Jul

6

Tyler Cowen gave an interesting talk at the NY Junto about the economics of worry, what you should worry about and what you shouldn't. He touched on his bearish views for the stock market, and felt Dow 8000 was a good goal because of the conjunction of the real estate and commodity crises, and various psychological anomalies. I kept wanting to say "Et tu, Tyler?" because I don't believe in bear markets, and always believe it's right to buy, especially at times like this.

John De Palma adds:

I greatly enjoyed the lecture on Thursday. It was the best talk I've attended this year.

1) He attributed part of the origin of the subprime problem to a calculation error where the perceived default rate could have been 1% in securities when the true probability of default was 4%. (Somewhat relatedly, Richard Clarida wrote in an October PIMCO commentary, "The proximate cause of this 'hard day's Knight' was the more or less simultaneous realization by millions of global investors that their underlying assumption about the distribution of returns on a wide "variety of asset-backed securities" was fundamentally flawed.")

I also think a rational bubble was a source. The Keynesian beauty pageant as an asset pricing model could be consistent with buying and selling of assets at values that adhere to an overall market convention that is inconsistent with how each market participant would appraise the asset if unable to flip it to another participant. (Keynes BTW compared investment to "a game of Snap, of Old Maid, of Musical Chairs"). In my view the bursting rational bubble would just be a breakdown in the pricing convention.

If a bond fund manager gets evaluated by Morningstar ratings and receives capital inflows on the basis of a narrow trailing 2 or 3 year performance, then the incentives to harbor blowup risk in a portfolio is such that the manager marginally setting prices in the market could be apathetic about whether he privately believes that default rate is 1% or 4%.

It conjures up an interesting thought experiment: Can credit risk be underpriced and yet everyone in the market thinks bonds are overvalued? Or the parallel inquiry from a rational bubble section of my senior thesis in college: Can eToys be worth $10 billion when mutual fund managers collectively think it is worth $1-$2 billion? (I surveyed fund managers, many of whom owned the stock, and the average response was the latter figure at a time when the market cap was multiples higher.)

2) I liked how Cowen's view of the macroeconomy was nuanced instead of a one dimensional scapegoating of an overly accomodative Fed, over (or under) regulation, etc. that is so popular. I find scary the compulsion towards narrative fallacies, attribution errors, and cramming world events into a preexisting ideological view.

3) His metaphor comparing subprime securities to poisoned water seemed apt. Bill Gross chose a "Where's Waldo" metaphor to eloquently make the same point in some of his commentaries during the financial crisis– ("…While market analysts can guesstimate how many Waldos might actually show their face over the next few years - 100 to 200 billion dollars worth is a reasonable estimate - no one really knows where they are hidden…"). In analyzing earlier crises Mohamed El-Erian has also related the lemons problem to EM debt pricing.

4) Cowen spoke about how the inequality of happiness in Denmark is similar to the U.S. despite a lower income inequality there. My takeaway from Daniel Gilbert's book was happiness set points and the power of habituation. Couldn't the inequality of happiness just converge upon some distribution regardless of the level of income inequality if there haven't been recent changes?

Also, I think in Gilbert's book there is an assertion about how the most realistic people (i.e. least susceptible to cognitive biases) are ones that are classified as mildly clinically depressed. Similarly, if people generally worry too much (which seemed to be your contention even if there are certain things people worry insufficiently about), then maybe some self delusion would be useful to avoid excess sensitivity to perceived threats.

5) In general comments on income inequality he mentioned how the rate of inflation varied by income right now. This is a bit of a non sequitur, but it's a topic I've been thinking about in the context of the Fed's fervent interest in inflation expectations. Surveys show how expectations differ by region and even gender in normal conditions. People's expectations have a consistent upward bias and overweight more frequent purchases. If the Fed is so obsessed with controlling these expectations than perhaps we need separate monetary policies by region, gender, and income so that we can reset an expectations-augmented Phillips curve to a price stability point. Since we of course don't, then maybe the Fed and market participants shouldn't look at these surveys to the second decimal place and pretend that the fate of the economy depends on 1.8% vs 2.2% inflation.

6) He made a point on health care about how people are blindly deferential to not properly incentivized doctors reminded me of this good column that David Leonhardt wrote in November– ("… Economists sometimes refer to this situation as an "expert service problem," because the same expert who is diagnosing the flaw is the one who will be paid to fix it. In most of these cases, consumers aren't sophisticated enough to make an independent judgment. That's why they went to the expert. The problem, of course, extends well beyond the car business. Anytime you call a plumber or roofer to your home or anytime you visit a doctor or dentist, you're at risk of having an expert service problem…If anything, Professor Hubbard argues that the expert service problem is more serious in medicine than in auto repair, because most people are less willing to question a doctor than to question a mechanic. Any effort to reform American medicine has to grapple with these conflicts of interest…").

7) Cowen commented that a catastrophe isn't more likely because markets don't price the prospect more aggressively now than in the past. However, in an article he linked to on his blog, Peter Thiel said the pricing is distorted because no one would be around to collect the insurance payout in the event of the catastrophe– ("…The catastrophe is so large that no functioning market or government remains: This is the only case where one would incur catastrophic "losses," although nobody might be left to collect them…" ) Similarly, there was recent speculation that a market on a Large Hadron Collider-motivated catastrophe would break down because of the inability to collect a payout in an apocalyptic event. ("…Unfortunately this is one kind of question where an Idea Futures market would not work too well, because people who correctly bet that the reactor will destroy the earth may not be able to collect their winnings. This would cause the market to under-estimate the risks…")


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10 Comments so far

  1. steve leslie on July 7, 2008 8:55 am

    Mr. Depalma deliniates points that are very intriguing.

