Financial Bubbles

Financial Bubbles
25 novembre 2010, 18:21
Intro
Reality is always more complicated than the dichotomies we introduce into it.-George Soros 
 
In the world of unknowns, forecasting risks and hedging against them allows investors to function with some degree of certainty. Financial history shows that bubbles create capacity, which is no longer needed once they deflate. I,e, (quick and painful)correction between the real value of the underlying assets and the inflated price. Maneuvering portfolios amidst the bubbles ready to burst and bursting is a difficult task in itself. Benefiting at the time when capitals evaporate is a daunting task. Thus in order to be able to adapt to the situation with many unknowns and preferably outsmart it investor has to act with speed and accuracy. George Soros reminiscents: "As a participant I had to act under immense time pressure, and I could not gather all of the information that would have been available …The fact that the participant's thinking is time-bound instead of timeless is left out of the account by rational expectations theory."
As much as timing is important when dealing with potential or actual bubbles there is an even more important tool for the investor. It is understanding of the underlying assets he trades and their relationship to the overall economy (today it is global economy). An investor wishing to win should constantly analyze the industry conditions and only then make investment decisions. Simply going where the growth is will put one where the heard is and potentially where the slaughter will take place.
Today there is a multitude of financial instruments and investment opportunities available all over the world. One can choose from debt, equity, derivatives, real estate, and currency.
Derivatives can serve many useful purposes, but they also contain hidden dangers. For instance, they can pile up hidden imbalances in supply or demand which may suddenly be revealed when a threshold is breached. This is true of so-called knockout options, used in currency hedging.. (FT)
Still many investors have decided to perform an exodus when it comes to stocks bonds, derivatives and currencies and buy good old gold that has been growing as steadily as dollar was weakening. But at $1200 an ounce has given a sign to many that it is time to exit again.
Typically, bubbles have an asymmetric shape. The boom is long and drawn out: slow to start, it accelerates gradually until it flattens out during the twilight period. The bust is short and steep because it is reinforced by the forced liquidation of unsound positions. Disillusionment turns into panic, reaching its climax in a financial crisis. GS
Market participants cannot possibly base their decisions on knowledge—they have to anticipate the future, and the future is contingent on decisions that people have not yet made. What those decisions are going to be and what effect they will have cannot be accurately anticipated. Nevertheless, people are forced to make decisions. To guess correctly, people would have to know the decisions of all of the other participants and their consequences, but that is impossible. GS
 
Let us analyze the several components a prudent investor keeps track of:
Underlying Industry
Different industries are in different financial health and are developing at their own pace even though being interlocked in the interdependent world of global economy. Some industries are quite volatile. Others are negatively correlated to the overall economy.
There have been several bubbles attributed directly to specific industries and driven by psychological factors and lack of oversight. For example: the gold rush of the 1800s led to construction of outposts that subsequently became ghost towns after that bubble subsided, mining bubble of 2006-07…, the Internet bubble of the late 1990s with Alan Greenspan referring to irrational exuberance (the internet bubble gave rise to hundreds of publicly traded dot-com companies, many of which either merged with other technology companies or went out of business once the bubble deflated, It was also true of the portfolio insurance programs that caused the New York Stock Exchange's Black Monday in October 1987 or even the conglomerate boom of the late 1960s[1]. The latest example has been the subprime housing bubble of 2008 in US, which has lead to the burst of the super bubble of the credit expansion (The prevailing trend in this super-bubble was the ever increasing use of credit and leverage. The prevailing misconception was the belief that financial markets are self correcting and should be left to their own devices) and a world financial crisis eventually.
Thus choosing an industry of investment for speculative or hedging purposes an investor should study the trends within that industry. For example many investors are still eerie about investing in banks believing that the worst is not over yet. " that there are still a lot of problems on their books." Financial Planning
Others prefer energy companies. Believing that oil companies provide a good inflation hedge anticipates an inflation spike in coming years.
 
Investors that continually expand their knowledge leverage look at healthcare as an area with good deals and organic sustainable growth.
 
Currency
One way to survive and possibly prosper during the times of financial turmoil is to take long position in cash. One investor has observed "I couldn't have not lost money last year unless I was 100% in cash[2]," Financial Planning
 
Of course as the situation improves cash percentage of the portfolio would need to decrease. At the same time a question arises -what currency should an investor hold, since not only some industries but whole currencies are in high risk zone, according to analysts. For example a higher oil price and speculative capital inflows driving Russian appreciated the Russian rubble. But while the strong rouble may be a positive signal for investors, it has created its own problems: export competitiveness and, worse, the possibility of a new asset bubble worry experts.(FT)
 Chieese the renminbi is undervalued, and speculators can borrow overly cheaply in New York to finance hot money flows into China and other emerging markets. One consequence is a huge bubble in China's commercial and residential real estate markets, which is forcing the PBC to try to curb the expansion of domestic bank credit. (FT)
 
Countries
While many believe that Europe and Japan will not experience significant growth in the coming years; many countries may be prone to overheating and bubbles.
Returning to China; many investors are concerned that asset bubbles that forming in real estate, banking, and in the stock market. Contrarian hedge fund manager James Chanos of Kynikos Associates recently labelled China an extraordinary bubble ready to burst.
 
