Saturday, October 27, 2007

Bubble in the making

Before moving forward let me state that although on this blog I would share my views on topics related to finance and economics but occasionally other topics may also find their way.

Now on to today's topic. Emerging markets are zooming like anything. The sensex itself makes lifetime highs every other day, this calls for great celebrations without a doubt but this is increasingly making me uncomfortable. Let's go into the genesis of this asset boom, so here is how the story begins------

In trying to do away with subprime problems in the US the federal reserves cuts its fed fund rate, this makes the world awash with liquidity. Now the first issue i just don't understand is how does cutting the interest rates help in the crisis. If I have the paper (debt) which no one wants to buy at any price it doesn't matter what the interest rates are. The problem is the Fed is trying to cure the problem with a tonic which in my opinion was the cause of this problem to start with. If it feels it can pull US economy out of the mess by doing this each time it is sadly mistaken because all it is doing is making a downturn longer and bigger both in impact and in geography.

The effects have started to reflect in front of us. Liquidity is what causes inflation and growth, related by the famous Milton Friedman equation:

PY=LV; where P is inflation, Y growth, L liquidity, V velocity of money.

However as the liquidity increases the change in inflation is much steepr that change in growth. Ofcourse if increase in liquidity doesn't increase both growth and inflation you are in much serious trouble (liquidity trap in Japan). So keeping that scenario aside the representation of liquidity and inflation and liquidity and growth can be as follows:

where A,B,z,phi,e are positive variables. *Note that the equations is just to give an idea of the relationship betweeen the variables.
So the flush of liquidty on accounts of fed rate cut is increasing asset price inflation without increrasing real growth and this is what is causing the asset price bubble. Although let me commend the move by SEBI to prevent this from happening. How successful will be this current move, well only time will tell. But one thing is for sure now whenever this bubble bursts (not very far off in my opinion) it will be very painful. The same analysts who are upgrading their targets of every other company based upon their so called VALUATION ( one of the biggest craps in the field of finance -- we shall discuss about this in greater detail in later articles) will be rubbing salt on their faces.
So what does one do in this scenario. Well 1 of the 2 things can be done and 1 thing should necessarily be done.
--Should be done: Don't invest in equity assets from an investment point of view.
--Could be done: 1. Step away and wait
2. Buy the chalice and do volatility trading or make a portfolio of 2 calls and 1 put ratio (at the money)
-- Reason behind the second suggestion: Buying 2 calls and 1 put of Nifty would entail an investment of around 30000, now the rate at which the market is moving up one would surely end up making good profits at the end of each month and whenever the day of reckoning arrives ('The Great Crash') the one single put would not only cover the loss in the 2 calls it would also add substantially to your bank balance.--------

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