Monday, May 29, 2006

Thoughts at the Edge of a Perfect Storm

Can the financial models of hedge funds and investment banks adequately account for what will happen when everyone makes their decisions from similar models?

I'm not sure American investors recognize how jammed the exits became when Mumbai's Sensex recorded its worst-ever point decline.

Or when investors took $8-9 bln USD out of Turkey's market--almost as much as they had attracted in capital last year.

Russia's stocks lost a quarter of their value in nine days.

In all, the recent losses in emerging markets were the greatest since 1998.

It's relevant to American investors, because daily changes in the emerging markets correlate about .74 with daily changes in the S&P 500 Index.

Banks are key to the contagion of financial crises.

Which is why the health of emerging market banks is of great concern in the face of growth problems.

Though South Africa was also caught in the downdraft, it remains confident that growth in China and India will continue to prop up its own and world economies.

There is hope that this is merely a correction brought on by rising U.S. interest rates and that the emerging market story has not come to an end.

No, the decline has not caused any aversion to investing in Asia.

Just witness the stampede for China's bank IPOs, which have attracted the participation of one in every five or six Hong Kong adults.

These are banks with untested risk management systems and a history of corruption.

And they propose to ramp up their loan issuance, even as China raises downpayments required for real estate transactions in an effort to dampen the explosion of (bad) loans.

For now, though, we're told there's no need for alarm in the Philippines and other Asian markets.

But, if I recall correctly, it was after the storm--and a sigh of relief--that the levees broke in New Orleans, in the face of multiple danger signs.

When everyone is drawing upon similar models, is it just a matter of time before they all head for the exits and create a Category 5 storm?

Note: More intermarket perspectives will be posted to the Trading Psychology Weblog later tonight.


Paulo de León said...

Great research Bret, very informing. My first job was an emerging market analyst in South America (Argentina, Brasil and Chile), and being a latin myself i can say that the US and First World Investors don´t get it right from this kind of markets. The principal mistake is asumming that what works in their markets also works in the emerging ones. This markets are very inefficient, iliquid, and subjet to rumors and sayings, among other inperfections (maybe the ones that the US markets suffer 100 years ago). It´s very hard to apply technical analysis, and the usual techniques used in US markets. That´s why i do not trade them, maybe investing on the long term but with local knowledge.
In one Kirk post a link confirm that the US investor put record money into emerging markets about 2 months ago, only to suffer the bog drop.
A private equity model is better to invest in Latinamerica and not a trading model.
tx once again.

Brett Steenbarger, Ph.D. said...

Thanks, Paulo, for that very helpful perspective. Your caution about using U.S. trading models for emerging markets is well taken. It will be interesting to see if the EEM exchange traded fund offers trading opportunities for individual traders.


yinTrader said...

I concur wholeheartedly about differing analyses for First World and Emerging markets.

I suffered almost total carnage in CAO, which was suspended in the Singapore Stock Exchange for a year and just recently re-listed but with consolidation of the shares, diluting my shareholding.

I was prepared to write it off compaletely, but with our government's help, CAO is now being given a new lease of life to give us a chance to recover something.

Since then, I have been wary investing in China!

Brett Steenbarger, Ph.D. said...

Yes, volatility is a two-edged sword. Diversification of markets and time frames can help to balance those risks. All too few traders, however, think of risk in *portfolio* terms. Thanks for the note--