The Guru's Mistakes
I was aware of the uncertainty associated with reflexivity, but even I was taken by surprise by the extent of the uncertainty in 2008. It cost me dearly. I got the general direction of the markets right, but I did not allow for the volatility. As a consequence, I took on positions that were too big to withstand the swings caused by volatility, and several times I was forced to reduce my positions at the wrong time in order to limit my risk. I would have done better if I had taken smaller positions and stuck with them. I learned the hard way that the range of uncertainty is also uncertain and at times it can become practically infinite. Uncertainty finds expression in volatility. Increased volatility requires a reduction in risk exposure. This leads to what Keynes calls increased liquidity preference. This is an additional factor in the forced liquidation of positions that characterize financial crises. When the crisis abates and the range of uncertainty is reduced, it leads to an almost automatic rebound in the stock market as the liquidity preference stops rising and eventually falls. That is another lesson I have learned recently.
George Soros
 
Asia Monitor: China & North East Asia Monitor writes:" it is not out of the question that China could repeat the path of Japan[3] in the 1980s. . In China's case, reduced demand from overseas, and the hasty response threatens to do the same if measures are not taken to cool the market. As was the case in Japan, there is a risk that companies begin to focus overwhelmingly on financial investment rather than their core businesses to sustain profit growth, particularly property investment, a scenario which could hurt profitability in the long term
Dr Sushil Wadhwani is chief executive of Wadhwani Asset Management, and a former member of the UK Monetary Policy Committee expresses his opinion on the 2010 growth across the globe: We expect growth in the developed world during the first half of 2010 to surprise on the upside. … A positive growth surprise is likely to be associated with higher equity and commodity prices, which would plausibly produce upside surprises in headline inflation rates.
 
Stocks
When it comes to stocks (according to one strategy Financial Planning ) is to find companies that significantly out of favor that their shares trade at fire-sale prices, further limiting the downside. And hold on to them for long enough for the market – hopefully – to reappraise them.
Still currently experts warn us:"Stocks are overbought and a slight correction would not be unexpected," says Anthony Conroy, head of trading at BNYConvergEx.
Bill Strazzullo, chief market strategist at Bell Curve Trading. "For the vast majority of people, stocks are the only game in town and we are seeing a lot of performance-chasing." All of this could push markets well beyond fundamental values, setting up investors for a big fall, unless the economy grows much faster than bulls currently assume.
"Something will break the current trend and I'm worried about the risk of a 1987 style one-day correction," says Mr Ricchiuto.
 
Conclusion
Can we outperform the market?
Bubbles have always threatened investors an always will. Some investors bight adopt a proactive part, some might take a defensive position.
What we have experienced in the recent past was a burst of a super bubble, a perfect storm if you will. Its outcome is not yet certain. We will certainly see inflation and a s a consequence tightening of the financial instruments In such an environment, valuations would have to be much lower than they are today in order for stocks co perform well. Investmnts
Bernard Baumohl, chief global economist at The Economic Outlook Group says ""The real economy may be itching to grow, but unless banks and other lenders return quickly to help finance consumer and business activity, the paucity of credit will stunt the economic recovery at best, or totally derail it at worst,"
Soros: Looking ahead, we would expect financial markets to act in a schizophrenic fashion, alternating between worrying about deflation and inflation risks. Recall that this is what occurred in Japan during the last decade, where the oscillations in bond yields were considerable - the 10-year yield fell from about 1.5 per cent in early 2002 to 0.5 per cent in mid-2003, before rising to almost 2 per cent over the following year.
 
Russian scientist Kondratieff has long ago argued for the existence of the waves in the development world economy. Cycles would suggest a repetitive nature to events. While the underlying economic conditions will repeat over time due just to the physical nature of our world, our reactions will always be tempered by knowledge and experience. Kondratieff recognized progress as the irreversible trend.
 
 
[1] the underlying trend is represented by earnings per share, the expectations relating to that trend by stock prices. Conglomerates improved their earnings per share by acquiring other companies. Inflated expectations allowed them to improve their earnings performance, but eventually reality could not keep up with expectations. After a twilight period the price trend was reversed. All the problems that had been swept under the carpet surfaced, and earnings collapsed. Soros
 
 
[2] reflecting his view that a credit bubble was on the verge of popping and investors weren't adequately
compensated for the risk they were undertaking by owning stocks and bonds
 
 
[3] As Japan's export model came under pressure from a stronger currency, the Japanese authorities allowed a huge asset bubble to stimulate domestic demand and stabilise its economy, with negative longer-term implications