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

One possible cause of bubbles is excessive monetary liquidity in the financial system

Liquidity

One possible cause of bubbles is excessive monetary liquidity in the financial system, inducing lax or inappropriate lending standards by the banks, which asset markets are then caused to be vulnerable to volatile hyperinflation caused by short-term, leveraged speculation. For example, Axel A. Weber, the president of the Deutsche Bundesbank, has argued that "The past has shown that an overly generous provision of liquidity in global financial markets in connection with a very low level of interest rates promotes the formation of asset-price bubbles."  According to the explanation, excessive monetary liquidity (easy credit, large disposable incomes) potentially occurs while fractional reserve banks are implementing expansionary monetary policy (i.e. lowering of interest rates and flushing the financial system with money supply). When interest rates are going down, investors tend to avoid putting their capital into savings accounts. Instead, investors tend to leverage their capital by borrowing from banks and invest the leveraged capital in financial assets such as equities and real estate.

Simply put, economic bubbles often occur when too much money is chasing too few assets, causing both good assets and bad assets to appreciate excessively beyond their fundamentals to an unsustainable level. Once the bubble bursts the central bank will be forced to reverse its monetary accommodation policy and soak up the liquidity in the financial system or risk a collapse of its currency. The removal of monetary accommodation policy is commonly known as a contractionary monetary policy. When the central bank raises interest rates, investors tend to become risk averse and thus avoid leveraged capital because the costs of borrowing may become too expensive.

Advocates of this perspective refer to (such) bubbles as "credit bubbles," and look at such measures of financial leverage as debt to GDP ratios to identify bubbles.

http://en.wikipedia.org/wiki/Economic_bubble

A rising price on any share will attract the attention of investors.

Positive feedback

A rising price on any share will attract the attention of investors. Not all of those investors are willing or interested in studying the intrinsics of the share and for such people the rising price itself is reason enough to invest. In turn, the additional investment will provide buoyancy to the price, thus completing a positive feedback loop.

Like all dynamical systems, financial markets operate in an ever changing equilibrium, which translates into price volatility. However, a self-adjustment (negative feedback) takes place normally: when prices rise more people are encouraged to sell, while fewer are encouraged to buy. This puts a limit on volatility. However, once positive feedback takes over, the market, like all systems with positive feedback, enters a state of increasing disequilibrium. This can be seen in financial bubbles where asset prices rapidly spike upwards far beyond what could be considered the rational "economic value", only to fall rapidly afterwards.


http://en.wikipedia.org/wiki/Stock_market_bubble

How the Bank of England made £62bn 'disappear'

By Edmund Conway

I’ve used my elementary Photoshop skills to add those blue lines that mark where the emergency loans for the banks began and ended. Look at the right hand graph – the assets side of the balance sheet – and in particular the purple bit that denotes “other assets”. That includes the currency swaps and, according to Simon Ward of Henderson (the City’s big expert on these complex central bank balance sheets), most likely the emergency loans as well. And, indeed, note how there is a pretty big bulge between October 08 and late January 09 – the precise period when the loans were being issued.

So the answer is that hiding this much money is actually pretty damn easy when there’s all manner of financial chaos going on. It is a finding that will definitely cheer the Bank of England, which rather likes the idea that it can step in and save a bank without anyone finding out and causing another Northern Rock. Not that RBS or HBOS ended up in a much better state in the end, but that’s another story.


http://blogs.telegraph.co.uk/finance/edmundconway/100002192/how-the-bank-of-england-made-62bn-disappear/?utm_source=tmg&utm_medium=TD_62&utm_campaign=finance2611am

Five ways the internet has transformed our personal finances

Five ways the internet has transformed our personal finances
As The Telegraph marks 15 years of its online presence, we look at how the internet has transformed the way we deal with money matters.

By Richard Evans
Published: 3:40PM GMT 25 Nov 2009

1. Internet banking
Millions of people now take for granted that they can pay bills and transfer money at any time of day and without having to worry about queues – whether in branches or on telephone lines. These days, you never even have to speak to a human being when it comes to personal banking. You can also use the internet to find the best deals on savings accounts and then set up and run accounts online. Sixty per cent of people with instant-access accounts have registered for online banking, according to the British Bankers' Association.

