Interesting article related to the recent gains we've seen in the stock market.

Bubble tipped to burst in 2011

Andy Mukherjee COMMENTARY

Thursday, May 10, 2007

Harvard University economist Jeffrey Frankel has an interesting theory about the timing of the next emerging- market meltdown.
He says capital flows into developing economies follow a 15-year pattern: "seven fat years followed by seven lean years." The year between the two phases is when the flow of money suddenly stops. Why 15 years?

"After 15 years have gone by, there is somebody new on the trading desk who did not personally live through the last crash," Frankel said at a globalization forum, organized by the International Monetary Fund in Washington. "They sort of know about it, but it is easier for them to say the world has changed than if they lost money in it."

There have been two such cycles in the recent past, according to Frankel. The first wave began around 1975, following a sharp increase in oil prices in 1973-74. After seven years of frenzied recycling of petrodollars into emerging-market securities, Mexico blew up in 1982.

Then there were seven slow years, before investors came back to these markets with renewed vigor in the early 1990s. That boom, which again went on for seven years, ended with the Asian crisis in 1997. By this logic, the next blow to emerging-market economies will come in 2011 or 2012. So all those who envision that the current subprime mortgage crisis in the United States will lead to investors bailing out of risky, emerging-market securities may be disappointed.

The time is not ripe, yet, for a disaster. "It is too soon, memories are still fresh," Frankel said. "Argentina and Turkey, they were not that long ago, so I think it is too soon."

Could the next meltdown start in Asia? The region has a seemingly inexhaustible war chest of US$2.5 trillion (HK$19.5 trillion) in foreign- exchange reserves. Besides, most Asian current accounts are now in surplus. East Asia is no longer funding its expansion with capital borrowed from overseas. Now it is exporting capital to the rest of the world.

All of this makes a currency crisis unlikely. But other risks remain.

Nouriel Roubini, chairman of Roubini Global Economics in New York, is predicting "a new and different type of financial crisis in Asia," one that is triggered by excessive liquidity and asset bubbles. The risks stem from Asia's currency policies. China remains reluctant to allow the yuan to trade more freely.

That means other Asian nations will not be able to tolerate significant currency appreciation without their exports losing market share to cheap Chinese-made goods in Western markets.

One country that did try to live with faster currency gains - Thailand - had to resort to capital controls to prevent its exports from sinking under the weight of a stronger baht.

Cheap Asian currencies are not a free lunch. The bloated and growing Asian forex reserves are being increasingly financed by an expansion in the monetary base. Base-money growth in China was 21 percent in 2006, double the annual average of 2004 and 2005. It was about 20 percent in Korea in 2006, six times the average in the preceding two years, according to a World Bank report last month.

Unmistakably, Asia is contributing - along with petrodollars and Japanese carry trades - to a surfeit of global liquidity and a mispricing of risk. For now, excesses may continue to build up. The spread, or the extra yield demanded by investors to hold dollar-denominated emerging-market bonds instead of risk-free US securities, has shrunk to about a 10th of its post-Asian crisis level, according to a JPMorgan Chase index.

Those who want to sell you developing-country debt will tell you what a fine job these nations have done in containing public debt and inflation.

Besides, countries such as Brazil are buying back dollar bonds, reducing supply; so the high valuations are warranted, they will say.

Standard & Poor's, which raised the credit rating on eight out of 34 emerging-market sovereigns and lowered its assessment on just one in the 12 months through August 2006, is talking about the need to redefine the "emerging market" label, and in certain cases, even eliminate it.

This excessive show of optimism has "bubble" written on it in bright neon. Yet, investors will wait to see emerging-market risk turn to zero before being stung by losses.

The same is true for equity.

Morgan Stanley Capital International's MSCI index of emerging- market shares reached 1000 this week. It has doubled in 2 years. Do not be surprised if it doubles again. The bubble is alive and well. It just might keep growing for the next five years, if Frankel's prophecy is right.

BLOOMBERG

http://www.thestandard.com.hk/news_detail.asp?pp_cat=22&art_id=44077&sid=13528100&con_type=1

Commentary

Bear in mind that the Dow Theory triple high back in February in the Dow Transports, Industrials, and Utilities gave a new market buy signal that is extremely rare, and combined with the all-time record short interest on the NYSE, it puts a tremendous "bid" under the market as shorts get scared and cover their positions. The higher the markets go, the more the shorts are losing and the higher their financial "pain". It's also worth noting, for those unfamiliar with short-selling that the potential risk of loss for a short is infinite. If a "long" buys a stock, the most they can lose is the total purchase price of their stock (ie: it goes to zero value). When a short seller initiates a position, they borrow the stock certificate (generally this is electronically executed) and sell it with the promise to replace that stock certificate at a later date. If they stock they shorted is valued less when they buy it back to return to the brokerage (covering their short is what it's called) than the price they sold it at when they initiated their position, they pocket the difference as profit.

However, if the stock increases in value ABOVE what they shorted it at, then they lose money with each dollar that stock increases in value. And since there is no limit to how high a stock can go in price, their potential for loss is infinite.

Something to thing about in coming weeks/months as we assess the long term potential for the indices, and stock overall. Let's not forget that, even though the Dow and S&P have reach new highs, the Nasdaq has yet to achieve the same. It's unlikely we'll see 5000 on the Nasdaq anytime soon, given how high it assailed in 2000. But it's quite possible we could print 3400 by this time next year.

It all depends on Asia, in my opinion. China's markets are definitely due for a correction, but with the Olympics coming up next year, we can all anticipate that the government in Bejing will do anything they can to delay the pain of such a correction until after the medals are all passed out.

So, I might be wrong, but I suggest we all try and enjoy the next couple of years. Because when the financial hangover comes, it's going to be a doozy!!

The Scrutinizer