12-Nov-2005

>Life Cycles of Emerging Markets

 Because investing in emerging markets has become a very popular subject, a closer analysis of how markets really “emerge” may be in order.

In many ways, stock market cycles closely resemble the human life cycle. First, stocks are in an embryonic stage. Then, when they reach adolescene, they grow very rapidly (bullish phase). During this stage, they are accident-prone (crashes).Later, markets mature, lose some of their energy and volatility, then become tired and finally die (bear markets).

Fortunately for stock markets, there is usually life after death. A new cycle begins that, like reincarnation, is very different in nature from the previous cycle.

This discussion focuses on the events that tend to occur and the symptoms that become apparent during the stages of emerging stock markets. These events and symptoms will show up in varying degrees, depending on each market’s peculiarities. Obviously, the more extreme they are, the more likely it is that it will be possible to identify which phase of the cycle the stock market is moving into.

======================>Phase Zero

Events

· Long-lasting economic stagnation or slow contraction in real terms.

· Real per capita incomes are flat or have been falling for some years.

· Little capital spending, and international competitive position is deteriorating.

· Unstable political and social conditions (strikes, high inflation, continuous devaluations, terrorism, border conflicts, etc.)

· Corporate profits are depressed.

· No foreign direct or portfolio investments.

· Capital flight.

Symptoms

· Little tourism (unsafe)

· Hotel occupancy is only 30%, and no new hotels have been built for several years. Hotels are run down.

· Curfews at night.

· Little volume on the stock exchange.

· Stock market has been moving sideways or moderately down for several years.

· In real terms, stocks have been ridiculously undervalued.

· No foreign fund manager visits the country.

· Headlines in the press are negative.

· No foreign brokers have established an office, no country funds are launched, and no brokerage research reports have been published for a long time.


======================>Phase One

Events

· The social, political and economic conditions begin to improve (new government, new economic policies, external factors, discoveries, the rise in price of an important commodity).

· Improvement in liquidity because of an increase in exports, the repatriation of capital and increasing foreign direct and indirect investments.

· The outlook for future profit opportunities improve significantly.

· Increase in cash balance and wealth.

· Consumption, capital spending, corporate profits and stocks begins to rise sharply.

Symptoms

· Stocks suddenly begin to pick up.

· Tourism improves.

· Foreign businessmen become interested in joint ventures and other direct investments.

· Hotel occupancy rises to 70%.

· A few foreign fund managers begin to invest.

· Curfews are lifted.

· Tax laws are changed to encourage capital formation and to attract foreign investors.


======================>Phase Two

Events

· Unemployment falls and wages rise.

· Capital spending in order to expand capacity soars, as the improvement in economic conditions is perceived to last forever (error of optimism).

· Large inflows of foreign funds propel stocks to overvaluation.

· Credit expands rapidly, leading to a sharp rise in real and financial assets.

· Real-estate prices rise several-fold.

· New issues of stocks and bonds reach peak levels.

· Inflation accelerates and interest rates begin to rise.

Symptoms

· The business capital resembles an enormous construction site.

· Hotels are full of foreign businessmen and portfolio managers. Many new hotels are under construction.

· Headlines in the international press are now very positive.

· An avalanche of thick, bullish country research reports are published by foreign brokers. Foreign brokerage offices are opened up. Country funds are launched.

· The thicker the reports, the more offices that have opened up and the more funds that are launched, the later it is within Phase Two.

· Countries in Phase Two tend to become favorite travel destinations.


======================>Phase Three

Events

  • Overinvestment leads to excess capacity in several sectors of the economy.
  • Infrastructural problems and an excessive credit expansion lead, via rising wages and real-estate prices, to strong inflationary pressures.
  • The rate of corporate profit growth slows down, and in some industries corporate profits being to fall.
  • A shock (a sharp rise in interest rates, a massive fraud, a business failure or some external shock) leads to a sudden and totally unexpected decline in stock prices.

