It is common sense that the stock market anticipates what will happen in the economy after some time. The invisible hand of the market driven by millions of investors who make decisions according to different quantity and quality of information eventually represent the best way to encapsulate and synthesize the current status and prospects of the world's economy. But is this always true? Or for some reasons markets are resilient to change and slow in timely reading the information available?

If this is the case, what are these reasons and when does this happen? Can markets be manipulated by strong hands or there are simply forces that render decision making viscous and create a breakout friction before markets actually change the course they are following? Like a ship takes some time before reacting after the wheel is turned.

These questions are relevant today as they were before the beginning of the crisis two years ago. As loan underwritings standards deteriorated, the securitized mortgage market developed a bubble in housing prices that continued for quite some time until it finally popped. Even if we now read on several reports that it was clear to many what was about to happen, until the very last moment almost everybody continued to play the same sheet of music. Investors, regulators, government. The markets went on with huge inertia along the tracked lines of unrealistic risk assessments, walking on quants' clouds and careless of gravity. The longer they continue the more violent is the reaction eventually.

It seems to me that currently markets are in a similar situation. After the impressive injection of liquidity in the system (like an adrenalin shot to the heart) aimed to restore confidence and normal functioning of shaken markets, prices of assets have reflated for over a year now. In order to do this, sovereign debt in Europe and the US is increasing to levels that everybody knows are unsustainable. Still, for political reasons nobody wants to take the bitter medicine that would be needed. The show goes on with cheap money poured into assets that go up with a regularity and pace that is almost unprecedented. Regardless of unemployment, housing prices that in some states are going down again, the contracting credit to consumers, some states and cities are very close to bankrupcy, banks continue to be seized by the FDIC, industrial production levels are still 10% lower now than at the pre-recession peak, durable goods orders are almost 20% lower now than they were before the recession began. Finally, equities are up 75% from the lows, but earnings are still almost 40% below their pre-recession levels.

Is this manipulation? When and how is this going to finish? Or actually this time markets are reading correctly what is going on and are simply anticipating a global recovery and the consequent future increase in corporate profits?

Laurel Kenner writes:

The wonder is that the market didn't go up much more, given the trillions of stimulus. Since '07, the market has made short-termers of all of us– at least, of everyone fortunate enough to still possess enough liquidity to trade. We're all dancing in the dark until the tune ends. Meanwhile, the music has changed in the bond market.

Russ Sears writes:

It is my contention that the markets are good at forecasting what is predictable. However, much is not forecastable, like the weather.

I will be presenting a paper Tuesday that Dr. Dorn and I have authored in Chicago Tuesday.

In it we content that faulty risks evaluations can cause neurotic outcomes, in individuals, companies, sectors and even whole economies.

The markets can become, and apparently did become, a mechanism to trade short term gains while coming at the expense of increasing long term risks from over-allocation of resources. The risks of over allocation is often a chaotic system, meaning it is impossible to predict specifically when and how hard it will crash. Statistically, this could be thought of as trying to predict when the correlations will become a self reinforcing mechanism approaching 1 . Or is more practical examples when would over- building of housing in California, Arizona, Nevada etc. lead to deflationary spiral and foreclosures and inability to refinance all across the country and world. Another example would be the over allocation of delta hedging and portfolio insurance in Oct 87.

I am hesitant to make predictions, especially after Bear Stearn then Lehman and AIG and a government run mortgage market in Fannie and Fredie. But I am not as pessimistic as many that this is only a short term bounce. This stems from my belief that while the mortgage markets securities economic value are difficult to predict… the markets are giving at least giving them a more realistic view of their worth given this uncertainty. If this discount for uncertainty is as healthy a discount as I believe; there is still considerable liquidity and value that can return to the markets once these values are realized and known. The markets, at least in my modeling, seems to still give a considerable chance to the deflationary spiral returning.

Mick St. Amour writes:

Paolo, thank you for sharing your thoughts. I like your comments on inertia because that is at work. I see this all the time with retail investors and as of right now that dynamic is at work in that those folks still haven t taken a bullish slant and have been slow to change their minds. most investors are slow to embrace a change in thought when conditions change and they tend to ignore what market prices tell them. They tend to get locked into some ideology and usually only change their belief until after bulk of gains are made. Best trades are made when you can find inertia still at work and market prices begin to shift in different direction opposed to prevailing view. I have found those to be the best low risk trades.





Speak your mind

1 Comment so far

  1. Gary Rogan on April 11, 2010 11:36 pm

    As the control of the economy is getting more and more concentrated, the traditional function of the market of discounting economic trends a few months into the future, a dubious “job” to begin with (why not decades into the future or hours into the future?), is changing. Today this function has been reduced to predicting just two “trends”: what will a small group of men decide to do (I don’t mean as some sort of a conspiracy, just individually, although sometimes cooperatively) and how will the cataclysmic events out of their control constrain their ability to act?

    While there is some zeitgeist logic in the unfolding of economic trends when millions of competing entities are maximizing their profits and the prediction function is relatively smooth except for emergencies or pre-planned discontinuities like Fed decisions and major statistical releases, the ability of the market to predict the decisions of those key players is very limited. Combined with what I consider to be a certainty of debt-based worldwide collapse, the ability of individuals to front-run market decisions has become more difficult. Ask yourself if just a few months ago you had any real idea of what effect the Greek debt crisis would have on the euro or any particular stock and government debt market? Do you know what effect the fate of California’s ability to pay it’s debt have on anything in particular? Will it be bailed out? Will Greece be bailed out? By whom? On what terms? Will China’s ruler unpeg their currency and what exactly will that do? Who, when, and how will confront Iran and what effect will that have? What will the rest of the PI(I)GS countries do in response to any particular bailout? What will be the effect of the change in the Fed’s activities in the residential mortgage market? Will the Fed get back in when the going gets tough? What will happen if there is an undersubscribed Fed auction? Can the Fed actually print money at will or how will the various inflation-pegged US government obligation constrain this ability? Will North Korea sink another South Korean ship? What if they sink ten, what then? What if the events in Kyrgyzstan affect the American military base? What if the spike in Chechen “freedom fighting” affects the flow of energy to Europe? Does that crash of the Polish plane mean anything to you? Will the events in Thailand matter? What exactly will happen with various tax proposals and plans? If the US were to forced not to honor all of its obligation will that mean the end of the dollar? What will that do to the price of stocks? Which stocks? When you first became aware of the “subprime crisis” did you know how it would unfold? When Paulsen asked for TARP did you now what he would actually do with the money? Does anybody know what would happen if there was no bailout of any kind? Why was Lehman not saved? Do you really know anything at all with any degree of certainty and can you make a rational prediction? If you had some statistical game a year ago is that game still valid? What if some really important guy makes some really unpredictable decision tomorrow that will make your game invalid? Do those millions of investors really matter? Can you tell manipulation from a perfectly rational reaction in the absence of any real information? Is there anybody whose job it is to make the world appear rational to you?

    Of all of these questions I only know the answer to the last one and it is a resounding “No”. Act accordingly.


Resources & Links