Sunday, November 28, 2010

Speculative Bubbles

  Why Asset Price Booms are Bad ?

The Indian stock market investors are supposed to be enjoying one of the best stock rallies for the past two and a half years. The current stock rally had it's origins in the month of  March 2008. The major market indices, S&P CNX Nifty and BSE  Sensex recorded new all time closing highs in the first half of November 2010. However, a cursory look at the stock charts of some popular shares from the Nifty index selected randomly show a very different picture. It is seen that these darlings of the 2008 boom have not done anything in the recent rally to justify the investor's faith in them. Let's examine the charts of  these randomly selected  Nifty companies to see whether any similar patterns can be seen. The period of these charts starts from July 2007 and ends  as on 26th November 2010 covering the peak of  the previous boom and the recovery so far.

RCOM - Weekly Chart July 2007 - Nov 2010

RCOM is from the telecom sector which saw a boom in the 2003 to 2008 period. This is the worst performer of the randomly selected five Nifty components for the reason that the stock recorded it's low for the period on last Friday. The stock's high and the low during the period were 845 and 129  respectively. The last close was at 130.50 near to it's all time low.
 RELINFRA - Weekly Chart  July 2007 - Nov 2010

RELINFRA's buisness is in the power generation and infrastructure sectors. The stock's high and the low during the period were 2641 and 352  respectively. The last close was at 854.
DLF - Weekly Chart  July 2007 - Nov 2010

DLF is the leading company from the real estate sector which was one of the speculative leaders of the 2003 - 2008  boom. The company had it's IPO during the late stages of the boom. The stock's high and the low during the period were 1225 and 124  respectively. The last close was at 287.  

UNITECH -  Weekly Chart July 2007 - Nov 2010

UNITECH is also from the real estate sector even though the company has been in the listed space for a long time. Unlike other companies in the real estate sector, this company had a record of  delivering good returns to the early investors. However, the stock has seen poor performance during the period. The stock's split  adjusted high and the low during the period were 547 and 22 respectively. The last close was at 60.    

 JPASSOCIATES - Weekly Chart July 2007 - Nov 2010

JPASSOCIATES is from the cement, construction and infrastructure sector. The stock's high and the low during the period were 340 and 31 respectively. The last close was at 106.  

Common Patterns

Now, let's check whether any similarities are seen in the stock price charts of this random sample of Nifty stocks. The first pattern is that all these stocks lost 85 to 94 % of their peak prices at their bear market lows. RCOM,  which made a new low on last Friday, is quoting at just 15 % percent of it's all time high. UNITECH's bear market low was just 4 % of it's high. ( Or simply put, the stock lost 96 % of value in the  journey from it's high to the bear market low. ) The second pattern is that all these stocks are still laggards and have not participated in the new rally. The third pattern is that even after the customary dead cat bounces, these stocks were trading in ranges during the recent rally. The last pattern is that these stocks are still at the receiving end of the bear fury, at the first sign of correction in the markets.  The key take away from this discussion is that stocks which were never fancied by the investors in a boom may perform better in the next boom than the popular stocks of a busted boom. These popular stocks may take a long time to recoup the losses and may  continue to under perform.

It is said that all asset price booms or bull markets start with a reason but what kills them is the speculative excesses at the peaks. Near the end of the boom, all kinds of new investors are attracted to the scene and they suffer the most when the boom busts. In such booms, the participant companies and industries normally overextend their businesses on the back of new found false confidence and the cheaply available capital. At the first sign of the trouble, all these sources of capital dries up and it may take a long time for them to recover. This further leads to business restructuring and  poor performances in the near future. ( And also scams in the Indian context !!! ).

However, these kinds of after effects of speculative excesses are not just limited to just companies and  industries. These apply to even to the big economies of nations and the whole world. It takes a long time to solve the problems of overextended companies or economies. The present problems faced by Ireland is just one example. Let's now check out some charts of major  stock indices which went through the boom bust process to understand long term effects of speculative bubbles.

Dow Jones Industrial Average - Monthly Chart - Years 1928 to 1942 

The above chart covers a period of around 13 years and shows the effects of great crash of 1929-1930 from which the US economy escaped only with the help of the second world war related demand and reconstruction.

Nikkei 225 - Monthly Chart - 1984 to 2010

Japanese economy went through an export lead asset price boom in the Eighties. As seen in the chart, the Nikkei index and the Japanese economy are yet to recover from the slump which followed the bust. 

All these charts show the risks involved with the equity investing. Even those investors who might have used  index investing, instead of directly investing in stocks, would have made losses had they invested in Dow or Nikkei during the sample period, even after holding on to their investments for a ten year period.  Normally, investors hear only the sunny side of the investment theory. These charts are proof that stock investments should be made carefully and also that asset price booms of the speculative variety does more harm than what is being commonly understood. 

Cheers and Prosperous Investing !!!

Keywords : Asset Price Booms. Booms and Busts, Speculative Excesses, Stock Investing, Index Investing, Equity Risk etc. 

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