Thursday, May 24, 2007

Growing Consensus on China....

Alan Greenspan joins the chorus.... Mainland China is in the middle of an equities bubble.

How long can bubbles last? In principle, for a long time. The reason is that it is very difficult to make money from knowing that the market represents a bubble, even if you turn out to be correct.

At the risk of displaying my ignorance of the nuances of financial markets, I'll develop this argument further. First a couple of disclaimers: I'm a macroeconomist, NOT a financial advisor. What follows is intended to stimulate discussion, NOT as investment advice. OK- on with the argument.....

Suppose Greenspan, Li Ka-shing, and Yetman :-) are all correct. To profit from this, one could short mainland equities, and generate income from their inevitable decline. But shorting equities is costly. If you're correct, you make a large profit; if you're wrong, and equity prices continue to rise, you loose 100% of the capital you spent shorting them. In the meantime, you've also lost out on the continuing share price appreciation by being absent from the market. So even though you will eventually be correct, you might have lost so much potential gain that you would have been better off staying in the market!

The result of this is that investors who believe that the market is a bubble might be better off keeping their positions while buying partial insurance against a market correction by shorting the equities, rather than pulling their investments out entirely. Thus investors are biased towards making bigger bets on continued market growth than might be optimal. So the bubble continues for longer than it should, and when it crashes, it falls further.

If I'm right, bubbles are more persistent and more economically damaging because of an underlying asymmetry in share price instruments: it's easier to make money from an expanding market than a contracting one. All we need is access to instruments that allow investors to benefit from a declining market more efficiently, reducing their incentives to bet against a market fall.

Consider, for example, "inverse shares" whose value moved in opposition to the market. If the share price increased by 2%, the "inverse share" would loose 2% of it's value. They'd provide an efficient way for the median investor to effectively purchase an entire portfolio of short positions that are currently only available to large, institutional investors.

I'm sure there are a million reasons this wouldn't work, and I'm looking forward to reading why in the comments!

(See also my earlier posts on bubbles here and here).

5 comments:

All Blog Spots said...

nice blog

Mike said...

one of the problem of the bubble is too little supply. Those IPO just float a small portion of its shares in the market. As a result, one way to cool down the market is taht government start unloading its stake in SOEs massively to fill up its warchest of social security fund. It can kill 2 birds in one go. Or, CSRC should allow more companies to list, including blue chips overseas like HSBC, China Mobile, Hutchison or Citicorp (why not?). At least, big-caps can't swing as wide as small-caps (if you look at ICBS A-share secondary trading, you'll see).

Mike said...

forgot to add one point. CSRC actually contemplate launching stock index future for a long time, which will provide a way to bet against the market. however, it keeps postponing the product launch for fear of pricking the bubble themselve.

anyway, i think any future or listed option can suit your purpose. but as long as CSRC view stock index performance as their own achievement, no proposal will get the stamp.

James Yetman said...

See also.... http://www.bloomberg.com/apps/news?pid=20601039&sid=aoHE5wlTGnSg&refer=home

Mike said...

see also http://www.economist.com/finance/PrinterFriendly.cfm?story_id=9225696