Many people also research the mortgage market online, and some even apply for home loans over the internet.

2. Price-comparison websites
If you want to find the best interest rates for your savings or the best price for your home insurance, you can save time by using a price-comparison website. These provide up-to-date lists of the top accounts, as well as data on the best deals on credit cards and other financial products.

In the old days, we had to phone around brokers or insurers to compare prices for car or home insurance, giving out the same long-winded information every time. Most of us would have given up after a handful of calls.

Comparison sites do all the work, showing the cheapest providers, policy details and links to application forms.

Other sites, such as Kelkoo and Pricerunner, find the lowest prices for goods such as cameras, fridges and PCs.

Comparison sites are also much in demand for finding the best deals on energy, although recent research by The Daily Telegraph found that energy-comparison sites did not always agree about which supplier offered the best deal.

Consumers are becoming more savvy about these discrepancies. While a recent survey by Mintel, the analyst, found that six out of 10 people had used a price-comparison site, the consumer group Which? found that consumers lacked trust in them, with one in four finding better value financial products elsewhere.

3. Voucher codes
The recession has sharpened shoppers' appetite for a bargain – and many cost-conscious consumers have turned to the internet to track down special offers. If you want to save money at Tesco you can just type "Tesco voucher codes" into a search engine and find dozens of sites offering the discount codes – short combinations of numbers and letters that you enter into the online checkout. Hundreds of retailers operate these schemes; some also allow you to print off vouchers from the website to claim discounts in shops and restaurants.

According to research from moneysupermarket.com, more than 2.2 million discount vouchers are redeemed every day, while an internet traffic analyst found that the number of web searches in Britain for discount vouchers had increased by 48 per cent over the past year.

4. Dealing and investing
Ten years ago, small investors who wanted to trade shares had to phone a broker. Now they can buy and sell online. Nine out of 10 share deals are made online, according to Barclays Stockbrokers.

Access to information online has helped level the playing field between small shareholders and professional investors with the resources of large banks behind them. "The role of the internet is key, giving the individual at home with a laptop access to the kind of tools, research and up-to-the-minute data previously the preserve of City traders," said Des Byrne, head of Barclays Stockbrokers. "The internet brought financial democracy to newly empowered investors."

People can buy investment funds, such as unit trusts from "fund supermarkets" – online shops that usually offer discounts on charges. These funds are often held in tax-free wrappers, such as individual savings accounts or personal pensions.

5. Buying and selling
Auction websites, such as eBay, have made it far easier to buy and sell second-hand goods, which in the pre-internet age would have meant a trip to the car boot sale. The average British home is estimated to have at least £450 worth of saleable items, typically clothes, CDs, DVDs, books and toys. Online auctions offer a quick way to turn them into cash. About one billion items have been sold on eBay.co.uk in the past 10 years, and 17 million people use the site each month.


http://www.telegraph.co.uk/finance/personalfinance/consumertips/6651262/Five-ways-the-internet-has-transformed-our-personal-finances.html

Market bubbles and individual stock bubbles are investor traps

Bubbles are not caused by fundamental events. It is investors themselves who create them. Investors come to believe some things that are not true or not rational and thus create a mania in a stock, in an industry, or in the overall market. If the mania goes on for a time, a bubble is created, and that builds until its inherent instability leads it to break.

One of the interesting differences between bubbles and bear markets is that in a bear market, there are plenty of bulls and bears. In a bubble, the few bears are drowned out by the loud and almost universal bullishness. This happened with the Internet, because a mania is normally caused by a belief in something that is supposed to be new and amazing, even though this cannot be proved.

It is natural to like momentum and money, but if investors have no disciplines and no sense of bubbles, then they are headed not for the big money, but for quite the opposite.
 
There are market bubbles once in a great while, perhaps once in a life-time, but individual stock bubbles are more common. All bubbles have some similarities that concern how perceptions, emotions, and a lack of accurate information combine to set an investor trap.
 
 
http://myinvestingnotes.blogspot.com/2009/06/bubble-trouble.html
http://myinvestingnotes.blogspot.com/2009/09/markets-in-government-fuelled-bubble.html
http://myinvestingnotes.blogspot.com/2009/11/stock-market-bubble-to-end-morgan.html

****Every decision has to be taken on the basis of the factors present in the situation right NOW

Sunk Costs

One key to understanding how the past affects the present is the concept of 'sunk costs'.  This refers to the tendency to allow past investments or expenditure to affect decisions in the present.  Even though every decision has to be taken on the basis of the factors present in the situation right now, the pull of past events can be very strong.

