3 Valuable Lessons from the NASDAQ Bubble

The NASDAQ Bubble

Looking back, one can recall that the big capitalization technology stocks which controlled the NASDAQwere wildly overrated by out-dated measures. The Wall Street Journal had published on March 14, 2000, a prominent article - `Big Cap Tech Stocks are a Sucker Bet’. This article was contributedby the Wharton School finance professor and fellow Kiplinger’s columnist, Jeremy Siegel. He was of the opinion that `several investors of present time are undisturbed by history and by the failure of any large cap stock ever to justify, by its subsequent record, a (price-earnings) ratio anywhere near 100’. 

 

Bubble is a change and the nature of bubbles is that no one can predict when they could pop. If Nasdaq seemed to be overvalued in 2000, it was also overvalued in 1999 as well as 1998 and 1997. This resulted in investors rushing to buy stocks in late 1990s with the intention of not missing out on profits which their colleagues would be making. Most of the buyers overloaded their portfolios with big cap tech stocks with the belief that they could later sell to make a profit.


Education from the NASDAQ Bubble

Three of the most valuable education from NASDAQ bubble -

• Diversification - The main lesson from Nasdaq COMP, -0.63% bubble was diversification. Having ones’ savings in one high beta sector of financial markets would give rise to substantial risk of long lasting loss. Though the NASDAQ took fifteen years to break, an investor owning a 60%/40%stock/bond portfolio beginning on March 1, 2000 was at risk for less than four years. Besides, while NASDAQ was scrabbling its way back to break even, one generated an annualized return of 5.5% though not bad at buying while it was at its peak
• Price compression creates tail risk–Investors get involved in years’ worth of future returns into a very short time period. If the underlying entity does not give the actual value which it was priced in, this would give rise to disequilibrium. In other words, you would get investors who priced in high growth that does not seem to be profitable. When understanding dawns, the price decompresses and the bigger the compression, bigger is the decompression. As the Nasdaq bubble tend to get expanded, investors were looking forward to gain profits of the Internet, pricing in years’ worth of profits in a very short span of time. This means that they priced in a 15 years value of profit in a few years. When one fails to diversify accurately, one could be exposed to their savings being at risk. They should allocate their savings accurately to avoid being exposed to huge risk to their portfolio.
• Avoid chasing the next hot thing for maximizing returns –If one intending in maximising the primary source of income and allocating some of the income in, with the intention of planning for the future, proper allocation of saving is essential. The purpose of savings is not actual return maximization; on the contrary, return maximization within the boundaries of suitable risk taking. If one is a real saver on the lookout for stability, then the main portfolio goal is not simply a protection against purchasing power loss but the risk of long lasting loss. This means that it could be probably unwise to overweight the portfolio in favour of purchasing power protection.

Conclusion 

Most of the investors unfortunately turn to the stock market as a place where they could raise their profit and improve their financial status. In their eagerness to reach high, the risk factor is often overlook and sometimes ends in disaster. Caution needs to be exercised in every plan of investment to earn the fruits of a good labour.

China facing a new threat of credit crunch!

