most widely held stock in America.  The company paid its first dividend in 1893 and became known as the widows and orphans stock because it was such a consistent source of dividend payments for investors.  AT&T's history dates back to 1875.  The company's founder, Alexander Graham Bell, invented the telphone and together with several investors started the American Telephone and Telegraph Corporation.  As a telephone company, AT&T was so successful it achieved regulated monopoly status.  In 1984, the US Department of Justice broke the AT&T monopoly into eight companies:  seven regional operating "Bells" and AT&T.

For most of its history, AT&T had been largely insulated from market pressures and competitive forces.  After the break up, smaller and leaner communication companies stole AT&T's market share, first through price competition and later by becoming product innovators.  For the new AT&T to successfully compete in an unregulated environment, it would require a drastic change in corporate culture.  Over the past few years, operations and profits have continued to decline, and AT&T is now struggling to survive. 

AT&T's story of dominance and decline highlights the constant need for you to follow up your initial purchase analysis with a routine review to see if the companies you hold are performing as expected. 

• Each time you decide to continue to hold a stock, you are in fact making a new buying decision. 
• Understanding the business life cycle outlined above will enable you to identify companies that are about to emerge as great dividend payers, as well as help you to spot the mature companies headed down the road to extinction.

"Make Hay While the Sun Shines": When Greed leads to Heavy Losses

An illustrative story.

Rick found out the hard way that greed leads to heavy losses, not gains.

At age 40, Rick had been in an unfortunate accident that would prevent him from ever working agin.  To compensate for his loss of future earnings, he was awarded a lump sum of approximately $4 million.  In 1996, Rick's attorney recommended that he seek out a financial planner to manage his money.  Rick's goals were to set up an investment portfolio that would provide him with current income of $8,000 per month, and an income that would keep pace with inflation over the balance of his lifetime.  Because he depended on income from his assets for his sole support, he wanted to be very careful with his money.

Lump sum: $4 million
Current income:  $8,000 per month

As the stock market advanced unabated, Rick started to listen to the siren's song of the easy money to be made.  He told his planners that he wanted to get more aggressive with his accounts.  The high returns and easy money that the markets were offering were just too good to pass up.  He acknowledged that he had told his planners that he needed to be conservative before, but now he felt that he should "make hay while the sun shines!"  In other words, he perceived that there was little risk involved in getting more aggressive.

Rick did not need to chase high returns because his asset base was sufficient to allow him to pursue a lower risk and return strategy.  Most important, he would always be okay so long as he kept his capital base intact to produce the income he required.  His planners counseled Rick to stick with his conservative income and growth plan because he could not earn back the money he might lose.  But by 1999, the siren song proved too much for him.  He abandoned his investment strategies and moved his entire portfolio into high-flying tech stocks just before the speculative bubble burst.

The ensuing "Tech Wreck" shattered Rick's financial security along with that of millions of other investors.  Greed had won again.  Rick's more aggressive investment strategy that had looked like a sure path to untold wealth became the wrecking ball that destroyed his financial security.  With losses that averaged in excess of 70 percent, Rick's capital base was decimated, and with it, the engine of his income production.

To add insult to injury, the income strategies Rick abandoned actually increased in value.  With the huge stock market declines, investors fled to the relative safety that income-producing investments provided.  Bond prices increased as did the prices of many high-yielding dividend-paying stocks.

People are risk takers or risk avoiders by nature.

As market rises, investors tend to forget that risk is a four letter word, greed takes over, and those who once thought themselves in the conservative camp abandon caution in search of higher returns and what looks to be easy money to be made. 

But an investor's tolerance for risk is part of his or her basic personality, and tolerance for risk rarely changes.  People are risk takers or risk avoiders by nature. 

Investors and the markets are said to be rational, but most people are heavily influenced by their emotions.  The primal emotions of fear or greed often cause investors to play the loser's game of buying high and selling low.

Cash: The real enemy of investors is not fluctuation of principal, it is inflation!

Many investors confuse safety of principal with a "sure thing investment."  Cash accounts provide investors with peace of mind because their principal does not fluctuate in value and because interest is added to the account on a periodic basis.  The institution providing the savings vehicle invests the money deposited by the investor in loans and bonds.  They take the dual risks of volatility and loss of capital - not the investor.  Unfortunately, investor peace of mind is an illusion, because the real enemy is not fluctuation of principal, it is inflation!  And "cash" investments do not keep pace with inflation!  As inflation robs investors of their purchasing power they must invade principal to buy the goods and services they need to live.  As the years go by, the investors' peace of mind is replaced by fear as they continually dip into their principal to pay for lifestyle expenses that rise with inflation.

In fact, cash flunks one of the most important tests we set for our perfect income investment.  In exchange for safety of principal and liquidity, the returns on cash are generally very low.  In fact, at current rates, the return on most cash alternatives isn't even as high as the rate of inflation, as measured by the Consumer Price Index (CPI). 

On December 31, 2003, the average yield on a 30-day Treasury bill was a paltry 0.85 percent while the annual rate of change in the CPI was 1.88 percent.  In other words, the interest on your money, would not be sufficient to replace the purchasing power you're losing to inflation.

Even if you think cash passes the safety of principal test because your principal does not fluctuate in value, it fails three other important safety tests.

• First, the safety of cash begins to look suspect if you're losing the true value of your money - the ability to buy the things you need - because of inflation.
• Second, since the yield is so low, the income generated by cash is not sufficient to buy the goods and services you need, which will force you to liquidate your principal. 
• Finally, the false illusion of safety is compounded because the low yield on cash is further reduced by taxes.  Worst yet, you will pay tax at your highest marginal rate.  Unfortunately the combination of a high tax rate and a low yield only increase your need to liquidate assets. 

So much for safety!

The more you study the inflation problem, the more you realize how important it is to a successful retirement plan.  Inflation has been pretty tame over the past 10 years, averaging only 2.75 percent per year.  Don't be lulled into a false sense of security and allow yourself to think that inflation is not going to be a big problem for you in the future.

In the 1970s inflation averaged just over 7.4%.  By the 1990s inflation had moderated to an average of just over 2.9%.  Still, the average inflation rate for the entire 30-year period from 1972 through 2002 was 5.12%.

