Was the Euro a mistake?

After much brouhaha about who will bailout Greece (some news reports alluded to the possibility of China coming to Greece’s rescue) the dust had settled when EU decided to put-together a rescue package (so we thought!). Today, the German Finance Ministry said it is unaware of any agreement by euro zone members to bail out Greece.

The Germans are wary - what signal would Greece’s bailout send to the other EU members who are facing similar problems? Would Portugal and Spain be next in line for a bailout?

Germany has been a big “paymaster” to the EU, contributing 60% of EU’s annual budget. Germany has gained significantly from the Euro. Almost half of German exports go countries in the euro-region – these countries have lost out because they can no longer devalue their currency to remain competitive. However, German taxpayers seem to be losing their patience – too many of their neighbors have rigid labor markets and little discipline when it comes to public spending.

I think the underlying issue is much bigger and more fundamental. The arguments in favor of the European Monetary Union were free trade, better labor mobility and enhanced competitiveness. However, many skeptics believed that a common currency made little economic sense. Economist Milton Friedman said in 2001 “As time went by, there would be serious differences in the EU over the policies the European Central Bank should follow”…. "You know, it's an ironic thing in a way," he said, "the euro was adopted really for political purposes, not economic purposes, as a step toward the myth of the United States of Europe. In fact I believe its effect will be exactly the opposite."

Friedman’s prognosis seems to be slowly coming true. By adopting the euro the member countries gave away their monetary policy freedom to the European Central Bank. This makes it extremely difficult for the member states to deal with asymmetric shocks and tailor monetary policies to suit local needs. Spain is a very good case in point. Spaniards could not use monetary policy tools to control the housing bubble – now the bubble has burst. Spain’s labor market has traditionally been too rigid, making it difficult for employers to hire and fire workers. Today Spain’s unemployment is at 20%. The construction boom of the last few years attracted so many workers from Eastern Europe who now stay put in Spain even during the economic downturn, making the unemployment problem in Spain much worse.

A country in the EU region can afford to lose its monetary policy and fiscal policy independence only when labor mobility within the EU region is near perfect (i.e. if unemployment increases in Spain, labor can move to France or Germany) and the potential for big local shocks get mitigated through a common regulations and fiscal policy. Both these conditions are difficult to meet! Labor mobility in the EU region will not be high because of language and cultural barriers. Common fiscal policy and common labor regulations are possible in the US because most of the policies are set by the Federal government but is very difficult to replicate in Europe.

So, is the euro a mistake? A common currency for the euro region appears premature, if not an outright mistake. The costs, at least to some countries, are much higher than the benefits.

Wrong Problem, Wrong Solution Mr. Krugman

Nobel prize winning economist Paul Krugman had commented in his recent New York Times article that the world should indeed be worried about China's currency policy. Krugman quotes Paul Samuelson to argue that China has stolen jobs from other countries through its currency policy.

I agree with Krugman on his comments so far, but Krugman also argues in favor of protectionism and "trade confrontation" by the developed world to get China to revalue the yuan.

I think there are a couple of flaws in Krugman's argument:
a) Currency is not the only factor which makes China competitive. Speak to companies that import stuff from China - they would tell you that currency is important, but one cannot ignore factors like labor availability, infrastructure and to some extent regulatory (health / safety / working conditions / minimum wages etc) arbitrage which makes China’s manufacturing competitive.

b) Krugman, through his "back-of-the-envelope calculation", has pegged the extent of job loss in the US because of China's currency policy at 1.4 million. I think Krugman has overestimated the ability of the US and other countries to competitively manufacture most of the goods that are currently imported from China. What might happen with yuan appreciation is just a rise in inflation and inflationary expectations in the world and not job creation. At a time when unemployment is high and economies are growing at a slow pace, high inflation can cause a lot of trouble.

c) Protectionism and trade confrontation are easy to recommend but extremely difficult to implement. I had argued in my earlier post that under WTO rules it would be difficult to force China to revalue its currency. The only way out would be to bypass the WTO and erect trade barriers against China. However, the US and the EU will be shooting themselves in their foot if they undermine the WTO.