We need, wherever possible, to see decisions in terms of future benefit rather than past losses or gains.  But we are often more likely to choose alternatives that are in line with our past spending rather than changing direction, because we don't like the idea that past investment is 'wasted', and wish to redeem it.  This can lead us into the trap of 'throwing good money after bad', or 'honouring' sunk costs.

What has been invested need not be financial, or even tangible.  In fact, we may feel a far stronger 'pull' from emotional investmetns than financial ones.  For example, we might wish to continue with a project because of the time we have put into it and the attention we have lavished upon it, even though it has become clear that the probability of success is far lower than we had thought.  The problem is that we have 'put something of ourselves into it'; to give up on it now is to give up on a part of ourselves.  Obviously, these feelings are a long way from objective decision making. 

When things go wrong: Key Ideas

We make mistakes because our brains are not suited to the processes of rational decision making.

If errors happen, we need to ensure that they have some positive impact; we need to learn from them.

Although blame is a natural reaction, it benefits the business to create a no-blame culture.

A no-blame culture implies that those who get bad results, but make decisions in the right way, should be rewarded.

The smart organization builds up its collective learning and decision-making ability to ensure a brighter future.

When things go wrong: Moving forward

Decision making is focussed on the future.  It is always forward-looking.  All actions in business should be focussed on what is to come:  on realising postive future outcomes and avoiding negative ones.

Better risk management and decision making are means to this end; they are tools to help you achieve your goals by looking forward, not back.

At the highest level, better decision making means better strategic direction for the business.  Strategy is about finding new answers the question 'what shall we do?'  By enhancing your understanding of risk, you can be as sure as possible that the answers you find will take the answers you find will take the business forward to a brighter future.

Through learning and practising, you will be able to move forward and achieve positive outcomes by taking decisions and managing risks more effectively.

When things go wrong: The smart organisation

Consultants and researchers David and Jim Matheson identify research and development (R&D) as a key area of decision making for business success.  R&D decisions affect any areas where innovation (rather than improvement) is required.  This principally means creating and marketing new products and services, but also includes designing the new processes and systems that will make them possible.  'Processes' could mean manufacturing processes, but it could also refer to strategically critical aspects of the business, such as its decision making processes.

Essentially, R&D is about ensuring that the business moves forward.  As we have seen, potential strategic risk downsides include

• failing to innovate,
• failing to achieve renewal, or
• putting processes in place that fail to allow for the right kind of development.

The Mathesons suggest three levels of 'smart' R&D:

Technology strategy:

• How will you support existing products, generate new ones and develop radically new ones?
• Will technology be developed or supplied from inside or outside the business?
• What skills are required?

Portfolio strategy:

• Which R&D projects will be funded?
• Which will not?
• How will resources be allocated so that they provide the best R&D value?
• How will you balance short-term business needs with long-term renewal?

Project strategy:

• How will you ensure that each individual project delivers maximum value?
• How could commercial concerns (as well as technical, budget and timescale issues) be brought in?

Nine principles of smart R&D

They also propose nine principles of smart R&D, or the attributes that businesses need in order to be capable of making strategic decisions:

• Value creation culture:  the business has a purpose that everyone understands; this purpose is the test of whether strategies and actions will deliver value for the business and its customers.
• Creating alternatives:  for each decision, there must be a good set of competing alternatives; these must be created if they don't exist or aren't apparent, and carefully evaluated
• Continual learning:  change is certain, and everyone must learn from new situations and information rather than feeling threatened by it.
• Embracing uncertainty:  since there are no facts about the future, everyone must learn to live with and recognize uncertainty, measure and evaluate it, and understand what they are doing.
• Outside-in strategic perspective:  rather than thinking about where the business is and then where it should be going (inside-out), consider the big picture first and work back to the business (outside-in)
• Systems thinking:  use tools and techniques (such as the decision tree) to simplify the complexities involved in strategic decisions as far as possible and enable insights (but not so far that objectivity is lost)
• Open information flow:  any type of information may be important, so information needs to flow, unrestricted, to all parts fo the business, the habit of hoarding information as a source of power must be driven out.
• Alignment and empowerment:  rather than micro-managing every action through 'command and control' systems, aim to involve people in decision making through participation, while building alignment through common understanding of goals
• Disciplined decision making:  build processes that recognise the need for strategic decisions to be made before it is too late; then apply systematic, disciplined processes to making those decisions.