Just a small increase can be crushing to retirees.  You would need to invest a lot more money initially in a cash investment to provide enough interest to be reinvested against the day when you need to take more income to keep up with rising costs.

Inflation is the Retired Person's Greatest Enemy

1972-2002 (30 years)  Average inflation rate 5.12%
1982-2002 (20 years)  Average inflation rate 3.36%
1992-2002 (10 years)  Average inflation rate 2.75%

Example:

Let's say you had an income need of $3,000 per month and you noticed that you could buy a five-year CD with a current yield of 4% (a generous assumption based on current yields).  To generate an income of $3,000 per month or $36,000 per year, you would need to deposit $900,000 in the bank.

The first year everything seems to work well, but in the second year you notice two problems:

1.  You had to pay taxes on your interest income, and you had not factored that into the question.  Where do you get the tax money?
2.  Your living costs are rising, and you forgot to factor in inflation.  If inflation averages just 3% for the first year, your annual expenses would increase by an additional $1,080, compounding your income need.  After only the first year, you would have to start liquidating principal to buy the same goods, and services you enjoyed the year before.


Safe but Sorry

Over the years we have seen many people make the same big mistake - they opt for the safety of principal that cash investments offer and ignore inflation risk.  Inflation robs them of the purchasing power of cash; this illusion of safety would cost dearly.  When interest rates drop, they maybe forced to dip into their original capital.  The more principal taken out, the less income will be produced putting them on a slippery slope. 

The classic problems of:

• low yield,
• high taxes and
• no inflation protection

 are pretty common to all types of fixed-income investments. 

Bonds start out with a little more income for each dollar invested, but suffer the same defects that cash investments do.  And, although it may not be widely understood by most investors, bonds can also suffer from high volatility and risk under the right circumstances.

Is there another option to meet your income needs without impairing the capital base?  We shall take a look at the difference dividend paying stocks can make.  As an investor in dividend-paying stocks, you not only get to keep more of what you earn from dividends becasue of lower taxes, but it's likely your dividend income and value will increase over time to keep you with inflation.  These exciting fundamental benefits are also available in dividend-paying stocks for growth.

CDs, Savings and Money Market Accounts

The big attraction of the choices in this group is their safety of principal.  In fact, they are considered so safe that they are generally lumped together as an asset class called "Cash/Cash Equivalents."  For the purpose of this article, let's call them all "cash".

The main attraction of cash is simple - the value of the principal does not fluctuate and may even be guaranteed depending on the amount of the investment.  Put a dollar in, and you'll get a dollar back, plus interest.  In addition, the assets in cash group can generally be "cashed in" at full value on short notice (although CDs may have meaningful early surrender penalties).  No matter what gyrations the stock market or interest rates are going through , the value of these assets stays the same.  Most financial planners will recommend that you have enough money salted away in cash/cash equivalents to cover three to six months' living expenses, plus an amount to cover any known major outlays you'll have to make in the next year or two.  This group of assets can also add stability to your portfolio because their value is stable.  All in all, cash plays a key role in building a portfolio as a sound foundation for funding emergencies or contingent expenses - but not for income!

Bubbles: From Inception to Crash (4 phases)

 

Market Bubbles
Proponents of market irrationality have pointed to market bubbles as a primary exhibit in their case against efficient markets. Through the centuries, markets have boomed and busted, and in the aftermath of every bust, irrational investors have been blamed for the crash. As we will see in this section, it is not that simple. You can have bubbles in markets with only rational investors, and assessing whether a bubble is due to irrational investors is significantly more difficult than it looks from the outside.

 

A Short History of Bubbles
As long as there have been markets, there have been bubbles. Two of the earliest bubbles to be chronicled occurred in the 1600s in Europe. One was the amazing boom in prices of tulip bulbs in Holland that began in 1634. A single Tulip bulb (Semper Augustus was one variety) sold for more than 5000 guilders (the equivalent of more than $ 60000 today) at the peak of the market. Stories abound, though many of them may have been concocted after the fact, of investors selling their houses and investing the money in tulip bulbs. As new investors entered the market in 1636, the frenzy pushed up bulb prices even more until the price peaked in early February. Figure 7.11 presents the price of one type of bulb (Switzers) in January and February of 1637.[1]

 

 

Note that the price peaked on February 5, 1637, but an investor who bought tulip bulbs at the beginning of the year would have seen his or her investment increase almost 30 fold over the next few weeks.

 

A little later in England, a far more conventional bubble was created in securities of a firm called the South Seas Corporation, a firm with no assets that claimed to have the license to mint untold riches in the South Seas. The stock price was bid up over the years before the price plummeted. The crash, which is described in vivid detail in Charles Mackay�s classic book titled �Extraordinary Delusions and the Popular Madness of Crowds�, left many investors in England poorer.[2]

 

Through the 1800s, there were several episodes of boom and bust in the financial markets in the United States and many of these were accompanied by banking panics.[3] As markets became broader and more liquid in the 1900s, there was a renewed hope that liquidity and more savvy investors would make bubbles a phenomenon of the past, but it was not to be. In 1907, J.P. Morgan had to intervene in financial markets to prevent panic selling, a feat that made his reputation as the financier of the world. The 1920s saw a sustained boom in U.S. equities and this boom was fed by a number of intermediaries ranging from stockbrokers to commercial banks and sustained by lax regulation. The crash of 1929 precipitated the great depression, and created perhaps the largest raft of regulatory changes in the United States, ranging from restrictions on banks (the Glass-Steagall Act) to the creation of a Securities Exchange Commission.

