Readers of this blog know I believe three things:
- Economics and Finance are at least half, if not principally, psychologies. Not math, not science.
- Economies, and their associated capital markets, are complex, emergent, and adaptive systems.
- Tied to 1 & 2 (and plenty of other reasons), mathematics is frequently a problematic approach in trying to describe (let alone forecast) the economy and/or capital markets.
The amazing thing is that, like automatons, much of this industry learns a bunch of math and rules and models, and seldom or never thinks of the linkage between those models and reality. Here’s a great perspective on that issue:
- The Risks of Quantification — William Byers
Amid the relentless outcry on the “dangers” of new financial products over the last years, it’s easy to forget that financial innovation—while of course it has its dangers—most often creates more information, more access, and greater versatility.
One such recent example is Howard Lutnick’s (of Cantor Fitzgerald) idea to create a derivatives market in property, pegged to rents, as a way to hedge against volatility in individual regional prices, or even to specific structures.
Cantor Aims to Change Game: Idea for Property Derivatives Pegged to Rents Arises From Surprise Acquisition — Dana Rubinstein
This is a great idea. It will simultaneously give folks ability to hedge against their property if they so choose and also allow market speculators to provide information in the form of prices on future expectations. (Yes, that’s generally a good thing.)
As noted last week, the IMF scandal is good theatre but of little consequence to capital markets or the wider economy. And after all the humdrum about corruption, all the blustering about Europe’s (and specifically France ’s) dominance over the IMF, the seeming choice in successor—Christine Lagarde—is pure form, ultra status quo. A career French politician. She might be in a different political party from Dominique Strauss-Kahn, but that won’t matter much as IMF leader.
But let’s say she won’t be ascendant. The reality is the EU holds about 30% of the vote for choosing the successor. So just about any other viable candidate will prove similar, including John Lipsky (currently acting as interim managing director), and long-shot Gordon Brown. None of these folks will represent radical change at the IMF. And that’s the part that should matter most to market watchers.
An important piece from Floyd Norris in last week’s NYT, and a view not articulated often enough these days. Japan and Tepco are an example here, but this is not about them—this attitude is pervasive in the last couple years.
I’ve read a lot lately about how the recent drop in oil was a “flash crash” of sorts, and caused by speculators, stop-losses, and a vicious cycle of ever-lower prices triggered as certain price thresholds were hit. Or, said differently, all non-fundamentals. Thus, that big drop in oil (and commodities with futures markets generally) have been totally delinked from the real economy.
Here’s what I don’t get: If it really was a “flash crash” in oil—and mind you, we’re talking about the deepest commodity market in the world—then why didn’t the price snap back just as quickly? Or at least within a few days?
Of course, the recent slide in oil was breathtakingly fast, but it’s also true that commodities don’t exactly have a history of smooth and easy linear movement. It was also breathtaking how fast oil went up and back down in 2008. From my view, there’s been quite a lot of reporting lately about bigger than expected oil inventories, and higher than expected production globally.
The point: Let’s not be so quick to call everything a flash crash. Markets can and will move sharply and quickly, but that doesn’t necessarily mean reality isn’t being reflected in the process—markets, once they figure something out, will price in truth very, very quickly, and generally without warning.
A purely anecdotal observation: an investor’s sense of time is often skewed. We’ve all heard “time flies when you’re having fun”, but I think the opposite is probably true in bad times: “time drags when the chips are down”.
The bear of 2008 not only still has sting for folks, but that period felt like it took forever and a half. Conversely, we’re into the third year of a new bull market and most don’t even realize it. Whizz-bang-boom! That was fast! Folks I talk to around the country—average investors of all sorts—seem to feel this way. They don’t see stocks are starting to approach their previous all-time highs, GDP in many regions (including the US ) is back at all-time highs, or earnings are set to make new all-time highs this year. Time flies when it’s not so bad.
Part of this is likely prospect theory: the Nobel Prize winning notion that people tend to dislike a loss 2.5 times more than they like a similar gain. So the sting is bigger, especially after an outsized bear market. But I also think the mind naturally plays tricks on us in terms of its perception of time—epochs of intense negativity have that agonizing, never-gonna-end feel to them. Whereas, when things are recovering or moving up generally, maybe attention gets diffused elsewhere, you worry less and less, and the next thing you know, time has flown by.
I have nothing to back this up other than my intuition and personal experience—here’s hoping a behavioral economist will take this question up soon (maybe someone already has and I just haven’t seen it yet). Either way, this is one of those issues where it pays to let the data tell you what’s going on—this includes history. Our memories are often distorted and we need to be reminded just how things happened.