The Smart Organisation: by David and Jim Matheson

When things go wrong: Collective learning

Unless you have successfully eliminated a risk, there is always a probability, however, small, that negative outcomes will happen.  The impact can range from the highly specific and individual (such as personal injury) to the general and communal (damage to the reputation of the business).  Any negative consequences are regrettable, but we can make them worse if we don't learn from them.  By failing to learn the lessons of our mistakes, we allow negative outcomes to extend into the future, instead of limiting them to the present.

The learning that comes from considering the outcomes of decisions is likely to be collective rather than individual.  Individuals who frequently make a large number of decisions that are similar in nature, and stay around to observe the results, are best placed to learn from them.  Weather forecasters and poker players are examples of this rare breed.  Managers, unfortunately, are much less likely to make frequent decisions of a similar type and be able to learn from them.

In business, individuals are likely to move on, get promoted or retire before the consequences of their most significant decisions play themselves out to a conclusion.  This makes it vital to embed the learning from major decisions in the organisation, rather than leaving it to individuals:

• record the information that supports decisions
• document the decision making process
• document responses to problems arising
• share information between decision makers

Measures like these help to prevent information about how decisions were taken from being lost when the decision makers leave the company.  Losing such information could potentially pose a major strategic risk to the organization, since it could result in big mistakes being made again and again.

The recording of information about decisions needn't be a huge undertaking.  Even brief notes on how a decision was taken can be illuminating when returned to a later date.  As we've seen, people have a strong tendency to 'edit' their memories to fit their own perspective.

When things go wrong: Lessons for risk management

The responses to risk will vary from business to business and from risk to risk, but they tend to fall into one of these categories:

• eliminating risks
• tolerating risks
• minmising risks
• diversifying risks
• concentrating risks
• hedging risks
• transferring risks
• insuring risks.

Deciding which of these responses is appropriate in any given situation requires careful analysis of the risk in terms of probability, impact and potential outcomes.


If the downside result of a specific, foreseen risk occurs, you will want to look at the way you analysed it and chose your response, and the effectiveness of the chosen response.  Consider questions such as: 


1.  Are there any clear lessons for your estimates of probability?  (For example, has an event that was regarded as extremely rare happened twice in a week?)


2.  How accurate was your assessment of impact?

• Was it more or less severe than anticipated?
• Did it affect areas you didn't predict?
• Did it have consequences of a different nature than those you expected?

3.  Were the plans and processes made to deal with operational risks effective in practice?

• Should they be improved?
• What alternatives are there?

4.  Could operational problems occur again?

• Is the situation different now?
• If not, how should it be changed?

5.  Did you choose the right response to the risk?

• How has it worked out in practice?
• Do you need to choose a different response in future, or just make the chosen response work better?

6.  If you chose to tolerate a risk, was this the right decision?

• Was it based on enough probability and impact information, or information of sufficient reliability?

7.  If you chose to try and minimise a risk, what effect did this have on its impact?


8.  Can you demonstrate the link between your decisions and the positive results for the business?


9.  If you chose to hedge against a risk, how good was the hedge?  How balanced were the different risks against each other?


10.  If you chose to diversify risks, was the extra effort worthwhile?


11.  If you chose to concentrate risks, was the saving in effort worth the extra exposure incurred?


12.  If a risk was transferred, did the third party accept responsibility when things went wrong?


13.  What knock-on effects are now apparent?

• Is the outcome fully known (or knowable), or is it still unfolding?
• What new risks have arisen?
• What new decisions now need to be taken?

Malaysia’s next export: Maids?

Malaysia’s next export: Maids?
By Lee Wei Lian

Malaysians could soon find themselves filling the same roles as these Indonesian migrant labourers. —

KUALA LUMPUR, Nov 24 — The nation’s mismanagement of talent could have serious repercussions not only on its ambitions to become a high income economy on par with that of developed nations but could also lead it to fall further behind even its counterparts in the region.