 

The period after the second world war ushered in a long period of stability for the United States, and while there was an extended period of stock market malaise in the 1970s, the bubbles in asset prices tended to be tame relative to past crashes. In emerging markets, though, bubbles continued to form and burst. In the late 1970s, speculation and attempts by some in the United States to corner the precious metals markets did create a brief boom and bust in gold and silver prices. By the mid-1980s, there were some investors who were willing to consign market bubbles to history. On October 19, 1987, the U.S. equities market lost more than 20% of their value in one day, the worst single day in market history, suggesting that investors, notwithstanding technological improvements and more liquidity, still shared a great deal with their counterparts in the 1600s. In the 1990s, we witnessed the latest in this cycle of market bubbles in the dramatic rise and fall of the �dot-com� sector. New technology companies with limited revenues and large operating losses went public at staggering prices (given their fundamentals) and kept increasing. After peaking with a market value of $ 1.4 trillion in early 2000, this market too ran out of steam and lost almost all of this value in the subsequent year or two. Figure 7.12 summarizes the Internet index and the NASDAQ from 1994 to 2001:

 

 

The chart again has the makings of a bubble, as the value of the index internet index increased almost ten fold over the period, dragging the tech-heavy NASDAQ up with it.

 

Rational Bubbles?
A rational bubble sounds like an oxymoron, but it is well within the realms of possibility. Perhaps the simplest way to think of a rational bubble is to consider a series of coin tosses, with a head indicating a plus day and a tail a minus day. You would conceivably get a series of plus days pushing the stock price above the fair value, and the eventual correction is nothing more than a reversion back to a reasonable value. Note too that it is difficult to tell a bubble from a blunder. Investors in making their assessments for the future can make mistakes in pricing individual assets, either because they have poor information or because the actual outcomes (in terms of growth and returns) do not match expected values. If this is the case, you would expect to see a surge in prices followed by an adjustment to a fair value. In fact, consider what happened to gold prices in the late 1970s. As inflation increased, many investors assumed (incorrectly in hindsight) that high inflation was here to stay and pushed up gold prices accordingly. Figure 7.13, which graphs gold prices from 1970 to 1986, looks very much like a classic bubble, but may just indicate our tendencies to look at things in the rear view mirror, after they happen.

 

Note that the surge in gold prices closely followed the increase in inflation in the late 1970s, reflecting its value as a hedge against inflation. As inflation declined in the 1980s, gold prices followed. It is an open question, therefore, whether this should be even considered a bubble.

 

Bubble or Blunder: Tests
There are some researchers who argue that you can separate bubbles from blunders by looking at how prices build up over time. Santoni and Dwyer (1990), for instance, argue that you need positive two elements for a bubble �

• positive serial correlation in returns and
• a delinking of prices and fundamentals as the bubble forms.

They test the periods prior to 1929 and 1987 crashes to examine whether there is evidence of bubbles forming in those periods. Based upon their analysis, there is no evidence of positive serial correlation in returns or of a reduction in the correlation between prices and fundamentals (which they define as dividends) in either period. Therefore, they argue that neither period can be used as an example of a bubble.

 

While there is truth to the underlying premise, these tests may be too weak to capture bubbles that form over long periods. For instance, Santoni and Dwyer�s conclusion of no serial correlation seems to be sensitive to both the time periods examined and the return interval used. In addition, detecting a delinking of prices and fundamentals statistically may be difficult to do if it happens gradually over time. In short, these may be useful indicators but they are not conclusive.

 

Bubbles: From Inception to Crash
One or the more fascinating questions in economics examines how and why bubbles form and what precipitates their bursting. While each bubble has its own characteristics, there seem to four phases to every bubble.

 

Phase 1: The Birth of the Bubble
Most bubbles have their genesis in a kernel of truth. In other words, at the heart of most bubbles is a perfectly sensible story. Consider, for instance, the dot.com bubble. At its center was a reasonable argument that as more and more individuals and businesses gained online access, they would also be buying more goods and services online. The bubble builds as the market provides positive reinforcement to some investors and businesses for irrational or ill-thought out actions. Using the dot.com phenomenon again, you could point to the numerous start-up companies with half-baked ideas for e-commerce that were able to go public with untenable market capitalizations and the investors who made profits along the way.

 

A critical component of bubbles building is the propagation of the news of the success to other investors in the market, who on hearing the news, also try to partake in the bubble. In the process, they push prices up and provide even more success stories that can be used to attract more investors, thus providing the basis for a self-fulfilling prophecy. In the days of the tulip bulb craze, this would have had to be word of mouth, as successful investors spread the word, with the success being exaggerated in each retelling of the story. Even in this century, until very recently, the news of the success would have reached investors through newspapers, financial newsmagazines and the occasional business show on television. In the dot.com bubble, we saw two additional phenomena that allowed news and rumors to spread even more quickly. The first was the internet itself, where chat rooms and web sites allowed investors to tell their success stories (or make them up as they went along). The second was the creation of cable stations such as CNBC, where analysts and money managers could present their views to millions of investors.

 

Phase 2: The Sustenance of the Bubble
Once a bubble forms, it needs sustenance. Part of the sustenance is provided by the institutional parasites that make money of the bubble and develop vested interests in preserving and expanding the bubbles. Among these parasites, you could include:

 

Investment banks: Bubbles in financial markets bring with them a number of benefits to investment banks, starting with a surge in initial public offerings of firms but expanding to include further security issues and restructurings on the part of established firms that do not want to be shut out of the party.
Brokers and analysts: A bubble generates opportunities for brokers and analysts selling assets related to the bubble. In fact, the ease with which investors make money as asset prices go up, often with no substantial reason, relegates analysis to the backburner.
Portfolio Managers: As a bubble forms, portfolio managers initially watch in disdain as investors they view as naive push up asset prices. At some point, though,, even the most prudent of portfolio managers seem to get caught up in the craze and partake of the bubble, partly out of greed and partly out of fear.
Media: Bubbles make for exciting business news and avid investors. While this is especially noticeable in the dot.com bubble, with new books, television shows and magazines directly aimed at investors in these stocks, even the earliest bubbles had their own versions of CNBC.
In addition to the institutional support that is provided for bubbles to grow, intellectual support is usually also forthcoming. There are both academics and practitioners who argue, when confronted with evidence of over pricing, that the old rules no longer apply. New paradigms are presented justifying the high prices, and those who disagree are disparaged as old fashioned and out of step with reality.

 

Phase 3: The Bursting of the Bubble
All bubbles eventually burst, though there seems to be no single precipitating event that causes the reassessment. Instead, there is a confluence of factors that seem to lead to the price implosion.