Almost all the economists alarmed an increase in risk every day to see a new burst in credit bubble in Asia and now things seems to be clear now. The rating agency Fitch indicates that such event without precedent in the history of the modern world could burst in China. The Tribune does not beat around the bush; and citing a threat of a credit crunch. We have discussed these things already on various times. The occurrence of this new credit crisis may in turn be hit hardly soon. The main resources for these happening are the excessive growth of bank loans to the private sector and the loans outside the formal sectors etc which lend in turn more difficult to repay by the borrower. On Friday, the Chinese interbank rates showed a sharp decline, the refinancing rate to seven days - part of the cost of interbank lending - dropping from 11.62% to 8.33%, such a move could not be obtained thanks to rumors suggesting that the PBOC (the Central Bank of China) was pressure to release the donor funds, or it can intervene directly. Earlier, panic had seized the Chinese interbank market, the benchmark rate to a record high at 13.91%. In the end, according to Bloomberg, 50 billion Yuan (about 6.15 billion Euros) were injected into the market by the central bank. The situation with less tense will prevail in recent weeks and it will continue, and the worst is still to be feared to come out. Leading analysts consider that the PBOC should maintain its policy to severely restricting access to credit for businesses and individuals. Reasons behind this are; it will help to restrict the high level of bad loans held by Chinese banks. A context is that investors fear that banks are facing difficulties increasingly strong to refinance. During the past two weeks, the rate of refinancing had indeed soared, the Chinese Central Bank stopping the injection of liquidity, despite the economic downturn. A measure which provoked a strong restriction of access to credit, draping the exchanges while blocking the lending capacity of banks. Monetary authorities and Chinese policies now want to end the very rapid credit growth in recent years. It is true that there is an emergency, leading institutions in the viewfinder smaller banks, which have increased their loans while speculating heavily. A situation that pushes the government to "clean up" the banking market, closing the valve to riskier institutions, a policy may lead some to bankruptcy. Another worrying and not least: in May, a report released by the rating agency Moody indicated that informal lending outside the banking sector in China had increased by almost 70% over the past two years ... representative now the equivalent of 55% of gross domestic product (GDP). Financial products of the informal sector amounted at the end 2012 to 29,000 Yuan (3,600 billion Euros), according to preliminary calculations by Moody's. A narrower definition of the sector excluding loans fiduciary obligations and asset-backed companies, the informal sector would weigh only 21000 billion Yuan, but still 39% of GDP. The Moody's report indicated that parallel "informal banking sector could have a leverage effect on the finances of the wider economy and amplify fears of a credit bubble. The rating agency felt that the rapid growth of informal loans increased risks to the banking system and the Chinese economy as a whole. "Given the sheer size and growth of informal banking in China, we doubt the ability of banks to guard against a significant increase in defaults" in this area, yet warned by Moody's. In March, the Banking Regulatory Commission noted that it had ordered banks to control the funds asset management more closely in order to contain the risk and increase transparency. According to Fitch, Chinese banks have somehow hidden in a second parallel balance the equivalent of 2 billion loan mechanism to circumvent the official boundaries and new regulations put in place to curb the excesses. Practices that cause the bursting of a credit bubble. Because, according to Fitch, half of the loans must be renewed every three months and hence forth at least in less than six months. According to Charlene Chu, senior director of Fitch in Beijing, "The country has duplicated the entire U.S. commercial banking system in five years." Adding that the credit is increased from 9 000 to 23 000 billion dollars since the collapse of Lehman Brothers. "All this is far worse than anything we could know before in a major economy. We do not know what will happen. The next six months will be crucial, "said Chu also. For her, "the model of growth based on credit is clearly exploding. This could fuel a massive crisis of over-capacity, and potentially a Japanese-style deflation. " According to Wei Yao of Society General, the debt level of Chinese enterprises has reached the threshold of 30% of GDP, the threshold is nothing but a typical of financial crises.

The Financial Bubbles Happened In The Past! -1

What is the common point between the Asian crisis of 1997, the Internet crisis of 2001, the subprime crisis in 2008, the sovereign debt crisis of 2010 and what will be the next financial and economic crisis? They all originate from the bursting of a speculative bubble. This phenomenon of artificial inflation of prices though not new, for more than three centuries actually, economic agents know that trees do not grow to the sky. And yet they are still surprised when a bubble bursts. It all began in the late sixteenth century, when Dutch traders introduced in the country of tulips from Turkey. New, rare and unlikely mix of colors, a combination which gave very quickly tulip flowers to have high value relative to many other flowers that were the kingdom. Tulip and gradually became a luxury item particularly popular with the wealthy but also by the Dutch bourgeoisie. Finally freed from Spanish rule, the latter had indeed reaped significant benefits from trade with Asia, not hesitating to build large houses surrounded by flower gardens particularly with tulips. For almost forty years, the price of tulip flowers then continued to grow at a moderate pace at first, then more sustained from the 1630s rhythm, and in 1635 it took an average of 2,500 florins to buy a tulip flowers,to a greater cost of 25 750 euro( as the value of 2002 ,if we are to believe the calculations of the International Institute of Social History). The price of tulip flowers reached its peak in 1636, the same year; parliament actually discussed a project on the transformation of the nature of the contracts that would become the purchasing options and not obligations which is a windfall for speculators. Thus says at the beginning of year 1637, a tulip flowers could be traded on the futures market against the equivalent of three paintings by Rembrandt, or ten times the annual salary of a skilled craftsman, or against a field of five acres ... data often from pamphlets of the time which it is impossible to verify the accuracy.

