Tuesday, October 2, 2007

Mysterious Markets....

So the markets have decided that the credit crunch is over, and equity valuations have jumped. The DJIA is at all time highs, and closer to home, the HSI is growing in leaps and bounds. What is going on here?

To a macroeconomist, it can be difficult to make sense of the market at the best of times! Market valuations of equities should equal the discounted value of firms' expected future profits. But I do not believe that increased expected firm profitability is playing any more than a minor role in current market valuation rises.

The co-movement between Hong Kong and the US makes at least makes a little sense- if the Federal Reserve continues to cut rates, as the market appears to expect, then Hong Kong's booming economy will benefit as well as the US, due to our fixed exchange rate. But, based on macro analysis, I cannot avoid the conclusion that both markets are most likely overvalued.

The US housing market correction is far from over (see here and here, for example), and this alone will continue to exert a significant drag on the US economy- and on US firm profitability- in the come quarters. In the case of Hong Kong, the increase in equity prices by 35% in the last one and half months (since 17/8) simply defies rational explanation.

If I were a betting man, I know which way I'd be wagering on the next big movement in world markets....

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