The mistake that led to the biggest bubble in history

Jul 7, 2010

In this issue:
» Environment minister hits back at the aviation minister
» Dow to witness a huge fall, says Prechter
» Government thinking of opening up retail
» CEOs reap a dividend bounty
» ...and more!!

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Imagine a stock priced at Rs 100 and having a market cap of Rs 10,000. One day a fund decides to buy 5% of the company at Rs 120 per stock and thus pays Rs 600 towards the purchase. On seeing this transaction, other shareholders would be reluctant to sell their shares below Rs 120. This in effect would now make the new price of the stock as Rs 120 and push up the market cap of the company to Rs 12,000. We hope you have noticed the magic of the modern monetary system. A monetary transaction of Rs 600 has pushed up the wealth of investors by Rs 2,000. Thus, the overall wealth has gone up by 2,000 while the money involved is just Rs 600.

It should be noted that a similar magic was behind the creation of the biggest bubble in history. The US real estate bubble or what is now popularly known as the subprime bubble. All that the US authorities had to do was encourage a few more housing transactions so that prices could be pushed up. Thus, interest rates were lowered and more people were brought into the housing market. It should be noted that if prices for even 5% of the homes went up, the remaining 95% would also witness a similar rise in value and thus, overall wealth was increased.

So far, so good. The problem arose when home owners started assuming that their wealth was money and hence, would never go down. Infact, they went ahead and even borrowed fully against this new found wealth of theirs. The end result? When prices collapsed, their wealth came crashing down, leaving them with the huge debt burden. So, where did homeowners go wrong in US? They made the cardinal sin of equating wealth with money. To make matters worse, they even borrowed against wealth. We hope you would be careful not to make a similar mistake in your lifetime. Please bear in mind that difference between wealth and money is day and night. If debt is made available, the former can be increased at will. But not the latter.

 Chart of the day
The pay of a private company's CEO in India could certainly be comparable with the best in the world. But the same cannot be said about the CEO of the country, in other words, India's prime minister. As today's chart of the day shows, the ratio of the prime minister's basic salary in India to the GDP per capita in the country is among the lowest in the world if one takes the purchasing power parity into account. In fact, the same for China is also on the lower side. The heads of the developed nations on the other hand have quite an edge over the average citizens of their respective nations. In fact, US and Japan pay their leaders as much as 8 times the GDP per capita of their countries.

Source: The Economist

Couple of days back we had highlighted how the Civil Aviation ministry had lamented over the delay in getting environment related approvals for a new airport in Navi Mumbai. Now, a fresh salvo has been fired by the environment ministry. The environment minister has replied to the allegations by the aviation minister saying that the project has serious environmental issues that need to be addressed first. He believes that it is too premature to say about its fate as the project is still to be taken up for discussion by an expert committee. We hope that the committee thoroughly looks into all the ecology related issues and only then takes a call. Otherwise, environment will once again have to suffer at the hand of economics and politics.

This one is surely for the bravehearts! Investors looking for cues from the US stock markets need to prepare themselves for some shocking predicament. It comes from renowned technical analyst and president of Elliott Wave International, Robert Prechter. Prechter believes that the Dow Jones index could fall to between about 1,000 and 3,000 points during the next five to seven years. The benchmark index closed upwards of 9,700 in yesterday's trade. Prechter is known for his very bearish views on the US economy. He is also credited with predicting the 1987 market crash. The reason he cites this time around is that the US economy is sinking into a depression, one that is led by spiraling low prices. What in economic terms is referred to as 'deflation'. While we cannot offer an opinion on the accuracy of Prechter's predicament, what we know for sure is that US' economic recovery is no where round the corner!

Normally the media pays a lot of attention to corporate salaries. And compared to the paychecks of mere mortals, corporate chieftains earn quite a lot. But that is not their source of wealth. Not even close. The real money comes through dividends that their companies pay. As majority shareholders, business barons earn in billions of rupees through dividends.

Reportedly, Mukesh Ambani, Azim Premji, the Bajajs, Sunil Bharti Mittal and Pawan Kumar Munjal together took home nearly Rs 35 bn in FY10 by way of dividends. That's a 66% YoY increase. Hero Honda's Munjal family tops the list with Rs 12 bn in dividends. It may be noted that in India dividend is not taxed in the hands of recipients although the company pays a dividend distribution tax. In our view, paying out dividends completely depends on whether the company is able to find investments which earn a rate of return higher than the cost of capital. If yes, it should retain funds. If not, it should pay out dividends and let the shareholder allocate capital.

