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.


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