Monday, 2 November 2009

If something is too good to be true, it is too good to be true

Since the beginning of the year, the prices of all sorts of risky assets – shares, oil, etc have increased by fantastic proportions. Take equity. In virtually any market in the world, you would have made returns of 50% plus, even if you are an idiot. Did somebody say we were in the midst of a huge crisis ? Here was massive money to be made, by just being there. Sounds too good to be true ?? As the old saying goes, when something is too good to be true, it usually is.

I read a very interesting article by Nouriel Roubini, the highly respected Professor from New York’s Stern School of Business, in today’s Financial Times. Its somewhat technical, although very readable. I commend even a layman to read this. At the risk of extreme oversimplification, I will paraphrase his argument as follows

- Interest rates are extremely low and will be maintained at very low levels by the US Fed to stimulate the economy
- The dollar is falling. Because it is falling, everybody is short selling the dollar.
- Short selling the dollar essentially means that you can borrow at negative rates of interest, as long as the dollar is falling .
- Invest this in any risky asset – say shares in Hong Kong. Prices of those shares will rise as demand for them increases.
- One month later (or whatever), sell the shares and make a tidy profit. Now these are worth much more in US$ terms as the US$ has fallen. Settle your short sale of the US$ and make a huge profit.
- Repeat step 1 to 5 again.

This is what Prof Roubini is arguing is happening. Of course, this cannot go on for ever. One day the dollar will not fall. Then like a herd on stampede , everybody will sell the risky assets and cover their short positions on the dollar. The bubble will truly burst.

That’s what usually happens to bubbles. When asset prices rise by 70% in 9 months, it is a bubble. The bigger it gets, the worse will be the explosion.

If you want any more evidence that Prof Roubini’s views must be taken seriously, read what he said

“In the coming months and years, he warned, the United States was likely to face a once-in-a-lifetime housing bust, an oil shock, sharply declining consumer confidence and, ultimately, a deep recession. He laid out a bleak sequence of events: homeowners defaulting on mortgages, trillions of dollars of mortgage-backed securities unraveling worldwide and the global financial system shuddering to a halt. These developments, he went on, could cripple or destroy hedge funds, investment banks and other major financial institutions”

The date ? Sep 7, 2006.

Just because somebody was right once, it does not mean that he will be right again. But it would be completely foolish not to listen to him.


J said...

Very nice article and scary too. I love watching Fareed Zakaria's show on CNN (GPS) and yesterday he interviewed Robert Shiller and Martin Wolf and Wolf made this comment which reminded me of your Goldman posts. Talking about the financial reforms, he said
"They're getting more capital in the system, but they're not lending. They're just playing games on the financial markets, making lots of profits."
So it seems that the big problem is that while there is a lot of money sloshing around, it is being invested more and more in financial assets rather than real assets that could spur on economic growth.
Sobering post.

Sandhya Sriram said...

another eye opener as ever ramesh.

given that my business sense is not too great, pardon me if i am making a gross assessment error.

drawing a parallel to India's recovery from recesion, i think here the investment was on fundamentals.
and i think the recovery which the country has put up is quite ok. i read in ET today that come Jan, interest rates will start firming. elections this year also saw lot of black money seep its way into the economy especially rural. I think all put together we will end the year with a 7% growth atleast.

but when Dr. Nourine's bubble bursts, India will again need to take the impact again, probably, india will sail through.

being a little selfish by thinking so local - sorry about this

Sandhya Sriram said...

sorry about the spelling of Prof Nouriel

Adesh Sidhu said...

Yes, bubble will surely burst and it will burst soon. Unfortunately, retail investor is the one which suffers most because they enter late into such gimmicks and by the time they bubble is already al set to burst. Poor chaps carried away by aspirations!!!

Ravi Rajagopalan said...

