Jamal Mecklai: Are we there yet?

MARKET MANIAC

Globally, markets are, once again, getting very nervous. The sub-prime crisis in the US came to broad public attention a couple of weeks ago, when Bear Stearns, one of the leading bulge bracket firms on Wall Street, had to unwind two of its mortgage-related hedge funds. The firm has already taken a bad hit on its last quarterly profits, and, with the process nowhere near finished, there's certainly more to come. And, of course, nobody knows whether this is simply the tip of the hedge fund iceberg.

The big picture concern is that, as more and more US "hooker mortgages" go into default, there could be a domino effect on the huge collateralised debt obligation (CDO) market, with more and more market players, large and small, getting caught, which could lead to a serious bout of risk aversion, which, of course, could lead to a tumble in the price of a wide array of assets worldwide.

In response to this, the VIX index, a surrogate for risk aversion, shot higher to 18.89 last week, a shade short of the level it hit in March this year, when the first sharp fall in Chinese equities (this year) triggered a sudden bout of worldwide nervousness, but way below the 45 level seen during the unwinding of the dotcom bubble. Thus, edgy though the market is, the risk is still quite cheap in historic terms, and, to be sure, the VIX has since dipped back to a more comfortable level.

US Treasuries, another key indicator of market sentiment, also slipped sharply, with June 13 seeing the largest one-day fall since 2004, with the 10-year bond yield climbing above 5.25 per cent and breaking a long-term technical resistance. However, here, too, the market has retraced some of its losses, but a lot of pundits remain on edge""some, very extravagantly so. I got a mail from an old friend, a very experienced US-based fund manager, who said, "Everyone (hedge funds, prop trading and technology-based firms in that space, discount brokerage firms and FCM's) is or has already gone public or ingested large sums of private equity within the past 6-12 months. As somewhat of a perpetual sceptic, I wonder why this activity is simultaneously occurring in all areas of our business, where astute traders who have made money for years are generously willing to let the public participate in the feast. Is it a market top of generational proportions or simply taking advantage of the unsatisfied demand for investment returns at any price...?"

A market top of generational proportions? Thems big words.

But, then, nickel has already fallen by over 30 per cent""that's right, 30 per cent""since end-May, and in technical jargon may be in the process of forming a frightening head and shoulders pattern, which, if triggered, could turn everything to dandruff. The volatility of the euro is the lowest it has been since the currency was first constituted in January 1999, suggesting some sort of breakout. Money supply in Japan has fallen below 100 trillion yen for the first time since mid-2000; as money supply tightens, demand for yen increases, which could put pressure on the gigantic volumes of the carry trade that has been (partly) fuelling the vitality of financial markets in recent years. Clearly, there are several signs of a major shake out.

So, are we there yet? Is it time to pay the piper for these past few years of good times?

I don't know.
But my sense is that we are not. There are far too many analysts predicting some sort of major collapse, and as we all know by now, one of the main jobs of financial markets is to prove the largest possible number of brilliant minds wrong. As Keynes famously said, the market can remain irrational a lot longer than you can remain solvent. I think the most correct interpretation of it is that rationality is not a natural state, which is why, time and again, the most astute""and rational""market analysts stumble long before the final hurdle, calling tops (or bottoms) months, sometimes years, before they actually occur.

Which is not to say that there won't be any hiccups in asset prices. But, I don't believe there will be any wide-ranging collapse, partly because the wide dispersion of risk created by the super-exponential growth of derivatives (and credit derivatives, in particular) will ensure that even large hiccups will be rapidly attenuated. But another, and to my mind, more important reason may be that global growth today is itself dispersed to a very micro level""the villages of India, for instance""where credit plays, at this stage, a relatively minor role.

So, even if another few hedge funds tumble, or if Chinese equities really correct, or if the yen surges to 115 on a serious unwinding of the carry trade, we may have a few weeks of risk aversion, but, in my view, these will all be buying opportunities.

India will, of course, respond to these signals, with both equities and the rupee likely to take a hit. However, despite the 8 per cent plus growth, which remains a certainty, the increasing failure of political governance""flooding in our international financial centre, tarring of the office of the President, and, of course, continued sclerosis in deregulation""will, sooner or later, hit sentiment, exacerbating any volatility induced by global events.