The huge stimulus package that the Chinese government had announced to tide over the global crisis went a long way in firing up the property market. So much so that property prices boomed and signs of a bubble forming seemed more and more imminent. As a result, Chinese authorities intensified a crackdown on property speculation. Some of these measures were raising minimum mortgage rates and down payment ratios for some home purchases. There are also talks of starting a trial property tax. In reaction to this, property transactions in the dragon nation have dipped.

Infact, Kenneth Rogoff of Harvard University is of the view that China's property market is beginning a collapse. And this is likely to hit the banking system. Others do not share the same view however. Further, prices in cities such as Beijing and Shanghai have not yet declined making the case for another crackdown that much stronger. There is definitely a strong link between the property market and banks as most of the loans for properties are channeled through banks. And so, a collapse in Chinese property markets is bound to have an impact on its banking system. Especially since these very banks have lent heavily to the sector.

One sector that holds big potential in India is retail. Most MNC retailers are eyeing a pie of the same. However what stops them are the regulations imposed by the government on foreign investment in the sector. This seems to be changing though. The government has floated a discussion paper on allowing global retail chains to operate in India. These companies (like Wal-Mart and Carrefour) already have an indirect presence through back-end outlets (cash and carry). However, what they are eyeing now is a last mile relationship with customers through their own branded stores.

So what's making the government change its stance? As per reports, the thinking in government circles is that higher foreign investment in retail can ease the huge supply bottlenecks. This will then help in bringing down the high inflation in the country, especially in food items that despite good production fail to reach the market in adequate quantity and quality.

Indian markets opened in the negative today and have continued to slip further from thereon with the BSE-Sensex trading lower by around 160 points at the time of writing. Heavyweights like Reliance Industries and ICICI Bank were seen exerting the maximum selling pressure. Most of the Asian markets also closed weak today whereas Europe has also opened on a negative note.

 Today's investing mantra
"You do things when the opportunities come along. I've had periods in my life when I've had a bundle of ideas come along, and I've had long dry spells. If I get an idea next week, I'll do something. If not, I won't do a damn thing." - Warren Buffett

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8 Responses to "The mistake that led to the biggest bubble in history"

D J Deshmukh

Jul 8, 2010

I want to express my view on the Chart of the day :
Salary of Indian P.M. or an Indian Minister or Member of Parliament( or CEOs' or Pilots' or Crickters' remuneration for that matter ) should be viewed in with relation to the earnings of an average Indian and not as a percentage of the GDP. The reason is that the average salaries or earnings of citizens of USA / Japan / Russia / UK are also much more compared to the average earnings of Indians. When is that going to happen ? It is for the politians including the PM and the Ministers and MPs to work for and achieve before they ask for salaries comparable to the salaries in the Developed World.


Adi Daruwalla

Jul 8, 2010

Bigger mistakes happening in India.......
There is no washing powder that can wash the stains of corruption this nation faces. There is alos no purdah behind which the officials can hide their faces.
With FDI and FII that are major players in the Indian market reports that a US based company, CCI has alleged that it bribed officials of BHEL NTPC and others
to get contracts.
These contracts were purpotedly in the Power sector? How can you expect foreigners to come in with investments to India, when there are such
This was on all the news channels on TV yesterday 7th Jul 2010. What is the truth? Can Equitymaster hit the hammer on the nail head...........How will this affect the investment in India in the Power sector??


Vinod Narayanan

Jul 7, 2010

Another important point is the greed of the customer to make more...Greedy people are sucking out others by buying more than what is required for them. Individual should be discouraged to own more than normal requirement. Government should step by taxing additionally the extravegant needs. People from all walks of life should help Government in doing this.



Jul 7, 2010

The standard of content of your newsletter is getting worse in recent days.
Don't get reader confused with comments from 50 different people. Write what you believe in...



Jul 7, 2010

Given that the stimulus package can be easily held
responsible for the high rate of inflation prevailing,and include the 5% odd increase in petrol
prices if you must,then it is easy to see that a bubble
can easily form unless the money is redidtributed into
profitable export sectors.Moreover the Govt. can and
should certainly help in paying extra to farmers to
enable them to grow more corn,maize and sugarcane for
conversion to ethanol and require OMCs to supply such
fuel only for meeeting all energy requirements of new
airports whether T3 in Delhi or the proposed airport
in Navi Mumbai.


manoj desai

Jul 7, 2010

its really gr8 thing 4 us cz we kno wat happnd in past n wat cud b happn in future



Jul 7, 2010

Is this what Harshad Mehtha had done?After artificially boosting share price selling one shot ditching others.



Jul 7, 2010

its quite interesting to know the things happend around the world at the end of the day. good work keep it up

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