Symptoms

  • Many condominium and housing projects and new hotels, office buildings and shopping centres are completed.
  • The business capital resembles a boom town – lively nightlife and heavy traffic congestion.
  • Frequently a new airport is inaugurated and a second one is in the planning stages.
  • “New cities” are planned and developed.
  • Real-estate and stock market speculators flourish, make the headlines with their rags-to-riches tales, and fill the nightclubs.
  • The stock and real-estate markets become a topic of discussion. There is active retail and speculative activity, much of it on borrowed money.
  • The locals being to invest actively overseas in things they have no understanding of (art, real estate, stocks, gold courses, etc.).

Happy times and excessive prosperity do not last forever. As noted, something totally unexpected will usually spoil the party. But prices can also begin to fall under their own weight. A typical feature of Phase Three is that even after an initial, and usually sharp decline in prices, the mood remains very optimistic. Prices are now perceived to be a bargain, and the sharp decline is regarded merely as a correction within a long-term uptrend. Few people realize that the overall trend has changed from up to down. It is from here onwards that serious money will be lost by investors who still believe the market to be in Phase Two.


======================> Phase Four

Events

  • Credit growth slows.
  • Corporate profits deteriorate.
  • Excess capacity becomes a problem in a few industries, but overall the economy continues to do well and the slowdown is perceived to be only temporary.
  • After an initial sharp fall, stocks recover as foreign investors who missed the stock market’s rise in Phases One and Two pour money into the market and interest rates begin to fall.
  • Stocks fail to reach a new high because a large number of new issues meet demand (the sellers are locals who either know better or are strapped for cash).

Symptoms

  • Condominiums have reached prices that exceed the purchasing power of the locals. They are now advertised overseas.
  • Office capital values and rentals being to level off or fall.
  • Tourist arrivals slow down and are below expectations. Hotel vacancy rates rise and discounts are offered.
  • Brokers continue to publish bullish reports.
  • Political and social conditions deteriorate (a coup, a strong opposition leader, strikes, social discontent, increase in crime etc.).

======================>Phase Five

Events

  • Credit deflation.
  • Economic, but even more so social and political, conditions now deteriorate badly. Consumption slows noticeably or falls (car sales and housing and applicance sales are down).
  • Corporate profits collapse.
  • Stocks enter a prolonged and severe downtrend as foreigners begin to exit the market.
  • Real-estate prices fall sharply.
  • A “big player” goes bankrupt (one who made the headlines in Phase Three).
  • Companies are strapped for cash.

Symptoms

  • Empty office buildings, high hotel vacancy, discontinued and unfinished construction sites are now common.
  • Stockbrokers lay off staff or close down.
  • Research reports same thinner. Country funds that sold at a premium during Phase Two and Three now sell at a discount.
  • The country is no longer a favorite tourist destination.

======================>Phase Six

Events

  • Investors give up on stocks. Volume is down significantly from the peak levels reached in Phase Three.
  • Capital spending falls (error of pessimism).
  • Interest rates decline further.
  • Foreign investors lose their appetite for any new investments.
  • The currency is weakening or is devalued.

Symptoms

  • Headlines turn very negative.
  • Foreign brokers finally turn bearish.
  • Flights, hotels and nightclubs are empty.
  • Taxi drivers, shopkeepers and nightclub hostesses tell you how much tey have lost by investing in stocks.

In many ways, Phase Six is the opposite of Phase Three. Towards the end of Phase Two and in Phase Three, people were very optimistic and upbeat. But in Phase Six, the boom and the atmosphere of greed which were based on an error of optimism give way to a crisis of confidence and fear (the error of pessimism). To quote Pigou once again: “This new error is born, not an infant, but a giant; for an industrial boom has necessarily been a period of strong emotional excitement, and an excited man passes from one form of excitement to another more rapidly than he passes to quiescence”.

In Phase Six, the error of pessimism will begin to depress business and result in a business contraction. It is important to understand that the realization at some point that the profit opportunity is not as great as was hoped, or that a market cannot go any higher, leads to a revulsion of speculators’ sentiment and panic selling. Whereas a few years earlier everyone wished to participate in the mania, now everyone wants to get out.
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(taken from ValueInvestor)
Hope this helps in knowing where we stand today and same in future.


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