This takes us back to the question - How should the US and EU deal with Chinese currency "manipulation"?.... My answer is still the same - China 's currency policy is clearly unsustainable and market forces will eventually force China to revalue its currency. The developed world should leave the timing of yuan revaluation to market forces.

Dealing with "manipulation" of the yuan

I have been reading many reports on the pressure from the US and the EU on China to revalue its currency to reflect "market realities". How should the US and EU deal with Chinese currency "manipulation"? I think the US and EU should just sit tight and do nothing.

China has had a significant trade surplus over the last many years (over $800 billion in just the last four years). China's trade surplus peaked last year at around 9% of GDP. In 2009, it is expected to be around 5% of GDP. China's huge trade surplus and its rising economic power has increased pressure on elected officials in the US and EU to act on China's "currency manipulation". Chinese premier Wen Jiabao rejected the calls for currency revaluation as "unfair". "Their measures are restricting China's development" Wen Jiabao said.

There is no evidence that revaluing the yuan will have a positive effect on the unemployment statistics in the developed world. Former Federal Reserve Chairman Alan Greenspan mentioned in 2005 - "I am aware of no credible evidence that ... a marked increase in the exchange value of the Chinese [yuan] relative to the dollar would significantly increase manufacturing activity and jobs in the United States." I agree with Greenspan. There is not much of an overlap between the exports of China and the US and EU. If China revalues its currency, the US and EU imports will move from China to some other country (say India or Taiwan or Vietnam) or increase inflation in the developed world instead of creating jobs in the developed world.

Even if we assume that there is a correlation between Chinese currency appreciation and jobs in the developed world, the US and EU cannot do much. The WTO does not have too many rules against currency manipulation. There is no consensus that the China's pegging of yuan to the US dollar (which many people think is currency manipulation) would qualify as a "subsidy" under the WTO treaty. Hence it would be difficult to force China to revalue its currency under WTO rules.

Market forces will eventually force China to revalue its currency (when it revalues is anybody's guess). Today, People's Bank of China keeps its currency artificially low by absorbing dollars from the market and investing them in US Treasuries. This increases yuan in circulation, increasing inflation in the process. The central bank has to then remove these additional currency in circulation by issung bonds (at an interest rate much higher then the interest rate on US treasury securities). The cost of doing this is very high - the interest rate differential of around 5% would amount to over a $100 billion per annum on a $2 trillion reserve! This process of running huge trade surpluses and accumulating reserves will become increasingly unsustainable.

Bottomline - there is neither a need nor a way to force China to appreciate the yuan. Sit tight and leave yuan revaluation to market forces.

It's the deleveraging process stupid

I read an impressive article on Bridgewater Associates (the world's biggest hedge fund) and its CEO Ray Dalio, in the Fortune magazine. His flagship fund has clocked an annual return of 15% over the last 18 years – a very impressive performance indeed. The fund never imploded during the many crises the financial markets have seen over the last two decades. Also, when 70% of the hedge funds lost money last year and the average hedge fund was down 18%, Dalio's fund returned an impressive 14%.

The article claims that over the last two years, the hedge fund industry in aggregate terms has been closely correlated to the S&P 500 and had even reached a 75% correlation. I am not able to digest the fact that hedge funds had such a big bias towards growth even though signs of strain in the economy had begun to surface 2 years ago.

I liked the way Dalio put the current economic woes in perspective:
“Most people think that a depression is simply a really, really bad recession. But in reality, the two are distinct, naturally occurring events. A recession is a contraction in real GDP brought on by a central bank tightening monetary policy, usually to control inflation, and ends when the central bank eases. But a D-process (deleveraging process) occurs when an economy has an unsustainably high debt burden and monetary policy ceases to be effective, usually because interest rates are close to zero, and the central bank has no way to stimulate the economy. To compensate, the value of debt must be written down (risking deflation) or the central bank must print money (a trigger of inflation), or some combination of both.” In recent years the level of debt as a percentage of GDP in the U.S. has skyrocketed past previous highs last seen in the early 1930s. And the Federal Reserve's benchmark rate is now hovering just above zero. "It seems very likely that stocks will get materially cheaper," he says. "We have to go through an important debt restructuring process, and a lot of assets are going to be for sale, huge numbers of assets. And there's going to be a shortage of buyers."