Head of research at Corston-Smith Asset Management, Lim Tze Cheng, recently did a tour of South East Asian countries and came away sufficiently impressed that he feels Malaysia may soon be found lagging behind its neighbours that it was once ahead of.

He cited a recent visit to the Philippines, a current major supplier of maids, where he visited a company, International Container Terminal Services Inc (ICTSI) and he drew comparisons to local port champions Westport and Port of Tanjung Pelepas.

He said that ICTS now draws 50 per cent of its revenue from eight profitable ports outside the Philippines, and noted that no Malaysian port company can boast of similar achievements.

“I give it a 70 per cent chance that Malaysia will be exporting maids in 20 years. I wouldn’t be surprised if that happens unless we get our act together,” he said.

Lim says that the issues plaguing Malaysia includes its “problematic” education system and distressingly low ability to retain talent.

“Whoever manages to excel in our education system will be courted by Singapore,” he points out.

Lim is not the only one who is worried about Malaysia’s talent issues and there has been warnings from other parties as well including the World Bank and the Malaysian Employers Federation (MEF).

MEF executive director Haji Shamsuddin Bardan says that Malaysia is currently a net exporter of talent with outflows exceeding inflows.

According to Haji Shamsuddin, Malaysia has only about 38,000 expatriates as compared with seventy to eighty thousand in the 1990s even while some 785,000 Malaysians are working abroad, two out of three of which are professionals.

“Our ability to attract expatriates is quite challenged,” he said.

If Malaysia falls further behind our neighbours in the next twenty years, it wil be a case of history repeating itself.

Lim points out that Malaysia in the 1970’s was once economically on par with Korea.

“Electronics will be dominated by Thailand and Philippines, plantations by Indonesia, financial services by Singapore and our oil could be depleted in 20 years,” Lim predicts.


Malaysia’s future? Bangladeshi workers wait at an airport carpark turned immigration depot in KLIA. — Reuters pic

“The (Malaysian) economy seems to be caught in a middle-income trap - unable to remain competitive as a high-volume, low-cost producer, yet unable to move up the value chain and achieve rapid growth by breaking into fast growing markets for knowledge and innovation-based products and services,” the World Bank said recently.

Prime Minister Datuk Seri Najib Razak appears aware of the problem and has been stressing the need for the country to embrace innovation to escape the “middle-income trap” as well as attract overseas talent, Malaysian or otherwise.

He noted recently as an anecdote that half of the medical specialists working at the Mt Elizabeth hospital in Singapore were Malaysians and two weeks ago hosted a dinner for about 100 Malaysians in Singapore and told them that the government would make Malaysia a better place to live and work in, to bring back its citizens who are residing overseas and also attract global talent to the country.

“We will create more opportunities, more excitement and more buzz in Malaysia to attract the Malaysian diaspora and expatriates to the country,” said Najib.

Lim says that revamping the education system could take years and one fast way to lure talent was to open the Malaysia My Second Home programme to talented individuals such as scientists and researchers instead of limiting it to just retirees.

Haji Shamsuddin says that the government needs to put in place the right policies and structures to retain local talent.

“Otherwise, we become a training ground for others,” he said.


http://www.themalaysianinsider.com/index.php/malaysia/44439-malaysias-next-export-maids

When things go wrong: Lessons for decision making

When things go wrong, an important area of learning is the decision-making process itself.  With the benefit of hindsight, you can consider how efective your processes for making decisions were.  Consider questions such as:

• how likely is it that you were influenced by a taken-for-granted frame?
• do you need to rethink the way you regard risks (i.e. as opportunities or threats)?
• are there any lessons in terms of the way you regard outcomes (i.e. as gains or losses)?
• did you identify all the alternatives, or has it become clear that unconsidered alternatives would have been better?  how can you ensure that your future decision-making frames cover these alternatives?
• what information has come to light that could help to reduce the subjectivity of your probability assessments in futures?
• how can learning be enshrined in the business and made easily available and usable for future decisions?
• are downsides and/or upsides in line with expectations? are there any unforeseen dimensions or knock-on effects in the outcome?