• The first is that bubbles need ever more new investors (or at least new investment money) flowing in for sustenance. At some point, you run out of suckers as the investors who are the best targets for the sales pitch become fully invested.
• The second is that each new entrant into the bubble is more outrageous than the previous one.

Consider, for instance, the dot.com bubble. While the initial entrants like America Online and even Amazon.com might have had a possibility of reaching their stated goals, the new dot.com companies that were listed in the late 1990s were often idea companies with no vision of how to generate commercial success. As these new firms flood the market, even those who are apologists for high prices find themselves exhausted trying to explain the unexplainable.

 

The first hint of doubt among the true believers turns quickly to panic as reality sets in. Well devised exit strategies break down as everyone heads for the exit doors at the same time. The same forces that created the bubble cause its demise and the speed and magnitude of the crash mirror the formation of the bubble in the first place.

 

Phase 4: The Aftermath
In the aftermath of the bursting of the bubble, you initially find investors in complete denial. In fact, one of the amazing features of post-bubble markets is the difficulty of finding investors who lost money in the bubble. Investors either claim that they were one of the prudent ones who never invested in the bubble in the first place or that they were one of the smart ones who saw the correction coming and got out in time.

 

As time passes and the investment losses from the bursting of the bubble become too large to ignore, the search for scapegoats begins. Investors point fingers at brokers, investment banks and the intellectuals who nurtured the bubble, arguing that they were mislead.

 

Finally, investors draw lessons that they swear they will adhere to from this point on. �I will never invest in a tulip bulb again� or �I will never invest in a dot.com company again� becomes the refrain you hear. Given these resolutions, you may wonder why price bubbles show up over and over. The reason is simple. No two bubbles look alike. Thus, investors, wary about repeating past mistakes, make new ones, which in turn create new bubbles in new asset classes.

 

Upside versus Downside bubbles
Note that most investors think of bubbles in terms of asset prices rising well above fair value and then crashing. In fact, all of the bubbles we have referenced from the tulip bulb craze to the dot-com phenomenon were upside bubbles. But can asset prices fall well below fair market value and keep falling? In other words, can you have bubbles on the downside? In theory, there is no reason why you could not, and this makes the absence of downside bubbles, at least in the popular literature, surprising. One reason may be that investors are more likely to blame external forces � the bubble, for instance � for the money they lose when they buy assets at the peak of an upside bubble and more likely to claim the returns they make when they buy stocks when they are at the bottom of a downside bubble as evidence of their investment prowess.

 

Another may be that it is far easier to create investment strategies to take advantage of under priced assets (in a downside bubble) than it is to take advantage of over priced assets. With the former, you can always buy the asset and hold until the market rebounds. With the latter, your choices are both more limited and more likely to be time limited. You can borrow the asset and sell it (short the asset), but not for as long as you want � most short selling is for a few months. If there are options traded on the asset, you may be able to buy puts on the asset though, until recently, only of a few months duration. In fact, there is a regulatory bias in most markets against such investors who are often likely to be categorized as speculators. As a consequence of these restrictions on betting against overpriced assets, bubbles on the upside are more likely to persist and become bigger over time, whereas bargain hunters operate as a floor for downside bubbles.

 

A Closing Assessment
Based upon our reading of history, it seems reasonable to conclude that there are bubbles in asset prices, though only some of them can be attributed to market irrationality. Whether investors can take advantage of bubbles to make money seems to be a more difficult question to answer. Part of the reason for the failure to exploit bubbles seems to stem from greed �even investors who believe that assets are over priced want to make money of the bubble � and part of the reason is the difficulty of determining when a bubble will burst. Over valued assets may get even more over valued and these overvaluations can stretch over years, thus imperiling the financial well being of any investor who has bet against the bubble. There is also an institutional interest on the part of investment banks, the media and portfolio managers, all of whom feed of the bubble, to perpetuate the bubble.

 

 

 http://pages.stern.nyu.edu/~adamodar/New_Home_Page/invfables/bubbles.htm

 

****Insightful analysis of stock market surge since March 2009

Another Stock Market Bubble?

C. P. Chandrasekhar
September 14, 2009

India’s stock market recovery over the last six months is a bit too remarkable for comfort. From its March 9, 2009 level of 8,160, the Sensex at closing soared and nearly doubled to touch 16,184 on September 9, 2009. This is still (thankfully) well below the 20,870 peak the index closed at on September 1 2008, but is high enough to cheer the traders and rapid enough to encourage a speculative rush.

There are two noteworthy features of the close to one hundred per cent increase the index has registered in recent months. First, it occurs when the aftermath of the global crisis is still with us and the search for “green shoots and leaves” of recovery in the real economy is still on. Real fundamentals do not seem to warrant this remarkable recovery. Second, the speed with which this 100-percent rise has been delivered is dramatic even when compared with the boom years that preceded the 2008-09 crisis. The last time the Sensex moved between exactly similar positions it took a year and ten months to rise from the 8,000-plus level in early 2005 to the 16,000-plus level in late 2007. This time around it has traversed the same distance in just six months.

With firms just looking to exit from a recessionary phase, this rapid rise in stock prices cannot be justified by movements in sales and profits. In fact, as the Business Line noted in its editorial on September 9, 2009 [ http://www.thehindubusinessline.com/2009/09/09/stories/2009090950560800.htm ], the price earnings ratio of Sensex companies now stands at 21, which is much higher than an average of 17, which itself many would claim is on the high side. Those comfortable with the market’s rise would of course argue that investors, expecting a robust recovery, are implicitly factoring in future earnings trends, rather than relying on earnings figures that are the legacy of a recession.

That would be stretching the case. Once the next round of arrears has been paid, the once-for-all component in the stimulus that the Sixth Pay Commission’s recommendations provided would wane. With the deficit on the government’s budget expected to reach extremely high levels this fiscal, a cutback of government expenditure is likely. Further, exports are still doing badly and the global recovery is widely expected to be gradual and limited. That would limit the stimulus provided by India’s foreign trade. And, finally, a bad monsoon threatens to limit agricultural growth and accelerate inflation. This would dampen the recovery in multiple ways. Given these circumstances, excessive optimism with regard to corporate earnings is hardly justified. The change in perception from one in which India was a country that weathered the crisis well to one that sees India as set to boom once again is not grounded in fundamentals of any kind.