If Dalio’s predictions come true, the expectation that the markets have bottomed out could be short-lived.

Jon Stewart vs Jim Cramer

Jon Stewart, host of The Daily Show, recently interviewed Jim Cramer, the host of CNBC's Mad Money. Jon takes a dig at the business news channels that failed to educate viewers on what was happening in the financial markets and Cramer is defenseless.

The interview has had a huge fan faollowing in the US. The Washington Post reports White House Press Secretary Robert Gibbs saying "I Enjoyed It Thoroughly", when asked about the show.

When the equity markets were in a bullish phase, CNBC's Indian unit - CNBC TV18, made the mistake of celebrating (literally) every additional 1000 points on the Bombay Stock Exchange, knowing very well that the market was frothy. The reporters wore colorful dresses, cut cakes and decorated the studio with balloons! Why did they do all that? The TV channel has a stake in the market going up all the time and small investors feeling gung-ho about it. So it was just an act of playing to the gallery. One wondered whether CNBC TV18 is a business news channel or an entertainment channel.....

Watch Jon Stewart's interview here:

I hope shows like this highlight and encourage debate on the important issue of an inherent conflict of interest that the news media faces these days - the quest for profit versus the duty of quality reporting and investigative journalism. If the issue of conflict of interest is not resolved, news media risks failing in its role as a pillar of democracy.

Black Swan Fund gains 236% amidst capitulation in financial markets

Bloomberg reports that 36 South Investment Managers, a New Zealand based hedge fund, gained 236% in the last 12 months. This is a terrific record in a year where hedge funds lost 19% on an average.

How did 36 South manage to put up such an impressive performance? It has to do with the trading strategy. 36 South buys long-dated options it considers cheap - in currency, bond, equity and commodity markets, betting that rare and unforeseen events would generate unusually large profits. The premium it pays on those options are relatively small - but when the direction of the bet is right, the pay-off is huge.

36 South had profited from bets on interest-rate cuts in Australia and New Zealand, and the purchase of put options on major stocks around the world, including BRIC nations. The fund had also bought put options on commodities.

The risk premium on most of the financial instruments has risen significantly over the last few months, making such a trade not so lucrative these days. Volatility indices have risen substantially and consequently the options premia have shot up. So, a trade similar to what 36 South entered into last year, is unlikely to be lucrative this year.

What is 36 South going to do next? It will start a fund that will bet on inflation around the world going up significantly. With governments around the world planning to tackle recession by printing money and pumping it into their economies, 36 South is likely to make a killing once again.

Credit Default Swaps in India?

The Indian Finance Ministry has asked the Reserve Bank of India (India's central bank) to consider introducing Credit Default Swaps (CDS). I think this is a welcome step.

In my post of April 8, 2007, I had argued about the need to enhance liquidity in the debt market. Credit derivatives are essential tools to mitigate risk and the introduction of the derivatives is a step in the right direction. However, introducing CDS alone will not be enough - credit derivatives market cannot be moved onshore unless India moves steadily towards full capital account convertibility.

Some people argue that India should never allow full capital account convertibility. In their defence, they cite the example of how some of the East Asian countries were battered during the crisis of 1997. The article by Easwar Prasad and Raghuram Rajan (link) offers a balanced perspective.

China's $600 bn stimulus package

It is only two weeks ago that I was discussing with my friend Bala about the global implications of a slowdown in the Chinese economy and what the Chinese government could do to prevent a sharp slowdown. We agreed that the Chinese government would, as a last resort, deploy its massive reserves to build assets and keep the growth rate from collapsing. I had also argued in my previous post that the Chinese authorities are unlikely to allow the growth rate to drop below 9 to 10 percent, to avoid the risk of their political system becoming unstable.

We could not have been more prescient. The Chinese government has now declared a huge stimulus plan worth nearly USD 600 billion over the next 2 to 3 years on infrastructure build up. As always with China, there is not much information available on how the stimulus package will work and what part of it is in addition to the projects announced already.

There is no doubt that such a massive capex plan will ensure that demand in many basic industries do not fall off a cliff. However, one needs to guard against the build-up of non-productive assets, for which China is well-known.

