Tuesday, July 28, 2009

The making of a new asset bubble

Way back in October 2007 I wrote this post on what I saw as a credit induced bubble in the Hong Kong stock market and the Hong Kong real estate market. Although this was fairly close to the the last high water mark for both markets, I only took limited steps to protect the private portfolio against the likely deflating of those bubbles. (Mainly by building cash by not investing rather than selling assets.)

Starting in about October last year, both property prices and share prices have rocketed upwards. Share prices are still roughly 30% off their peak but property prices are getting much closer to the levels of 2007 and, in the luxury sector, possibly even the top of the pre-Asian crisis boom in 1997. Why?

The explanation for the dramatic rise in share prices is relatively straight forward. At the low point pessimism ruled the market. Banks were expected to fail. Trade was grinding to a halt. Exotic (if stupid) products like accumulators were causing investors a lot of pain as the market made rapid progress towards what would eventually be its low point. People became more concerned with the return of their money rather than the return on their money (to quote Mark Twain). The market was, in a word, oversold. What happened to turn this around? The banks didn't fail. Trade dropped but not as much as many people feared. Governments announced huge stimulus packages. Interest rates were cut from already low levels. Unemployment did not rise as much as people feared. Central banks flooded the world with liquidity and the HKMA was forced to follow the herd in order to keep the HK$ pegged to the US$. All that money had to go somewhere and unless you were happy with zero interest deposits the stock market was an obvious place to put your money. Shares were cheap.

The property market's turn around was less dramatic for the simple reason that prices did not fall as far as share prices but most of the same factors which propelled the share market up over 50% in about seven months have driven property prices up as well: cheap money and lots of it.

Today, neither property nor shares can be considered cheap (although there are still individual shares which offer good value). However, as long as money keeps flooding the market, it is difficult to make a case for preferring bank deposits over either asset class. In effect, we have the makings of a new bubble in the making.

History suggests that money will not remain either cheap or plentiful forever. At some point central banks will start to withdraw money from the banking system and raising interest rates to combat inflation that would likely follow once the economy starts recovering. While it is expected that monetary tightening will be introduced cautiously and (hopefully) after a recovery is well underway, it will happen at some point.

Reducing liquidity and raising interest rates would be expected to have a negative effect on both share and property prices. At some point I will have to adjust my asset allocation to that new reality. The challenge will be to find asset classes that, at the very least, hold their real value during the tightening phase.

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