ASSET MARKET BUBBLE

Presented by:

Phillip Freiberg .
Kirti Kakkar.
Tu Ngo.
Rajveer Diddan
 AGENDA
During the current financial crisis, various economists and market
commentators have repeatedly asked for monetary authorities to
start pursuing restrictive monetary policy whenever there are
case of asset “manias” and thus prick asset market “bubbles”
(including stock market “bubbles”).

 How would you assess these proposals with respect to stock

markets? What would the implications be for capital allocation
in the economy if monetary authorities decided to pursue this
strategy?

 Is it possible to design an investment strategy that would gain

from the upside of a ‘bubble’ but avoid any potential downside?
(ie. Can you market time?) .
Bubbles
Bubbles create capacity, which is no longer needed
once they deflate. i,e, (quick and painful) correction
between the real value of the underlying assets and the
inflated price
1. Tulip Mania
2. South Sea /Mississippi Company Bubbles
3. Railway Mania
4. Florida Speculative Building Mania
5. Roaring 1920s/1929
6. Poseidon Bubble
7. Gold
8. Japanese Asset Bubble
9. Dot Com/Tech/Telecoms
10. Global Real Estate/Credit Bubble
11. China/Shanghai Index Stock Bubble
12. Commodity Bubble
13. Oil Bubble
14. Leverage/Derivative/Financial Bubble
 Restrictive Monetary Policy
When monetary policy makers take actions to reduce a
nation's money supply.
Prevention/Solution: Reduce inflation.
Actions:
 Selling government bonds,
 increasing banks' reserve requirements,
 increasing the discount rate.
 Effects:
reduce the money supply (harder to borrow).
 eases inflationary pressures by lowering the amount of
money available for spending.

Benefits: Ensure stability in the nation's price system.

Different Views: monetary economics
 Why Restrictive monetary Policy??

Bordo and Jeanne suggest that restrictive monetary policy in the face of a stock market
boom is optimal “…when the risk of a bust is large and monetary authorities can defuse it
at a relatively low cost.”

“A cost shock that increases inflation may require a restrictive monetary policy in order to
prevent relative price increases from snowballing into an inflationary spiral .”

Restrictive monetary policy has shown its effectiveness with considerable force. Germany,
which experienced hyperinflation during the Weimar Republic and never forgot, has
maintained a very stable monetary regime and resulting low levels of inflation
 Why Not Restrictive monetary Policy?
Don't respond to asset prices per se rather respond to
changes in the outlook for inflation and aggregate demand
resulting from asset price movements .

Reasons:

>>Asset price bubbles can be hard to identify : can lead to

weaker economic growth .

>>Effect of interest rates on asset price bubbles is highly

uncertain.

>>There are many asset prices, and at any one time a bubble
may be present in only a fraction of assets.
 Considerations
“In US monetary policy was highly restrictive from 1928 to September 1929
and this restrictive monetary policy is cited by economic historians as the
initial cause of the Great Depression”

 Central banks must carefully weigh

economic conditions, as measured
by data on retail and wholesale
prices, unemployment rates, gross
domestic product, and other
measures, before enacting monetary
policy.

 Overly restrictive measures could

hamper consumption and
investment.
Effects to capital allocation in the economy
Monetary Policy on the Exchange Rate and Balance-of-Payments

The difficulty of controlling the money supply under fixed

exchange rates is exacerbated by international capital mobility

which prevents domestic interest rates from deviating
substantially from international level.
Restrictive monetary policy raises the supply schedule of funds

and thus raises the equilibrium cost of capital, reducing

investment
super bubble
sub prime housing bubble of 2008 in US, lead to the
burst of the super bubble of the credit expansion - the
ever increasing use of credit and leverage.
Profit from the bubble?
recognize and profit from wide disparity between
investor perceptions and market fundumentals

Be fearful when everybody is greedy and greedy when

everybody is fearful
Warren Buffet
Methods:
Understand the Underlying Industry
People were purchasing bulbs at higher and higher
prices, intending to re-sell them for a profit. At the
peak of tulip mania in February 1637, some single tulip
bulbs sold for more than 10 times the annual income of a
skilled craftsman. (75 000 $)

However, such a scheme

could not last unless someone
was ultimately willing to pay
such high prices and take
possession
of the bulbs.
Methods:
Follow the Currency

“"I couldn't have not lost money last year unless I was
100% in cash ”
For example a higher oil price and speculative capital inflows
driving Russian appreciated the Russian rubble. But while the
strong rouble may be a positive signal for investors, it has created
its own problems: export competitiveness and, worse, the
possibility of a new asset bubble worry experts. (FT)
Chieese the renminbi is undervalued, and speculators can
borrow overly cheaply in New York to finance hot money flows
into China and other emerging markets. One consequence is a
huge bubble in China's commercial and residential real estate
markets, which is forcing the PBC to try to curb the expansion of
domestic bank credit.
Methods:
Follow the Countries

China: many investors are concerned that asset

bubbles that forming in real estate, banking, and in
the stock market.
Kondratieff Waves
the underlying economic conditions will repeat over
time due just to the physical nature of our world

Buy a stock a wait for certain signals (eg. Increase in
interest rate) before we can start selling it.
Go long a call.
Buy stock and sell a put – Protective put
THANKS FOR LISTENING