The stock markets greeted the move with a big rally, but it will not be long before the rally peters out!

'I made a mistake' admits Greenspan

Financial Times reports Greenspan as having made the following comment during hearings at Capitol Hill: "I made a mistake in presuming that the self-interest of organisations, specifically banks and others, was such that they were best capable of protecting their own shareholders".

Greenspan is viewed by many as an oracle-type personality, but I have had misgivings against him (against the Fed (of which he was chairman), to be precise) for the following reason:
During the 18 year period when Greenspan was at the helm, whenever a crisis arose, the Fed came to rescue by significantly lowering the Fed Funds rate, often resulting in a negative real yield. The Fed did so after the 1987 stock market crash, the LTCM debacle, and the Nasdaq bubble burst. The Fed's pattern of providing ample liquidity resulted in the investor perception of put protection on asset prices. The result - every time the Fed put was in action, the bubbles just shifted from one asset class to another and kept becoming bigger. I had warned that the Fed's action of cutting interest rates in 2007 would not solve the issue, but would just postpone it and in the process create additional bubbles. I was right - Fed's action did create a bubble in commodities and emerging market equities. These bubbles have burst now, creating havoc in the process.

Coming back to Greenspan, I am happy that he has now admitted that unbridled deregulation is bad for the markets. I agree that capitalism is good - it is indeed our best hope to create equitable and sustainable development and prosperity. However, capitalism needs to have conscience. Recent event prove that markets are incapable of self regulation.

Many people believe that it is not the job of the central bank to identify and deflate asset bubbles – I beg to differ. When asset bubbles get created and finally burst, they cause heavy damage to sections of the populace which had no role to play in creating the bubble. The recent financial meltdown shows very clearly that it is not just the speculators who get affected – crises do have an effect on the economy, on jobs, and on the livelihood of poor families.

Some people do argue that central banks do have very limited tools. The plight of the Reserve Bank of India (RBI) in managing the relentless capital inflows into the Indian equity and real estate markets last year is a case in point. The RBI had to soak up USD from the market, releasing Indian currency. This increased liquidity in the system and also pushed inflation upwards. To flight inflation, RBI had to increase benchmark interest rates – the increase in interest rates increased the interest rate differential and led to even higher dollar inflows. It was a vicious cycle.

The world has become so complex that unless there is coordinated action from most of the central banks, it will be difficult to craft an effective response. Many people think China should let its currency appreciate faster. Try telling that to Chinese authorities who need to ensure 10% GDP growth to keep the political system stable!

Where is the global economy headed?

Where is the global economy headed? People will kill to get a definitive answer to that question.

There is so much panic, skepticism, and fear among not just investors but also laymen who are wondering whether they will get to keep their jobs, be able to feed their families and pay their mortgage. The scenario is so anti to how it has been over the last few years when words like optimism, confidence and euphoria defined the mood.

Not everyone has realized yet that the turmoil in credit markets will affect the real economy. The freeze in credit markets is bound to have a ripple effect on economic activity. People must be naïve if they think the credit crisis would affect only the financial markets. The crisis would push CEOs make preserving cash the objective, rather than chasing growth. Jeffrey Immelt, the Chairman & CEO of GE recently commented (not quoting him verbatim here) "for every dollar of economic activity, there is 10 dollars of financing involved in the entire supply chain. So if credit market freezes, economic output is bound to be affected."

Now back to the question - Where is the global economy headed?
A recent Reuters poll of economists showed that “the global economy will likely shudder to recessionary levels in 2009 as developed nations' woes damage emerging countries' economic prospects”. The IMF has also projected sharply lower growth for 2009. My take is that we should consider ourselves lucky if we can escape a deep and prolonged recession.

One bright spot in the economy right now is the fall in commodity prices. Oil prices have fallen 50% from the peak and prices of industrial commodities have crashed as well. Oil prices are likely to remain soft if OPEC does not become too greedy. Lower commodity prices will ease the pain many economies are facing.

