Wall of Worry, from James Sogi

August 21, 2007 |

 Worry is in the air. Concern over financial collapse is in the news. The sky is falling. Markets are down. The circle of life and markets needs a period of reconstruction, of regrowth. Thirty percent more bidders are joining the queue.

The year is positive. The market is almost six percent off its lows of last week. It is difficult to hold. Many worry whether the rally will last. What are the mechanics of the wall of worry? The Rose Garden Theory provides that markets are the social adjustment mechanism and prevent excess of politicians in upcoming election from giving clues as to timing. The idea that the market must provide for its own upkeep by the powers that be shows how knocking price down provides a profit by year end for the strong.

The timing during the summer holiday gives time for the process over several months and to accomplish the maximum haircut when players are out of the office and vulnerable. The current rally is the flip side of the "weak longs" bailing out. Only the strong are left to reap the harvest. As the markets rise additional players jump on board. As old highs approach, those that bailed try to get back on so as not to miss, but again at the wrong time, behind the form. The maximum pain trade, buying at point of maximum pain, seems to have been a reflection and antidote to the common natural reaction. Avoiding the herd down and up is always very hard for social creatures. It’s like walking up stairs during rush hour in the New York subway.

The formulae for Sharpe ratio, Black Scholes, Fed model have a risk-free factor keyed to the risk-free rates. The risk-free yields have dropped affecting the pricing of options, Sharpe ratio, and Fed model, all in favor of equities and giving equities a higher future expectation. What does all this subprime credit stuff have to do with equities anyway?

Larry Williams remarks:

"The quants froze" is what one of the most successful presidents of a hedgefund told me regarding what happened at his firm at the recent low. He had to step in for his traders — they just locked up. Great indicator! 





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