For any of these questions to be answered effectively, it's crucial that you have an objective record of your original decision making processes.

When things go wrong: Towards better decision making - measuring success

What to use to measure success - quality of decision making or results?

The implications for businesses are profound.  If it is the quality of decision making , rather than results, that are the measure of success, then those who take decisions in the right way should be rewarded, even if they make mistakes.  They should also be given more decisions to make in the future, not fewer.

This doesn't mean automatically promoting people who get bad results.  it means:

• encouraging better decison making and making it clear that it will be rewarded
• setting boundaries to limit the impact that mistakes can have; acknowledging and actively managing the risk of mistakes
• avoiding or limiting exposure to fatal downsides (doctors and airline pilots, for example, need systems to help them avoid errors)
• when rewarding people, considering the way decisions have been taken as well as the results of decisions
• questioning the business benefit of punishing those who get bad results
• weighing the negative impact of mistakes against the learning and development they can bring.

It is important to remember that none of this means ignoring poor results or mistakes.  Financial loss or commercial reverses are bad for business.  But failing to learn can be worse.  The focus of management has to be the future, and what can be learned from the present and past to help shape the future.  By focussing on learning and better decision making, the business is doing everything it can to do to avoid bad result in the future, rather than simply reflecting what has happened in the past.

When things go wrong: Towards better decision making - quality of decision and the role of chance

Business results are the outcome of the interaction between our decisions, our actions and chance. Even if we make no error, there is always the cahnce that a bad outcome will result from a 'good' decision. For example, we might play dice game version A (http://spreadsheets.google.com/pub?key=te9MzyHoIN6EyuoHmfDxMaw&output=html) ten times and lose every time, despite having established that hte risk had a positive expected value. But how would such a decision be regarded in business?

 

If we were rewarded solely on results, with no attention paid to the way we took our decisions, our $10 loss would look pretty bad.  Our performance report might read as follows:  'Despite your poor results, you played this game again and again, throwing good money after bad on the off-chance of things somehow coming right.  You recklessly gambled company money on an uncertain future.  Your poor results are evidence of your bad judgement.  What were you thinking?'

 

But if we were rewarded on the quality of our decision-making process, our actions would appear in a very different light, resulting in a different review:  'Although results have been poor, due to circumstances beyond your control, the quality of your decision making was excellent.  You obtained all the information that you could on possible outcomes, and the probabilities of each, and took a decision on that basis.  The negative results, though disappointing, have not bankrupted the company.  You will be rewarded on the basis of decision-making quality.'

 

The flip side of this is that people might make decisions on impulse, or randomly, and still get good results by chance. 

• By rewarding or promoting these individuals, the business risks having lucky managers rather than competent ones - fine, until their luck runs out. 
• Also, although spontaneous decisions may turn out to bring some business benefit, they don't teach us anything.  We can't use them to improve the way we take decisions, or to instruct others.

When things go wrong: Towards better decision making

In business, we tend to judge people by the results of their actions.  Many performance management systems are oriented in this way, placing a strong emphasis on management by results.  Realise upsides and you reap rewards and promotion; realise downsides and you are blamed and maybe even fired.

To most managers, this seems a natural way to 'encourage' and 'motivate' people to 'improve'.  If we reframe the argument in terms of decision quality, rather than result quality, the picture changes.  People's 'mistakes' indicate that they are willing to make decisions, and it is only by making decisions and observing the results that we can improve.  We learn about novel, unfamiliar or complex things through experiment and error.

A study of financial traders showed, it is a serious error for decision makers to assume that bad results mean a bad strategy, just as it is to asume that making money was because you have a good strategy.  In business, as in markets, luck plays a part, and the best managers are like the best traders in having an accurate and sufficiently modest view of which results to attribute to skill, and which to serendipity.

Business results are the outcome of the interaction between our decisions, our actions and chance.  Even if we make no error, there is always the cahnce that a bad outcome will result from a 'good' decision.  For example, we might play dice game version A (http://spreadsheets.google.com/pub?key=te9MzyHoIN6EyuoHmfDxMaw&output=html) ten times and lose every time, despite having established that hte risk had a positive expected value.  But how would such a decision be regarded in business?