Manic Markets

I stumbled on a very good cartoon image that captures what is happening in the markets right now.




source: unknown

Greenspan does it again

August 14, 2008: 7:10 AM EDT
NEW YORK (CNNMoney.com) -- Alan Greenspan, former chairman of the Federal Reserve, projects that housing prices could bottom out in 2009 - or maybe later - according to a news report.
"Home prices in the U.S. are likely to start to stabilize or touch bottom sometime in the first half of 2009, " said Greenspan to The Wall Street Journal.
But he also added that "prices could continue to drift lower through 2009 and beyond," according to the newspaper.

In my post dated 17th March 2008, this is what I had to say

The US Fed is blamed by many for taking no action to prvent the crisis. It is interesting to read the comments of Alan Greenspan, the former Fed Chairman, as gathered by Paul Krugman, a columnist with the New York Times

What Greenspan said: “The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal.”

What Keynes said: In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

‘Decoupling is inherently illogical’

In my post of March 13th, I had explained why the decoupling theory must be debunked. I seem to be in good company.

The Governor of the Reserve Bank of India (India's Central Bank) commented that "the Decoupling theory is inherently illogical". He adds, "decoupling is a theory which is contextually convenient but inherently illogical. The general analysis now is that it may not be decoupling but a divergence in terms of effect. Hence, you will find that the impact on growth is large in advanced economies while emerging markets escape with softer impact. So there is a differential impact on EMEs and among EMEs. But directionally everybody would have an impact".

I would imagine that directionally, emerging countries would see more people joining the "consuming class" driving up demand for food, energy, and industrial goods. Despite the short term excesses in the real estate markets, one can definitely expect the urbanisation process to continue and maintain an upward bias on real estate prices.

The demise of Bear Stearns

Bear Stearns has been absorbed by JP Morgan for just $2 per share – reportedly valuing the company at $236 million. It has been a dramatic collapse of a Wall Street Firm that was the darling of employees and stock markets. The employees seem to own nearly 30% of the company (though a significant chunk is likely to be owned by the top few executives) and it has been a terrible loss of personal wealth for them.

I feel sorry for Bear Stearns employees and investors. But I think such incidents tend to make the market healthier by weeding out excesses.

It is apt to be a little philosophical at times like these. Incidents like these reinforce our belief in the laws of Systems Thinking and Behavioral Economics

a) In my post of 30th March 2007, I had discussed how the ballooning asset bubble was threatening to push the financial markets off a cliff and the events that are unfolding now were not so hard to predict even a year earlier.
b) Students of Game Theory know about “Prisoner’s Dilemma”. To cut a long story short, it says that every individual acts in his own interest, thereby causing systemic failures. This failure ends up harming the individuals’ interest which they thought they could protect by acting in a “selfish” manner. Run on banks follows the same principle. When everyone is in a hurry to withdraw their assets from a bank (to protect their own savings, and in hurry to withdraw the asset before the neighbor next door does so), the bank collapses. It does not require erosion in the value of assets of the bank to trigger a crisis like this – it requires just erosion in confidence in the bank.
c) “The law of unintended consequences” is playing catch up: The last few moves of the Fed have had quite a few undesirable effects. Excessive rate cuts by the US Fed have always created asset bubbles – Nasdaq, Subprime, and now a short lived bubble in emerging market equities. Despite the rate cuts, the mortgage crisis is only gathering pace and the economy does not seem to stop sinking into a recession.

The US Fed is blamed by many for taking no action to prvent the crisis. It is interesting to read the comments of Alan Greenspan, the former Fed Chairman, as gathered by Paul Krugman, a columnist with the New York Times

What Greenspan said: “The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war. It will end eventually when home prices stabilise and with them the value of equity in homes supporting troubled mortgage securities.
Home price stabilisation will restore much-needed clarity to the marketplace because losses will be realised rather than prospective. The major source of contagion will be removed. Financial institutions will then recapitalise or go out of business. Trust in the solvency of remaining counterparties will be gradually restored and issuance of loans and securities will slowly return to normal.”

What Keynes said: In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.

Debunk the Decoupling Theory Atleast Now

My comments on January 20th (read post on this link) have all come true !!!

Just a day after I posted the comment, the Indian stock market fell 10% on an intraday basis. The next day it fell another 14% on an intraday basis. Though stock markets recovered a bit, they have been on a down-trend ever since.