This implies that the current bull run can be explained only as the result of a speculative surge that recreates the very conditions that led to the collapse of the Sensex from its close to 21,000 peak of around two years ago. This surge appears to have followed a two stage process. In the first, investors who had held back or withdrawn from the market during the slump appear to have seen India as a good bet once expectations of a global recovery had set in. This triggered a flow of capital that set the Sensex rising. Second, given the search for investment avenues in a world once again awash with liquidity, this initial spurt in the index appears to have attracted more capital, triggering the current speculative boom in the market.

While these are possible proximate explanations of the transition from slump to boom, they in turn need explaining. In doing so, we have to take account of the fact that, as in the past, foreign investors have dominated stock market transactions and had an important role in triggering the current stock market boom. As compared to the net sales of equity to the tune of $11.97 billion by foreign institutional investors during crisis year 2008, they had made net purchases of equity worth $8.75 billion in the period till September 11 during 2009. According to the Securities and Exchange Board of India, net purchases were negative till February, but turned positive in March with the net purchases figure being high during April ($1.3 billion), May ($4.1 billion), July ($2.3 billion) and August ($1 billion).

It is not surprising that foreign institutional investors have returned to market. They need to make investments and profits to recoup losses suffered during the financial meltdown. And they have been helped in that effort by the large volumes of credit provided at extremely low interest rates by governments and central banks in the developed countries seeking to bail out fragile and failing financial firms. The credit crunch at the beginning of the crisis gave way to an environment awash with liquidity as governments and central bankers pumped money into the system.

Financial firms had to invest this money somewhere to turn losses into profit. Some was reinvested in government bonds, since governments were lending at rates lower than those at which they were borrowing. Some was invested in commodities markets, leading to a revival in some of those markets, especially oil. And some returned to the stock and bond markets, including those in the so-called emerging markets like India. Many of these bets, such as investments in government bonds, were completely safe. Others such as investments in commodities and equity were risky. But the very fact that money was rushing into these markets meant that prices would rise once again and ensure profits.

In the event, bets made by financial firms have come good, and most of them have begun declaring respectable profits and recording healthy stock market valuations.

It is to be expected that a country like India would receive a part of these new investments aimed at delivering profits to private players but financed at one remove by central banks and governments. However, India has received more than a fair share of these investments. One way to explain this would be to recognise the fact that India fared better during the recession period than many other developing counties and was therefore a preferred hedge for investors seeking investment destinations.

The other reason is the expectation fuelled by the return of the UPA to government, this time with a majority in Parliament and the repeated statements by its ministers that they intend to push ahead with the ever-unfinished agenda of economic liberalisation and “reform”. The UPA II government has, for example, made clear that disinvestment of equity in or privatisation of major public sector units is on the cards. That caps on foreign direct investment in a wide range of industries including insurance are to be relaxed. That public-private partnerships (in which the government absorbs the losses and the private sector skims the profits) are to be encouraged in infrastructural projects, with government lending to or guaranteeing private borrowing to finance private investments. That the tenure of tax concessions given to STPI units and units in SEZs are to be extended. And that corporate tax rates are likely to be reduced and capital gains taxes perhaps abolished.

All of this generates expectations that there are likely to be easy opportunities for profit delivered by an investor-friendly government in the near future, including for those who seek out these opportunities only to transfer them for profit soon thereafter. These opportunities, moreover, are not seen as dependent on a robust revival of growth, though some expect them to strengthen the recovery. In sum, whether intended or not, the signals emanating from the highest economic policy making quarters have helped talk up the Indian market, allowing equity prices to race ahead of earnings and fundamentals.

Once the speculative surge began, triggered by the inflow of large volumes of footloose global capital, Indian investors joined the game financed very often by the liquidity being pumped into the system by the Indian central bank. The net result is the current speculative boom that seems as much a bubble as the one that burst a few months back.

There are three conclusions that flow from this sequence of events. 

• The first is that using liquidity injection and credit expansion as the principal instrument to combat a downturn or recession amounts to creating a new bubble to replace the one that went bust. This is an error which is being made the world over, where the so-called stimulus involves injecting liquidity and cheap credit into the system rather than public spending to revive demand and alleviate distress.  
• The second is that so long as the rate of inflation in the prices of goods is in the comfort zone, central bankers stick to an easy money policy even if the evidence indicates that such policy is leading to unsustainable asset price inflation. It was this practice that led to the financial collapse triggered by the sub-prime mortgage crisis in the US.
•  Third, that governments in emerging markets like India have not learnt the lesson that when a global expansion in liquidity leads to a capital inflow surge into the country it does more harm than good, warranting controls on the excessive inflow of such capital.

Rather, goaded by financial interests and an interested media, the government treats the boom as a sign of economic good health rather than a sign of morbidity, and plans to liberalise capital controls even more. In the event, we seem to have engineered another speculative surge. The crisis, clearly, has not taught most policy makers any lessons.

Comments:
Well laid-out analysis presentation. In your analysis this surge is not at all based on fundamentals but through the liquidity injection the world over. You have not mentioned when this bubble could burst e.g. current PE all the way to 25? What would be the criteria, either local event or global event, for this bubble to burst/party to be over?

from: Ranga Srinivasan
Posted on: Sep 14, 2009 at 13:25 IST
If there is a bubble in the stock market and it bursts, it will be the speculators and the greedy common investors who will suffer. But while the bubble is being created by foreign investors everyone suffers because too much money gets pumped into the country's monetary system creating inflationary pressures which drive prices through the roof. The government and the opinion makers worry only about a burst but remain unconcerned when the bubble is being created. Bubble or no bubble, a stock market boom is always considered a feather in the cap of the government.

from: K.Vijayakumar
Posted on: Sep 15, 2009 at 01:30 IST
The article has covered most of the facts about the current happenings. But it did not consider a simple fact that Indian equity markets did not crash on their own. We never reduced our stock values because of internal reasons. If it had taken that into the analysis then the whole dimension of this analysis would have been changed. And yes there can be a crash if the PE moves over and above 25 in short term but we may consolidate and our companies will maintain their PE at around 21-23.