When things go wrong: Some themes of a no-blame culture

Some themes of a no-blame culture include:

• discussion of risk (and responsibilities for them) before problems arise, rather than afterwards
• emphasising collective responsibility and shared business goals
• aiming for insights and understanding about decisions, arrived at through a process of co-operation and collaboration
• acceptance of a joint commitment for taking specific actions, with no-one putting their 'head on the block' (regardless of any individual responsibilities that are assigned)
• using tools (such as the decision tree) to generate and confirm a joint commitment to decisions
• taking risks in an informed way, with full knowledge of the potential consequences
• when problems arise from particualr decisions, remembering and re-stating the reasoning that went into those decisions
• aiming to draw collective learning rather than individual advantage from mistakes, problems and negative situations
• using passive language to defuse tensions and sidestep the assignation of blame (e.g. 'there is a problem' rather than 'so-and-so has made a mistake')
• understanding that creativity, innovation and new directions imply some freedom to make mistakes
• thinking of ways to reward people on the basis of how well they take decisions, not the results of those decisions.

When things go wrong: No blame, as blame is counterproductive and damaging

Blame is counterproductive and damaging for several reasons:

• it has a negative emotional impact on the person concerned, making them more likely to 'self-regulate' their future behaviour in a limiting way
• it closes down the discussions that should result from mistakes
• it shifts the spotlight away from analysis, learning and objectivity
• it discourages other people in the business from taking any kind of risk, whatever the expected value.

If decisions are based on careful, objective consideration of probabilities and impacts, and the potential downside of a risk is accepted because of its positve overall value, then there should be no blame if this downside actually comes about.

Decision tools such as the decision tree create joint commitment to an action, so that no one person's position or reputation is on the line if things go wrong.  In effect, this approach transfers business risks from the individual decision maker, who has much to lose from downsides occurring, to the business as a whole, which can absorb the impacts of downsides ( both financial and reputational).

Good risk management is about being prepared for problems, which in turn helps to avoid a culture of blame.  By valuing control, analysis and objectivity, the focus can be kept on the problems that everyone in the business faces together.

When things go wrong: No blame

Errors arise when individuals make decisions, but their root causes are deeper than how 'competent' we are at the point when we make decisions.  Their sources include :

• the tools available to help us make decisions (such as the decision tree)
• the information we have at our disposal
• our psychological make-up; our values; the way we use information; the frames we deploy; our memories and how we regard past events
• the organisational contex:  corporate values; support systems; the way decisions and their results are analysed and rewarded.

When things go wrong attribution makes us simplify all this hugely, by seeking the causes of negative outcomes in other people.  There is always pressure to demonstrate a response to downsides, and people often find it hard not to blame those who took decisions perceived as having led to them.   Our brains like simple causal stories, not ambiguous complexity, and it doesn't get much simpler than attributing downsides to the actions of someone else.  The implication is that error has arisen because an individual is deficient in character or ability ('look what you've done!).

Because  being blamed gives rise to negative emotions, and often leads to some kind of sanction or punishment as well, people who make errors tend to blame them on circumstances or events, rather than themselves ('it's not my fault!').

Neither of these all-too-familiar 'natural' perspectives on error is useful in improving the way we make decisions, or the way we respond when things go wrong.  Refraining from blame is a crucial part of informed decision making and good management. 

When things go wrong: Human errors

Preventing errors by good decision making is not easy. Our brains aren't computeres; they are poor at calculating probabilities, thinking of different possible outcomes and holding lots of information. Situations that are complex, or constantly changing, confuse us even further.

Our 'natural' decison-making processes are often false friends in business. To help our brains get to grips with uncertainty, we have to create mathematical and logical structures. The fact that these are hard to understand indicates how 'unnatural' they are for us. Our brains are designed for self-preservation -taking decsions quickly, under pressure - to ensure survival. To do this, we take 'cognitive shortcuts' that allow us to cut through the information we're facing and reach a decison. The problem is that we often make the wrong choice.

It's the same story with error prevention. When things go wrong, many 'natural' responses, such as blaming others, are self-preservation impulses. They won't help us to learn from our mistakes or share learning with others. To do so, we have to overcome our 'natural' responses and adopt approaches that can, at first sight, seem counter-intuitive.

