Jamal Mecklai: Money makes the world go round

MARKET MANIAC

This old ditty is proving truer with each passing day as, despite Mr Greenspan's efforts to "tighten" US monetary policy, the liquidity lion appears to have long since bolted the cage.

Asset prices the world over are soaring ""in addition to the BSE, a large number of equity markets, in both developed and developing economies, are at or close to all time highs.

Commodities, after a minor blip when it looked like China may be slowing down, are once again shooting the moon; this is all the more significant since the China story is no longer the loudest driver.

Oil prices are rocking, and the dollar bears are once again baring their teeth (and their chests).

In addition to these very obvious signs, there are other""slightly more arcane""signals suggesting that things are getting far too loose. Investors appear to be throwing caution to the winds as most measures of risk have been falling for the past several years.

The volatility of the S&P has been falling steadily and is today less than half its 5-year peak. Volatility in forex markets""certainly globally""is lower than it's been in several years.

Credit spreads, both on corporate bonds (relative to gilts) and on emerging market debt (relative to US treasuries), are much lower than they've been in years.

And, perhaps most loudly, the US bond market remains nervous but well bid, with long term yields completely unresponsive to either the Fed's prodding of the short end or continuing signs of stronger growth and""could it be ""inflation.

What is happening? How is it that financial markets, skittish at the best of times about risk, are so unperturbed by any of this?

One explanation could be that since 9/11, US investors have recalibrated the value of financial risk in comparison with the risk of loss of life or loved ones, and have decided that they are much more comfortable with financial risk than they were even a few years ago.

If this were true, it would suggest that the cost of financial risk has moved lower on a structural basis, and might help explain why markets appear to be so much more comfortable with risk.

This is an interesting thought, merging as it does behavioural studies with economics""and I note that the last two (?) winners of the Nobel prize in economics did work in just such "non-scientific" arenas.

However, being a fundamentalist, in terms of believing in God and markets, myself, I am not too convinced. I believe that one of the main jobs of financial markets""perhaps its only job""is to regularly prove people wrong. And when everybody gets on one side of the market, I get a little worried.

This was true back in October last year, when attendance at the Dollar Bears Club was at exactly 100 per cent of the speaking population of the world. The dollar was at 1.28 or 1.29 to the euro, and everybody""EVERYBODY"" knew that the dollar had to fall much further.

My concern was that if everybody knew this, why wasn't it already falling. As it turns out, I was wrong. The dollar did fall to 1.36 but since then it "corrected" to about 1.27 and is now once again pushing downwards to 1.35.

Again, the dollar bears have come out to the rooftops, but I do detect slightly less enthusiasm in their cries.

In any event, the point is that when everybody is taking more and more risk, perhaps it is prudent to step back a bit. Some of it, of course, also has to do with the levels to which markets have risen.

While I remain convinced of the strength of the Indian economy, my investment enthusiasm would be somewhat lower at an index of 7,000 than of 6,500.

Unless, of course, I had nothing else to do with my money. Which appears to be what is happening right now. There's too much money and not enough investments.

I heard a very elegant analysis last week by an analyst who pointed out that global investors are in a similar situation to voters in Bihar or UP""since they may not like Mulayam or Mayawati (US equities or bonds at current prices), they would diversify to lesser evils (say, the BSE Sensex, or copper, or whatever). But what happens when the Sensex hits 7,000 and copper gets to 3,300.

Well, rather like in North Indian politics, when the little guys start having too much power, the entire system gets unstable and, sooner or later, collapses.

Global markets appear to be in something of this state right now, and, for my money, I would try to protect against a sudden, sharp rise in global market volatility and risk aversion.

The trigger could be anything. Perhaps a highly unexpected move in a very widely held and traded commodity"" say, the dollar.

What if the dollar were to suddenly start strengthening? What if, after testing its all-time low sometime soon, it turned around and "corrected" again, moving beyond, say, 1.25 to the euro, past 1.20 and head towards 1.10?

Would people still see this as a correction to the bear trend? What would be the impact on investment flows into the US? What would happen to the US current account deficit? What would happen to the rupee?

Might this be the trigger to increase global risk parameters to more "normal" levels?

I don't know. But, when thinking about risk, you need to try and build scenarios that go contra to conventional wisdom. And try to visualise what would happen to your business under those scenarios.

Maybe it's time to take (some) money off the merry-go-round.

(The author is CEO of Mecklai Financial)