    I believe this is at the fundamental root of all speculative bubbles:

    (There was that ill-timed dance metaphor that then-former Citigroup CEO Chuck Prince used last July,”As long as the music is playing, you’ve got to get up and dance.”

    comment: The problem becomes in figuring out when the music stops.

    My friend Marion Dreyfus shared this story with me recently on human nature:

    A scorpion once came to the bank of a stream and wanted to get to the other side. He called out to a turtle, “Please let me ride on your back to the other side.” The turtle said, “If I let you on my back, you will sting me and kill me.” The scorpion promised that he wouldn’t and even sign a written agreement (#1). The turtle, worrying what the other creatures of the forest would say, took the scorpion to the other side. As soon as they reached the other side, the scorpion impaled the turtle with his poisonous stinger. As the turtle was dying, he cried out, “But you promised not to kill me.” The scorpion smiled ingeniously, “It’s not my fault. IT’S JUST MY NATURE.”

    The second is the flawed system we have how money managers are evaluated and compensated in our financial system. They are not compensated so much by their performance but rather to their peer group. On High Net Worth on CNBC on Friday they went into detail how hedge funds are raking in astronomical fees despite and inspite of performance.

    This is an old joke it would be funnier if it were not so true:

    A scientist and a philosopher were being chased by a hungry lion. The scientist made some quick calculations, he said “it’s no good trying to outrun it, its catching up”.

    The philosopher kept a little ahead and replied “I am not trying to outrun the lion, I am trying to outrun you !”

    sl.

  2. Chris Carolan on July 7, 2008 2:40 pm

    "… their underlying assumption about the distribution of returns on a wide 'variety of asset-backed securities' was fundamentally flawed."

    And they arrived at those flawed assumptions based on models they built after taking the same math classes as the climate modelers.

  3. nik on July 7, 2008 3:00 pm

    vic, i thought you are a speculator. just wake up and wait, the market will go down…

  4. Geoffrey Batt on July 7, 2008 3:05 pm

    In real terms, bear markets of varying lengths and severity are just about everywhere. Corn, wheat and soybeans have been in CPI adjusted bear markets since 1917. One feels an overwhelming urge to end this message with a simple "QED".

    But that may be premature if your ontological parsimony toward bears is in nominal terms. If so, then I agree bears of a nominal breed do not exist. But where does that leave us? In nominal terms the German stock market increased 89 times from 1914-1922. During the same interval coal increased 1250 times, iron increased 2,000 times and producer prices 945 times. Wealth qua purchasing power decreased in this so-called bull. And isn't increased wealth the goal of speculation?

    Any way you look at it, you seem way off the mark.

  5. George Parkanyi on July 7, 2008 10:22 pm

    Victor is right, based on simple mathematics alone.

    The best you can do with an un-leveraged short position - assuming you have to put up an equal amount of the initial position as margin - is double your money, at the theoretical risk of losing many times that.

    The same amount of money in an unleveraged long position, could theoretically rise 2,3,4,10 a hundred-fold or more, with the limited risk of losing 100%.

    I know that Motorola looks like a basket-case at $7 today, but if someone offered you a sizeable free position in that stock provided you had to pick one direction to hold for 5 years at the correct odds - which would it be? long or short? :)

    Cheers,
    George

  6. Brian Kuebler on July 7, 2008 10:59 pm

    I don’t know many big words and even fewer equations–but I know up from down. I think very soon there will be little debate whether this is a bear market.

  7. Lon Evans on July 8, 2008 5:07 am

    Mr. Leslie,

    Trite! You’re only something like a year late in your ’sudden’ realization that something stinks in Denmark.

    As I, long ago mentioned, when you dudes start talking bear, I’m buying.

    lon

  8. steve leslie on July 8, 2008 10:37 am

    I always wonder, Mr. Evans, since you are so obviously brilliant and prescient, how does one take advantage of such opportunity to know thee? Such wisdom. Do you run a hedge fund? Manage private money? Run a foundation? Live in great opulence and manage your own account in massive secrecy as Livermore once did? Are you attached to a far greater cause such as the Palindrome's moveon.org? Sit on a mountaintop in Tibet or Olympus and observe the world?

    Pray tell, please share so the less informed and vulnerable sheep such as I and others who frequent this site may benefit. And bow down before thee.

    Oh, by the way, you do not know me nor do you know anything about me and have no knowledgeof  how I run my financial life and as such can claim no insight as to how or what I trade. In other words, mind your own great success and leave me out of your sick world. Stick to the lithium, it tends to balance out the highs and the lows — and society in general will be better off as a result.

  9. lon evans on July 9, 2008 5:08 am

    Steve,

    Getting a little brittle, aren’t we?

    I live a simple life. Enough said. Still carrying about your “autographed” copy of the Chair’s enumerations?

    lon

  10. xoxoANP! » links for 2008-07-09 on July 9, 2008 6:12 am

    […] The Economics of Worry, from Victor Niederhoffer : Daily Speculations More on Mr. Dr. Professor Cowen’s talk on my real blog forthcoming (tags: econ psychology society) […]

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