Welcoming a banking giant: ICBC’s entry into our domestic banking space

Welcoming a banking giant

Tags: Banking | OSK Research

Written by The Edge Financial Daily
Tuesday, 24 November 2009 10:47

Banking sector
Maintain overweight: Industrial Commercial Bank (ICBC), China’s biggest bank, has been awarded a commercial banking licence to operate in Malaysia. The announcement followed a bilateral agreement this month between the China Banking Regulatory Commission (CBRC) and Bank Negara Malaysia (BNM).

ICBC’s entry into our domestic banking space has been widely anticipated. The move is also in line with Phase 3 of the Financial Sector Master Plan, which essentially entails the introduction of new foreign competition that can either offer specialised services or world-class banks that can bring value proposition.

In our view, ICBC’s scale and the potential to boost investments by China companies in Malaysia were the main reasons for this decision. The weakened state of most western global financial institutions in addition to the deleveraging these banks are undergoing may have played a role in limiting the possibility of interested and suitable foreign candidates getting access to large scale and well capitalised Asian banks.

ICBC ranks among China’s “Big 4” state-owned commercial banks (the other three are Bank of China, Agriculture Bank of China and China CONSTRUCTION [] Bank). It is the largest bank in the world in terms of market value and also by deposits, and the most profitable bank globally (net profit: US$16.5 billion or RM55.77 billion). As of 2009, it had assets of US$1.6 trillion and more than 18,000 outlets, including 106 overseas branches and a US$1.3 trillion deposit base.

This is the first banking licence under the bilateral agreement. The licence awarded to ICBC is an extension of a bilateral agreement between CBRC and BNM that was announced earlier this month. This is separate from the five new foreign commercial banking licences to be awarded from 2010 to 2011 as part of BNM’s financial liberalisation measures announced in April this year.

However, given that most major global financial banks are still in the process of recapitalising and deleveraging, we think that the near-term impact of greater competition is likely to be muted. Malaysia’s relatively saturated banking market coupled with the prevailing global uncertainties could pose a setback to efforts to promote foreign participation, at least over the immediate to medium term.

Although the entry of new foreign players will increase the intensity of competition in the industry, we believe that BNM would have taken cognisance of the strength and capacity of our domestic banking institutions to compete in an environment of measured and gradual liberalisation.

More importantly, we believe that BNM will continue to favour gradual liberalisation as it continues to impose operational restrictions on the foreign banks, which would mute any short-term competitive impact on our domestic banking institutions.

Under the liberalisation measures announced in April this year, locally-incorporated foreign commercial banks will be allowed to establish up to four new branches in 2010 based on a distribution ratio of one urban/market centre, two semi-urban and one non-urban.

The more intense competitive landscape over the longer term is expected to enhance the industry’s efficiency and competitiveness. This could, however, have negative implications on margins and the smaller banks that do not have the benefit of scale and niche expertise, and which may see their profits and growth compromised over the longer term.

Of the total of 22 commercial banks in Malaysia, 13 are foreign locally-incorporated and nine are local banks (excluding Islamic and investment banks).

However, of the 13 foreign commercial banks, only five — Citibank, HSBC, OCBC, UOB and Stanchart — are active in Malaysia at the retail level.

This could be attributed to the fact that Malaysia’s banking sector is relatively saturated, and that returns on investment (ROIs) are a more crucial investment criteria instead of absolute asset growth, which may have resulted in many of the foreign banks deciding to be less aggressive on expansion.

Note that ICBC only has an estimated 106 foreign branches out of the group’s 18,000-strong branch network, which further reaffirms our view that the intensity of competition arising from its maiden entry into Malaysia is likely to be gradual and relatively subdued over the medium term.

Based on our assessment of the loan market share of the seven domestic banks under our coverage versus that of the five active foreign banks, it is estimated that the combined market share of loans for the seven domestic banks expanded from 72.5% in 3Q08 to 76.5% in 1Q09. Meanwhile the combined market share of the five major foreign banks actually declined from 18.4% to 17.6% over the same period. The notable gainers of market share were Public Bank and CIMB, while Maybank’s market share edged up slightly by 0.2 percentage points. In terms of deposit growth, again the major domestic banks grew faster than their foreign peers. — OSK Research, Nov 23





This article appeared in The Edge Financial Daily, November 24, 2009.