Friday, July 9, 2010

Market Volatiltiy is Not Bad: Its the Better Alternative

Last week the United States stock markets dropped dramatically…the Dow Jones Index fell significantly below 10,000. This week the same markets are up sharply…the Dow Jones closed yesterday at almost 10,140.

Most financial markets this year have been especially volatile. All measures of volatility have risen. Yet, the world goes on!

When the markets are down, gloom pervades the scene and fears of a double dip recession or a drop back into economic depression flood media outlets. When the markets are up, optimism about the economic recovery increases.

Yet, this volatility is the better alternative to a financial market collapse which has been avoided this year, up to this point.

Where does this leave us?

What I have tried to convey in my recent posts is that economic conditions, in general, are improving but that there are a lot of problems that have not been fully resolved at this point. In essence, things are getting better but we are not “out-of-the-woods” yet.

On what do I base this conclusion?

At this point in time I see a lot of people trying to work out the problems that exist. Where the problems are identified and “owned” the process of resolution goes forward. When people fail to accept the fact that problems exist and deny that anything needs to be done to correct them, the road gets bumpy and further market problems ensue.

A case in point is the European crisis that took place earlier this year. Denying that a problem existed in the financial position of several European governments only exacerbated the situation and led to substantial financial turmoil. A cloud still hangs over the European Union with respect to the bank stress tests that are now going on. It took a major effort to make these tests a reality, but now the whole process is cloaked in a secrecy that only creates more fear and concern. When will people learn that opaqueness does not breed confidence?

As I have written before, “quiet” is good. That is, financial markets do not like surprises or the fear of surprises. Problems may exist, but if it appears as if people recognize that problems exist, if people are working hard to identify the problems, and if people are applying resources to correct the problems, the world goes along.

In such an environment there will be bad news from time-to-time, just as there will be good news. The financial markets, however, do not like news that falls outside the bounds of what is expected. In this respect, market participants are on the alert for “surprises”, especially “bad” surprises, pieces of information that indicate that things are worse than they had expected.

At times like the present, financial markets are particularly sensitive to bits of news that might point to “bad” outcomes.

The problem with “bad” outcomes is that they may cause people to discard their previous expectations. The danger is that the destruction of expectations may be so severe that people stop trading until they are able to re-construct expectations that they are willing to trade on. A time period in which people stop trading is a “liquidity crisis” and is usually connected with the breakdown of market expectations due to a “surprise” that shakes the market.

Many believe that European leaders risked such a consequence in their response to the financial market disruptions that took place earlier this year.

So what we want is a period of relatively “quiet” economic activity so that the problems that exist within the economy can be worked out. There is no arguing against the fact that there are still a lot of problems areas in the world today. That is why there is so much volatility in the financial markets. With so many problems still in existence, there are still many, many possibilities that new “surprises” may be discovered. Market participants have a right to be jittery.

In my mind, additional governmental stimulus programs will not correct this situation. More spending stimulus from the government, if it has any effect, will only work to postpone the resolution of currently existing problems. These problems must be worked out or they will just carry over to the next period of financial distress.

In fact, I have argued that this is what has happened over the past fifty years or so as governments have tried to stimulate economic activity in order to avoid excessive amounts of unemployed labor. The result of this activity, however, has been excessive amounts of under-employed labor as well as unemployed labor. (See my post, “Jobs and Skills: The Current Mismatch,” http://seekingalpha.com/article/213163-jobs-and-skills-the-current-mismatch.)

Government efforts to achieve “quiet” results are apparent in the banking industry. Big banks do not seem to be the major problem: problems do seem to exist among the “less-than-big” banks. Both the Federal Reserve System and the Federal Deposit Insurance System are working to provide an environment in which these problems may be worked out in an orderly fashion.

First, the Federal Reserve has provided for a massive infusion of liquidity into the banking system by keeping its target interest rate near zero and allowing for about $1.0 trillion to remain on bank balance sheets as excess reserves. In additions, the FDIC has instituted a systematic process to close problem banks and to encourage a change in control of many other banks short of capital.

The result has been a steady handling of the problems in the banking system with no surprises. At least, no surprises up to this point in time. This is good…very good!

And, what do we see happening? People are seeing opportunities popping up in these “smaller” banks. (See my post from yesterday http://seekingalpha.com/article/213630-are-smaller-banks-a-good-investment, but also today from the Wall Street Journal, “Wilbur Ross’s N. J. Bank Play,” http://online.wsj.com/article/SB20001424052748703609004575355031598784308.html?mod=ITP_moneyandinvesting_2.)

Problems are also being worked out in the economy as a whole. However, this “work out” process takes time and since it took about 50 years for the United States to get into the position it now finds itself in, things are not going to right themselves overnight. Impatience, like further short run fiscal stimulus plans, will not correct the situation because they work “against” the healthy correction of the economy, they do not work “with” the natural flow of activity. There are ways the government can work “with” the correction, but these also require patience for they have to do with re-training, education, innovation and a changing structure of incentives.

Volatility comes with the territory we now occupy. Volatility comes with the release of bad news and good news on the economy, government finances, and company performances. The volatility comes because people are still trying to understand what is going on and whether or not expectations are going to be met. However, knowing that people accept the problems and are working to correct them creates an environment that is more conducive to trust than the failure to acknowledge the fact that problems might exist. Even in hard times, knowledge is better than ignorance…or foolishness.