from: Deepan R
Posted on: Sep 15, 2009 at 14:06 IST
The government should keep a close watch on the FIIs who are taking stock markets to dizzying heights and then booking profits, leaving small investors with deep wounds to lick for a long time. By no account the rising stock prices can be taken as an indicator of prosperity of the economy. It may, sure it will, cause more harm than good to the economy. Any government which takes the rising stock market indices as signs of economic growth is bound to witness the people being pushed to the ills of inflation.

from: N S Shastri
Posted on: Sep 15, 2009 at 16:58 IST
The stock market level cant be considered as an indicator of improvement in economy.because agricultural sector is in trouble and it has large share ateleast in indian economy on which FIIs are betting on.

from: girish
Posted on: Sep 16, 2009 at 10:10 IST
Many companies cleaned up their balance sheets in the last year. This should lead to much higher earnings in the next two years. I feel that is also factored in the current bull run of sensex.

from: Kaushik
Posted on: Sep 16, 2009 at 19:24 IST
As Deepan pointed out the question of whether the current upward spiral is a bubble or simply a correction depends on how you see the original crash -as a panic reaction not justified by fundamentals or a bubble that went bust. Common sense tell us that the inflated property values, inflated stock markets and a world awash in cash were not normal by any sense of the term, so the earlier crash was a bubble-burst. Part of it could have been a panic effect but most of it was bubble. Which brings us to the current surge, which is yet another bubble this time financed not by greedy investors but by equally greedy govts keen on showing they have slayed the recession dragon.

from: Ganesh

Posted on: Sep 17, 2009 at 14:18 IST
Whenever there is a recovery in the Indian economy, foreign investors always played this game. They invest in bulk unless the shock market reaches an unbelievable peak, and then they suddenly withdraw. It is the poor investor whose hard earned money is put in the stock market not in billions or millions but in thousands, most often, their life-time savings. Yes, the government should keep a track of FIIs.

from: Umesh
Posted on: Sep 17, 2009 at 15:45 IST
A very informative piece indeed. I do agree with the point of impending bubble burst the author has made. We, Indians, in general, have a propensity to get excited with the outside results and seldom ponder over the process that goes into manifesting itself in the way it does. We should focus more on the intricacies of the matter and not just have a superficial perspective on things of such critical importance.

from: Subhash Jha
Posted on: Sep 18, 2009 at 21:25 IST
Everybody who watch NDTV Profit would have seen erstwhile Finance Minister saying that " FII money is hot money " But, why he or his successor have not taken any steps to curb its volatile inlows and outflows is a mystery. It is the Indian retail investor who is left to hold the baby after each bubble burst. They lose much more money in the subsequent fall than what they made in the preceding rally

from: Chockalingam
Posted on: Sep 18, 2009 at 21:51 IST
It is good to be proactive! I am a novice and this article makes a good reading.

from: G.L.N. Reddy
Posted on: Sep 21, 2009 at 09:38 IST
A very good article about the dynamics of our stock exchange.I am only watching this daily as I have put most of my retirement funds into various Mutual funds.
By the way, is the peak date mentioned not Jan 13 2008 instead of September 2008?

from: Shankar
Posted on: Sep 22, 2009 at 17:44 IST
The stock market improvement in India can be considered a short-term swing. The FII investors seem to divert their funds to India since the direction of U.S market is not yet fully known. Till the U.S market recovers, India or BRIC countries for that matter would be considered a safe-haven for the FII's.

from: Satish
Posted on: Oct 5, 2009 at 06:56 IST
You mention the bubble to burst, but I think this process, would take at least 3-4 years, and till then FII's will change their direction of investment to other markets, because by that time recession would have gone. So the bubble which keeps expanding will start contracting. Inflation problem will not occur. The stimulus packages given by the central banks are intended only for a short period. So as our banks stop those packages, the liquidity problem might also get solved.

from: Santosh
Posted on: Oct 8, 2009 at 11:41 IST
The virtual economy of which the Stock Markets are an index impacts only a small fraction of India's population. Stock market bubbles worry only the privileged few. What really matters is the real economy and stimulus spending is needed to keep up infrastructure development at a pace that prevents economic depression and loss of human resources. Krugman has pointed out that unthinking withdrawal of stimulus was precisely what led to the Great Depression of the 1930s. The Government must be wary of this possibility notwithstanding the sorrow that it might bring to some of the speculators on the bourses hoping to double their capital overnight.

from: Taffazull
Posted on: Oct 24, 2009 at 10:58 IST

http://beta.thehindu.com/opinion/op-ed/article19895.ece

Also read:


http://www.ft.com/cms/s/0/4ec41a1a-d616-11de-b80f-00144feabdc0.html?nclick_check=1
Germany warns US on market bubbles
By Ralph Atkins in Frankfurt
Published: November 20 2009 19:48 | Last updated: November 20 2009 19:48

Germany’s new finance minister has echoed Chinese warnings about the growing threat of fresh global asset price bubbles, fuelled by low US interest rates and a weak dollar.

Wolfgang Schäuble’s comments highlight official concern in Europe that the risk of further financial market turbulence has been exacerbated by the exceptional steps taken by central banks and governments to combat the crisis.

Inequality in Britain is of developing world level

Inequality in Britain is of developing world level

By Edmund Conway Economics Last updated: November 25th, 2009

18 Comments Comment on this article

I missed this report yesterday but it’s an interesting one. According to consultants AT Kearney, the richest 1pc in the UK hold some 70pc of the country’s wealth. That there is this divide between rich and poor is not exactly new – but the scale of it, and the likelihood that it is not being narrowed by the financial crisis, is a big worry. Indeed, according to the report, in the US the amount of financial assets owned by the richest 1pc in the US is far, far lower at 48pc, and only 34pc in Australia.

This must, to a large degree, be due to the fact that the UK set itself up in recent years as a haven for the super-rich, with its relatively generous rules on capital gains tax, because the income tax system itself is rather more redistributive than in the US. But the Kearney report is interesting because, unlike the traditional measure of inequality, the gini coefficient, it focuses not on income (the flow of money) but on actual substantive wealth (the stack of it that sits beneath us).