One thing is for sure though; the price of tulip flowers was abnormally high. Especially when we know that the color intensity of the flower was actually linked to a mosaic virus of the flower. Finally, in February 1637 that the euphoria ended and the prices of futures fall sharply, marking the end of speculation, understand the "trade wind." The tulip mania and was one of the first bubbles in economic history. It also marked the beginning of a long list of other bubbles - Crash of 1720 following speculation on the South Sea Company, crash of Vienna in 1873 due to soaring property prices in Paris Berlin and Vienna stock market crashes of 1929 and 1987 and, more recently, the subprime crisis - causes and consequences substantially similar. A mass hysteria and the rapid enrichment of people’s misunderstanding one another, movements of brutal impoverishment and bankruptcy.

The hurdles Fed has to overcome!

The persistent weakness of the U.S. economy - where deleveraging public and private sectors continues - has led to a stubbornly high unemployment and a lower than normal growth. The effects of austerity - a sharp increase in taxes and a sharp drop in public spending since the beginning of the year - further undermine economic performance. Indeed, recent data have silenced some officials of the Federal Reserve, who hinted that the Fed could start out the third round of quantitative easing, which is currently underway for a period indefinite. Given the low growth, high unemployment which fell only because discouraged workers are now leaving the workforce and inflation well below the goal of the Fed is not the time to begin to constrain liquidity. The problem is that liquidity injections by the Fed are not generating credit to finance the real economy, but to stimulate borrowing and risk-taking in financial markets. The bond sloppy risky under contractual commitments vague and excessively low interest rates is increasing, the stock market hit new highs, despite the slowdown in growth and the money goes mass to emerging markets high yield. Even the periphery of the Euro area has wall of liquidity triggered by the Fed, the Bank of Japan and other major central banks.

Because interest on state of the United States, Japan, the UK, Germany and Switzerland to absurdly low levels bond yields, investors are in a global search for yield. It is perhaps too early to say that many risky assets have reached bubble levels, and the levels of debt and risk-taking in financial markets have become excessive. However, the reality is that it is likely that credit bubbles and asset / equity form in the next two years, due to the accommodative U.S. monetary policy. The Fed has indicated that QE3 would continue until the labor market has improved enough probably early 2014, providing an interest rate of 0% until unemployment has dropped to less than 6.5%. Even when the Fed will begin to raise interest rates at some point in 2015, it will proceed slowly. In the previous tightening cycle that began in 2004, the Fed needed two years to normalize the policy rate. This time, the unemployment rate and household debt and public are much higher. A rapid normalization - such as realized in the space of a year in 1994 - would cause a crash in asset markets and the risk of a hard landing for the economy. But if financial markets already tend to bubble now, imagine the situation in 2015, when the Fed will begin to tighten its terms, and in 2017 at the earliest, when the Fed has completed the process of tightening. The last time interest rates have summers too low for too long during 2001-2004, and the normalization of rate thereafter was too slow, which had formed a huge credit bubble, housing and stock markets.

 We know the end of this film, and we may be ready to see more. The weakness of the real economy and the labor market, as well as high debt ratios, suggest the need to exit the monetary stimulus slowly. But a slow output may create a bubble of credit and asset as important as the previous one, if not more. The search for stability in the real economy, it seems, could again lead to financial instability. Some at the Fed - as chairman Ben Bernanke and Vice Chairman Janet Yellen - argue that policymakers can pursue two objectives: the Fed will raise interest rates to slow economic stability, while preventing financial instability (bubbles and credit created by the high liquidity assets and low interest rates) through supervision and macro-prudential regulation the financial system. In other words, the Fed will use regulatory instruments to control credit growth, risk taking and debt. But another faction of the Fed - led by Governors Jeremy Stein and Daniel Tarullo - argues that macro-prudential tools have not been tested, and that the debt limit in a part of the financial market only pushes liquidity elsewhere. Indeed, the Fed regulates banks, so that the liquidity and debt migrate to the informal banking system if bank regulation is stricter. As a result, Stein and Tarullo argued that the Fed has only one instrument of interest rates to tackle all the problems of the financial system. But if the Fed has only one effective instrument - interest rates - the two objectives of economic and financial stabilities cannot be pursued simultaneously.

Either the Fed continues the primary purpose of keeping rates low for longer and to standardize very slowly, in which case a huge credit bubble and assets would form in time, either the Fed focuses on the prevention of instability financial and increases interest rates much faster than the low growth and high unemployment have also requested, thus stopping an already sluggish recovery. Exit policies QE and zero interest rates the Fed will be treacherous: a too quick exit would cause a crash in the real economy, while a slow start out by creating a huge bubble and then cause a crash the financial system. If the output can be operated successfully partisan compromise Fed is more likely to create bubbles.