Thursday, November 26, 2009

About Overreaction Stories and the Tower of Babylon (revisited)

Today financial markets all over the world dropped by 2-3 percent. That is quite a big, taking into account that major financial and economic news during the past few weeks has been quite good. All major investors, economists and decision takers seemed to agree that we were leaving the recession caused by the Global Credit Crisis behind us.

But just as much as the Global Crisis was according to us at LMG a nice example of Overreaction, we're seeing a new example here! People will never learn! Time after time behavioral tendencies seem to lead markets into some kind of overreaction. Or like that famous German saying: ''Zum Himmelhoch Jauchzend, zum Tode getruebt'' (free after Goethe).

Financial journalists explained the 2-3 percent losses in all major Asian and European markets (the US couldn't give guidance due to the fact that it was also Thanksgiving) by the news that Dubai World had announced that it was incapable of paying off its debts of USD 60 billion. After some quick calculations analysts found out that European banks were holding some USD 40 billion of this debt. But in and of itself it was not 'new' news that Dubai was struggling. A couple of weeks ago it already became clear that new loans from Abu Dhabi were actually necessary to help Dubai pay off older debt and interest. This is such a different story when comparing it with the fantastic news stories seen a couple of years ago in all major magazines and news papers about a new world miracle taking place in the Arab desert. Dubai was a modern Babylon and the construction of the Burj Dubai tower, the highest building in the world, added to this.

The Dubai Skyline; with the Burj Dubai tower

The idea that Dubai would be capable in a few years to establish itself as the next major financial center in the world, doing in a few years what had cost countries like Hong Kong and Singapore decades, was the beginning of the overreaction (i.e. the positive side of it). Loads of investors, banks, governments etcetera seemed to forget that trees don't grow into heaven without paying some kind of price and/or without doing the necessary preparatory work. Trendy Europeans, Americans, movie stars, sports heros all of them tried to get a place under the sun (literally in this case) by buying one of the islands in the extravagant off-coast Palm Island project.

The Palm Island project in Dubai

But this type of overreaction was oh so similar to what already had been described by scientists Werner De Bondt and Richard Thaler back in 1985. Exaggeration leads people to pay too much to be part of an allegedly 'hot market'. That hot market in what in and of itself is a fantastic region in the world - the Middle East - was then caught by the Global Crisis and panicky investors. Property prices in Dubai dropped as much as 60 percent. The city, in the meantime transformed into a mega construction site, switched from being one of the world's busiest and most entrepreneurial places to one characterized by paralysis. New projects were cancelled and work on existing ones was stopped and postponed.

But OK, this was all already taking place. So let us now - after a good period for Emerging Markets since March of this year - analyze what was going on today. The total debt of Dubai World is $ 60 billion. World markets (ex USA) dropped 2-3 percent. Let's say 2.5 percent on average. That 2.5 percent is about the size of a market like the Netherlands or Switzerland when looking at global market sizes.

In other words: if Dubai World would go bankrupt completely without its government helping it out one way or another (directly or indirectly through the support of other United Arab Emirate partners like Abu Dhabi, Bahrein, Qatar etc) and this 2.5 percent drop would be 'correct' it would have to be similar in size to loosing markets of the size of the Netherlands or Switzerland. However, both are far bigger than the $ 60 billion that is at stake. True, Western banks that are just about to recover from the Global Crisis (helped by their governments) will have to face a new big problem and that could have far-reaching consequences.

But the bottom-line is that the sizes of the Dutch and Swiss economies are about 10-15 times larger than what is at stake here in Dubai. Therefore, by all means markets are overreacting once again.

And don't forget: the US markets were closed due to Thanksgiving. When observing how European markets move before mid-afternoon vis-a-vis the end of the day we all know that when the US markets don't provide investors across the globe with their guidance, paralysis and fear are more likely to strike.


* We at LMG don't believe that the Dubai debacle is an indication of major problems for Emerging Markets in general;
* Overreaction is a big part of it;
* Investors should use it as an opportunity to buy (if anything); and
* The Middle East will be here to stay, not with Dubai gaining its spot as a major world financial powerhouse within a few years, but be sure about it: the next 5-10 years Middle Eastern wealth and economic growth will play an important role across the globe and locally. Dubai went too far and created a Tower of Babylon type of story, but the experience of countries like Qatar (now the richest nation in the world in terms of GDP per head) and the fact that we as well as the Chinese do still need their oil is indicative of the long-run opportunities.

1 comment:

  1. The painting was done on Al Maha Tower on Staten Island. I wanted to remember the location so I wrote this on the back of the panel once I got home.

    Al Maha Tower