Says Penney Frohling, a partner at AT Kearney: “To understand the impact of the market crash, though, you need to look at wealth – not just how much people hold, but how it is held across different asset types. This is harder to do but drives quite different insights about how deeply and how widely the market crash and subsequent recovery have affected investors across age and wealth bands.”

“On an income basis, the UK and Australia have similar levels of equality according to the UN, with the US having proportionately more very high- and very low-earners. But in terms of the distribution of what people own rather than what they earn, the UK picture is more like an emerging market – though of course at a higher level.”

In the latest UN report on the gini coefficient (in which a score of 0 means absolutely equal income across the population and 100 means one person has all the income), the UK scored 36.0, Australia 35.2, USA: 40.8.

In part the poor score for the UK is due to its relatively ungenerous pension provision, compared with Australia where there is a compulsory pension savings scheme.

But what I find particularly intriguing (and this is something which won’t be clear for another year or more) is the question of whether this crisis has levelled out those inequality gaps. The Great Depression and its aftermath most certainly did, but despite the fact that the gini coefficient (certainly in the US, probably in the UK) are at levels comparable with the late 1920s and early 1930s, we haven’t yet seen any kind of dramatic social backlash as a result.

http://blogs.telegraph.co.uk/finance/edmundconway/100002243/inequality-in-britain-is-of-developing-world-level/

Are markets reaching bubble proportions?

At the end of each month, BBC World News business presenter Jamie Robertson takes a look at the world's major stock markets. This month he considers how long the rally in global markets can continue.


So how long can this go on for? As the markets race ahead, and investors bob along with them through the rapids, the sound of the waterfall ahead gets louder and louder, but no one knows exactly around which bend it will appear.

At the moment investors are driven by a frenetic desire to catch the bull market which many ruefully admit to having missed out on.

Others agonise over when the fall will come so they can jump aboard immediately afterwards, safe in the knowledge that the big drop is behind them.

There are plenty of institutional investors sitting on the sidelines. But there is a weight of money in these markets desperate for returns in a world of negligible interest rates.

Research group Compeer reported that the number of deals placed through retail stockbrokers rose to more than four million in the three months to June, a number surpassed only in spring 2000.

For many that is a sign that a market is reaching bubble proportions, the point at which, in the parlance of 1929, the bellboys are handing out stock tips in the lifts.

Economic optimism

Can we really have reached such a point so soon after the market hit rock bottom?

Yes, we can. The bear market of the 1990s in Japan was marked by many such moments. The crash of 1929 was followed by a 48% rally over six months - followed by another precipitous crash.

That bear market rally was fuelled by economic optimism at the very top. US Treasury Secretary Andrew Mellon said in December 1929: "I see nothing in the present situation that is either menacing or warrants pessimism."

Today's rally can hardly be based on ignorance of the economic facts. Scarcely a day goes by without an economist/politician/journalist explaining how weak the global economy is. And yet the rally continues.

Stimulus packages

Much of this can be put down to the stimulus packages, which have been without question enormously successful in preventing, easing, or perhaps just deferring recession.

Withdrawing those packages will require all the delicacy and finesse of extracting a royal flush from the bottom of a house of cards - which is why the G20 was so keen to assure the markets that nothing gets withdrawn until the recovery is well in place.

That may be some time. The Europeans have been celebrating the fact that Germany and France are out of recession. Yet there are some serious reasons to be concerned about future growth, and most of them lie to the east.


“ Germany may well not be in recession but the nature of the recovery and the scant prospects for its corporate base hardly justify a 34% gain in the Dax since March ”

Six months ago there was a real fear that the Baltic states, Ukraine and several of their neighbours could go into meltdown. The International Monetary Fund and the European Central Bank stepped in with ready cash and disaster was averted.

The stock market response to the crisis was justified. The Ukrainian market, for example, fell 83% from its peak. The response to the recovery (in Ukraine's case a 183% rise from the trough in March), is less so. Then again one expects such volatility from emerging markets.

What one expects less is such a strong rebound in markets that have extensive links with these fragile states. The IMF pointed out this week that European banks have written down only 40% of their bad loans. That failure to recognise dodgy debt lies largely in continental Europe, among banks that have heavy exposure to Eastern European economies.

Drop in lending

"Eastern Europe is in the throes of a very deep downturn, and European banks are still exposed to them, even if the loan losses are related to deep recession rather than to a crisis, as was feared six months ago," says Ken Wattret, Europe economist at BNP Paribas in London.

Wattrett points out that even if banks in Germany, Austria and Italy stay solvent, lending to the corporate sector across Europe is down 6% year-on-year and there is every indication that it will be reduced still further.

And there's more. For the last decade or so Eastern European economies have provided a ready and growing market for German goods.

"That's not coming back," says Wattret, "not for a long time. And that means one of the key drivers of the European economy, the German exports to the east, is severely curtailed."

Germany may well not be in recession but the nature of the recovery and the scant prospects for its corporate base hardly justify a 34% gain in the Dax since March, while a 43% gain in the Italian MIB Index, and a 50% gain in the Austrian market are starting to starting to take on a distinctly bubbly appearance.

Story from BBC NEWS:
http://news.bbc.co.uk/go/pr/fr/-/2/hi/business/8285470.stm


Published: 2009/10/02 09:05:55 GMT

© BBC MMIX

How to Distinguish Stock Market Bubbles?

The formation of a bubble starts with the clear and continuous rise of share prices caused by an exogenous shock affecting the economy. This initial displacement influences future outlook in a positive way, generating expectations of further rise. If share prices distinctly begin to rise, uninformed investors, partly due to the deduction problem, take this as a positive signal. Share of particular industries and companies may become popular. New buyers appear in the market and the proportion of shares increases within portfolios causing a surge in trading volume. As many investors are pursuing a positive feedback strategy, this coupled with the lack of relevant information will amplify noise trading.