It takes a brave man to voice opinion against the wisdom of the crowds and the events over the last few weeks make me feel vindicated.

What were those predictions and how have they markets shaped up against these predictions ?

a) During a downturn, money flows into the home market
There have been huge outflows from emerging markets. Indian and Chinese stock markets have been the worst performers this year.

b) If there is a recession in the US, no country can fully decouple itself and maintain its growth rate

There are signs of sluggishness in the Indian economy. Reports indicate that India’s Industrial Production grew by only 5.3% in January. Bank of China estimates Chinese GDP growth to slow down. Decoupling theory has now given way to Recoupling theory !!!

c) Reckless rate cuts will only stoke inflation rather providing a real impetus to growth (China is currently witnessing inflation of over 6% and the authorities have committed themselves to fight it through a tight monetary policy). Despite the heavy fall in short term interest rates in the US, the long term interest rates have refused to budge, indicating bullishness on inflation trends.

Just look at Gold and Oil. Gold has reached $1000 and oil has crossed $110 – close to a 100% gain in the last 12 months.

How do you position yourself ?

a) Act like a hedge fund; have a long-and short strategy. Immediately switch out of stocks that are dependent on discretionary consumer spending in the US. You can buy into emerging market equities on dips, but buy into those stocks which have lower export component and are fairly valued. Don’t buy stocks whose valuations are can be justified only by a great growth story.
The Indian and Chinese markets have fallen 25% from the peak and people who bought into “growth stocks” have burnt their fingers very badly.

b) If you play commodities, play agri-commodities – the switch from food to fuel is unlikely reverse in a hurry and will help maintain an upward bias on prices.
Soybean, Corn, and Wheat futures have gained around 25 percent from the time I posted the message two months back.

c) If you are currency trader, short the dollar and the pound and go long on the Chinese Yuan. The Chinese government is not answerable to its people and will not mind paying the cost of holding a huge forex reserve (the reserve is already worth about $1.6 trillion – over 50% of its GDP). The government is in NO mood to let the currency seek its natural level and China's trade surplus is not going to disappear in a hurry
Dollar is at an all time low versus a basket of currencies and the Yuan has gained further ground against the dollar. A short position on the dollar and long position on the yuan would have given handsome rewards.

We are in recession and what to do now ?

Recently, I posted an answer to the question of a blogger:


QUESTION

We are in recession and what to do now ?

The subprime wipeout alone, says history's best paid fund manager John Paulson, will last the next two and a half years. Even Merrill Lynch says Wall Street is "in denial" about a U.S. recession -- because recession has already arrived. "According to our analysis," one of the firm's most recent reports says, "this isn't even a forecast any more but is a present day reality."

Goldman Sachs agrees. And other big-time analysts are lining up to say the same. We're 'undoubtedly in a recession," says famous investor Jim Rogers. And Nouriel Roubini, the economist who called the housing bust, calls today the "tipping point" for U.S. consumers.

"The effects will be ugly," Roubini just told CBS Marketwatch "Expect the great recession of 2007 to be much nastier, deeper and more protracted than the 2001 recession." Even AT&T says they've had to cut record numbers of phone and broadband accounts because customers can't meet their bills.

What will be the impact on Indian / Chinese stock markets will more funds drive them up ?


ANSWER

As with most other downturns, this one has been induced by people buying “stories” ignoring caution and commonsense.

Let’s looks at some of the bubbles to get a perspective:

In March 2000, the NASDAQ hit 5,049, followed by a sell-off. The market plunged downward, reaching its bottom of 1,114 on October 9, 2002. People bought stocks with a belief that a “new economy” had emerged in which technology ensured that recessions were a thing of the past and productivity gains would continue at levels that formerly had seemed unattainable.

In 1989, the Nikkei hit its all time high of 38,916, and then slid downward for more than a decade, reaching its bottom of 12,698 in 2001. After a decade of deflation and banking reform, the Nikkei hit a five-year high in January 2006, about 33 percent of its peak value.