On the same Comments page of the FT you will find an article by Wolfgang Munchau, another respected economist. He believes central banks will start to make an Exit from prime-pumping the economy. He believes that the time is ripe for a nominal increase in short-term interest rates by the Fed. However economists are anxious to prevent the "Japan Effect" - when the Bank of Japan raised rates in the early 90s condemning the Japanese economy to experience a severe contraction that lasted ten years. Also Roubini himself points out that the Fed's note printing program - sorry quantitative easing - will have to stop at some time, and when the dollar does bottom out, the short-sellers will be exposed.

I am not sure if these humongous profits are being made on the retail side. If the institutions are involved - as they must be - they deserve to die when the carry trade unravels.

For once I hope the markets correct themselves.

Ramesh said...

@J - I am just not able to understand either the economics or morality of super profits being made during a recession. Prof Roubini's article reinforces that its all a huge bubble.

@Sandhya - You are right that there is real growth in the Indian economy. However there is no fundamental justification for what has happened in the stock markets. Because FIIs move the Indian market so much, I believe we aren't immunde to the bubble either.

@Adesh - You are right, the retail investor who comes looking for an easy buck (the average guy day trading) wil be hurt, and in my book deserves to be hurt.

@Dada - Missed the other article; thanks for pointing out. Yes everybody is scared of the Japanese example, but this situation seems as bad. The asset bubble is being inflated by institutions, but the retail investor is gambling as well. You would have made 10 times more money by sitting outside Dalal Street and looking knowledgeable than by a hard day's work. How can this be right ?

Anonymous said...

Thank you for the wonderful article. (I am learning business from you). Strategic prediction that was, in 2006. Wish his present comment is taken seriously!

Srivats said...

ITs a eye opener for non business , actually no business knowledge people like me. Its worth listening to such timely advice, but people generally try to make quick buck even at the worst situation. US sneezes and people die in other parts of the world, god save us.

Bala said...

Good post Ramesh!!

Got to get the link of your blog from my cousin... After checking it, felt much informative... Hope I would learn more about business from your blog...

Wish that you write more on things like Entreprenuership... Coz it's the one that is lagging in many of the Indian Youths today...

Many of us want to be an entreprenuer, but not sure about the way we should head... So If you could share your professional & acadammic experiences on such topics, it will be much helpful for ppl like me....

Ravi Rajagopalan said...

In 1929, the Dow crashed to 194 from a high of 329. In three weeks it was back at 264. Somebody made a killing in the rally. Much as though the morality (or immorality) of markets offends our olfactory senses, it is better to let them play a role in letting profits be made through its mechanisms. We all know the virtues of a market - but we are also aware of its pitfalls.

We committed the financial crime of condoning moral hazard in order to save the larger system. The key to avoid a repetition of the same is to not repeat this generosity if the dollar carry trade collapses. What other choices to policy-makers have. Ban short-selling the dollar? Will never work, and will destroy the primus inter pares role that the US economy enjoys. Already the Russian and Chinese are making noises about the role of the US Dollar. Ban certain asset classes? Will only distort pricing.

I think that as the supply of cheap dollars ends (with the end of quantitative easing), these trades will unwind. In the meantime I suggest you put your morality aside and call your broker.

You live in China, man. Easy with the moral scruples as far as money is concerned.

Deepa said...

Ramesh, you make Economics readable. A very informative post. It raised some questions in my head and by the time I came to post them here, they was answered by Mr. Ravi Rajagopalan in his comment!

Anonymous said...

Thanks for paraphrasing ... :-) Yes, it would be extremely not to listen to him.

Ramesh said...

@thoughtful train - They listen all right; and then they ignore such warnings ....

Ramesh said...

@bala - Thanks for coming and your comments. I'll try, but I am no entrepreneur .... :)

@Dada - Coming from Her Majesty's subject , from the land of fair play and toodle -oo ; I am ashamed of you :) :)

@Deepa - Thats one of the best compliments I have got. Make Economics readable. WOW :)

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