A stock market boom can be described as a bubble if there is high probability of a large scale fall in share prices. Stock market crash is not triggered by fundamental news or by a certain level of share overvaluation. Instead, it happens because of a drastic change in the behavior of market players. This is why the necessary and sufficient conditions for the bursting of a given asset price bubble, applicable in practice, cannot be provided with the tools of mathematical economics. A market crash will ensue with a high likelihood if noise trading becomes dominant, the signals of which are to be found in the following stochastic factors:

• Increasing effect of leverage. As a direct consequence, more money is at the disposal of investors. If investors borrow to buy shares, have the opportunity to postpone payment, or making a purchase without full financial cover, it is impossible for them to realize long-term profit on  that particular stock, i.e., they are unable to make dividend payment. This means a short sale constraint shortening the average investment period. The due date of debt repayment is private information incurring, on the one hand, deduction problem and noise trading. On the other, if there is an increasing pool of leveraged shareholders, repayment date and a short sale constraint will more likely be due at a given moment, amplifying the degree of the price fall.

• Increasing activity on part of the economic policy. Economic policy, and monetary policy in particular, can directly influence the conditions of credit, bond and money markets connected to stock markets, thus making the state a protagonist in the stock market. Intended monetary expansion or restriction is always a signal, as it attempts to stimulate or curb the rise of prices. For example, the frequent and tendentious revisions of the base rate convey a series of signals towards market players. In theory, the opportunity cost of shares (the rise in bond yields) prompts investors to lower the share of stocks in their portfolios. Sometimes, however, investors are late and inaccurate in integrating signals of the economic policy into their expectations, increasing the volume of noise in the market.

• Increasing number of corporate scandals, fraud and corruption. Share price rise augments the power and influence of executives, while directly affecting their wealth through managerial stock options. Information asymmetry enables them to use methods verging on fraud to maintain the trust of owners-shareholders if corporate performance is not contributing positively to the share price. The disclosure of such cases may undermine trust, causing a change in investor behavior and prompting the sales of the shares of other companies.

• Fundamentally unjustifiable co-movement of share prices. The co-movement of different shares or investments may signal a dominance of noise trading. When investors do not evaluate a given asset based on its expected future yield, i.e., do not evaluate an enterprise based on the probability of its future success, and instead they make simplifications and use rules of thumb, a fundamentally unjustifiable share price co-movement may ensue. If this co-movement increases, price fluctuation may signal a dominance of noise trading, forecasting a stock market collapse.

The last characteristic of stock market bubbles is that the boom and subsequent crash must have an impact on the economy. Only then will the natural instability of stock markets become a factor affecting economy, without which the concept of a bubble would be weightless. By negative impact we mean a slowdown in economic growth or a decline in consumption and/or investment.

However, a bubble may carry positive impacts as well which display themselves either during the boom or following the crash, in the long run. One such effect is the facilitation of capital issue for a given industry allowing a better financing of riskier solutions and developments. After a crash, the framework surrounding the stock market may also change, bringing about legal, regulatory and institutional evolution as a consequence of the collapse. If a stock market boom has no impact on the economy of a country or on related regulation and institutional structure, we contest such a phenomenon can be called a bubble.

Initial displacement, distinct price rise, new buyers (increasing trade volume) all are direct traits of a bubble, while leverage, the large number of economic policy signals, corporate scandals, fraud and corruption are indirect indicators of the phenomenon.


http://www.stockmarketbubbles.com/anatomy.pdf
Chapter 2.2 Page 79

A single question

“We should answer for a single question: are there more idiots
than stocks, or more stocks than idiots?”

 
André Kostolany (1991).

Asian Property Market Bubble Threatens In China And Singapore

Asian Property Market Bubble Threatens In China And Singapore
Published on: Wednesday, November 25, 2009 Written by: Property Wire


The threat of an Asian property market bubble have some concerned that government stimulus plans have worked too well, and have simply lead to unbridled speculation and a glut of development. Yet the low rate of home ownership in the region suggests there is still capacity for growth, even with prices climbing. Meanwhile, federal authorities in Singapore and China continue to keep a close watch over the direction of their real estate markets.
The government in Singapore will continue to monitor real estate prices to see if further measures are needed to cool the market to avoid a property bubble but officials said that so far cooling measures are working.

Many markets in Asia including Singapore, Malaysia and China have seen property prices rise in recent months amid fears that a mini boom could dent recovering markets and lead to another down turn.

But Singapore’s National Development Minister Mah Bow Tan said that releasing more land for development and making it harder for property buyers to defer payments seems to be dampening speculative demand.

‘The government will continue to monitor the property market closely and assess the market response to the measures introduced before deciding whether further measures are necessary to promote a stable and sustainable property market,’ he said.

But in China opinion is divided over whether or not the government should halt its stimulus packages which have led to soaring property prices.


China should immediately halt some of its real estate stimulus policies or risk inflating a bubble, according to an opinion piece in the government owned Financial News which is published by the central bank.

It described ‘rampant speculation in the country's property market’ as like a time bomb that could threaten future growth.

‘If China does not exit its stimulus policy property prices and the market may go out of control,’ it said.

Residential property prices in China have been rising since March propelled by a slew of government measures including lower down payments and mortgage rates and tax cuts.

Rising prices have encouraged developers to break ground on new projects, with real estate investment up an annual 18.9% in the first 10 months of the year, compared with a mere 1% rise in the first two months.

While the government has welcomed this surge in building activity, which is an important pillar of the economy, some officials now worry that property development is outstripping end-user demand in some locations and that prices are not affordable for ordinary citizens.

But others say there is no risk of a property bubble.

It is not a concern according to a new report from CLSA.

It says that the country’s home ownership ratio is between 30 and 50% in first tier cities and just 25% in second tier cities suggesting that the need for first home and upgrades is strong.

‘There is strong underlying housing demand which is underpinned by a low home ownership ratio, low leverage and high income growth,’ said Nicole Wong Yim, regional head of property research.

She predicts that the government will not curb mortgages although it may ‘fine tune’ its policies rather than tightening lending.

‘There is still room for property prices to climb in China,’ she added.

This article has been republished from Property Wire. You can also view this article at Property Wire, an international real estate news site.

http://www.nuwireinvestor.com/articles/asian-property-market-bubble-threatens-in-china-and-singapore-54134.aspx