However, asset bubbles are not a recent phenomenon, nor are they limited to stock markets. The Dutch Tulip bubble of the 17th century was one of the most dramatic examples. As the price of tulip bulbs increased, speculators began buying the bulbs from sailors and selling them to the wealthy. It is estimated that a bulb at the peak of the bubble sold for $34,584 in today’s dollars. Eventually, some investors began to liquidate their interests in tulips, supply increased dramatically, and during a six week period in 1636, tulip prices fell by 90 percent. To limit the chaos that followed, the government nullified all tulip contracts and declared tulip speculation a form of gambling. Tulip prices never recovered after the bubble burst, and today rare tulip bulbs sell for $0.30 to $0.40 apiece

Recent bubbles have been induced by “reckless” action from the US Fed. This is called the “Fed Put” - the Fed trying to rescue careless investors and traders by cutting interest rates. This action has created one bubble after the other – Nasdaq, Sub Prime, and the next could be emerging market equities and industrial commodities.

People have definitely bought into the “decoupling theory” and the “TINA – There is no alternative” theory, pumping money into India, China, Gold, Oil – you name it !!! US Dollar has been reaching new lows, creating problems for exporters (into the US), but providing better gains for investors in assets denominated in currencies other than the USD.

What will happen in future ? There are a few golden rules which probably will not be violated this time too
a) During a downturn, money flows into the home market
b) If there is a recession in the US, no country can fully decouple itself and maintain its growth rate
c) Reckless rate cuts will only stoke inflation rather providing a real impetus to growth (China is currently witnessing inflation of over 6% and the authorities have committed themselves to fight it through a tight monetary policy). Despite the heavy fall in short term interest rates in the US, the long term interest rates have refused to budge, indicating bullishness on inflation trends.

How do you position yourself ?

a) Act like a hedge fund; have a long-and short strategy. Immediately switch out of stocks that are dependent on discretionary consumer spending in the US. You can buy into emerging market equities on dips, but buy into those stocks which have lower export component and are fairly valued. Don’t buy stocks whose valuations are can be justified only by a great growth story.
b) If you play commodities, play agri-commodities – the switch from food to fuel is unlikely reverse in a hurry and will help maintain an upward bias on prices.
c) If you are currency trader, short the dollar and the pound and go long on the Chinese Yuan. The Chinese government is not answerable to its people and will not mind paying the cost of holding a huge forex reserve (the reserve is already worth about $1.6 trillion – over 50% of its GDP). The government is in NO mood to let the currency seek its natural level and China's trade surplus is not going to disappear in a hurry.

If the inter-connectedness of the global economy and the consequent complexity creates anxiety in you, Welcome to the Club !!!

Private Equity Boom - How long will it last ??

MUST READ
An amazing article (in the CFO magazine dated 1st Apr, 2007) on the private equity (PE) boom
http://www.cfo.com/article.cfm/8909971/1/c_8910395?f=home_magazine

Refer to my comments posted on this blog on March 30th
http://av.blogspot.com/2007/03/fallout-of-ballooning-asset-bubble.html

Fallout of the ballooning asset bubble....

Global M&A topped 1 trillion USD in the first three months of this year (Jan '07 to Mar '07) reports Financial Times.

This is 15% higher than same period last year. What is causing such a frentic activity ? The surge of liquidity in the last two years, has been blamed for most of the excesses.

Is this a bubble that is likely to burst and have far reaching consequences on the economy ???

How do bubbles get created in the first place ? Bubbles are created when the fundamentals of an underlying asset are ignored and purchasing decisions are based on just one factor - "is someone likely to buy from me at higher price later?"

The newspaper DNA reported about Mumbai's first real estate bubble
http://www.dnaindia.com/report.asp?NewsID=1082931

The $1000 billion worth of deals would have been financed primarily through LBO funds and a sizeable portion of it would have involved private equity players. The modus operandi - borrow money cheap, buy out, show short term improvement in operations, sell out. But what is strange is that players like Blackstone are raising money by taking their company public rather than selling their investments - "same phenomenon of expecting to sell assets at a higher price eventually?"

Let us hope that there is no sudden panic which would cause manic deleveraging. Otherwise it would lead to severe pain in the world's financial system.

How do you protect yourself ? If you are holding on to a risky asset, it is time you diversified or managed the risk by buying some form of insurance.