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.
Showing posts with label volatility. Show all posts
Showing posts with label volatility. Show all posts
Friday, July 9, 2010
Thursday, July 9, 2009
Uncertainty: The King of the Market and what to do about it
This is a time that is particularly conducive to impulsive or instinctive behavior. It is a time that behavioral economists love because it proves their case about irrational human behavior. People react and they react on the basis of a gut feeling or a snap judgment.
These researchers tell us that this type of behavior is what has helped the human species survive. However, it is not necessarily the kind of behavior that leads to decisions or actions that are in our best interest when investing. “Relying only on intuition in finance can lead to very bad outcomes, not only for individuals but also for markets.” (This quote comes from David Adler’s new book “Snap Judgment”: see my post that reviews this book, http://seekingalpha.com/article/145660-book-review-snap-judgment-by-david-e-adler.) Yet we humans, individually and collectively continue to perform in this way.
Right now, the concern is whether or not the economy is bottoming out and starting to recover. We get “green shoots” here, but then some other indicator of economic activity comes in worse than expected. Alcoa puts up better than expected loss numbers but retail sales come in lower than expected. Sales of existing homes improve yet we get wind of another wave of subprime mortgage problems. (See “Subprime Returns as Housing Woe,” http://online.wsj.com/article/SB124709571378614945.html#mod=todays_us_money_and_investing.) And, what about the problems in commercial real estate, credit cards, and Alt A mortgages?
Then there is the question about whether or not there should be a second round stimulus bill. Paul Krugman has argued for a long time that the first stimulus bill was not enough. Yesterday Laura Tyson indicated that she thought that there needed to be a second round. Now the debate is all over the place. But, wouldn’t another stimulus bill add more to the government budget deficit going forward? And, there are questions about the possibility that the government has already committed to too much debt.
So the Dow Jones average goes up from 6500 and looks very strong approaching 9000 and then goes into a swoon. The price of crude oil was approaching $40 a barrel in February and then shot up to above $70 but now has returned to the $60 range. The yield on the 10-year treasury issue was nearing 2.00% in December 2008, jumped up to around 3.90% in the middle of June and traded at 3.30% yesterday. An index relating the value of the dollar against major currencies was around 70 in July 2008, popped up to the mid-80s in March 2009 and has since declined to about 77.
When the economic indicators seem strong the price of oil goes up as does the stock market and the price of bonds and the value of the dollar decline. When the economy seems weaker we get just the opposite movements. And, my bet is that it is going to continue this way for a while. So, uncertainty, and hence volatility, rule the marketplace.
This is the short run. Recently, however, I have been writing more upon the long run, what deficits do to long term interest rates and to the value of the dollar. Over the longer run, historically, some patterns repeat themselves over and over again. This, of course, brings to mind the statement made by John Maynard Keynes, “In the long run we are all dead!” Still, we need to take the long run into account.
This is where we need to take heed of what the behavioral economists advise. We, as investors, must not rely on intuition or gut reactions. We must not over react to the environment we now find ourselves in. Research has shown that acting in this way is not necessarily in our best interest.
The research also indicates that investing based on fundamental economic reasoning does work. Therefore, it seems as if now is a time for discipline and hard work. And, it is a time for patience.
But, this does not mean that one needs to totally ignore the short run. It is perhaps impossible to expect that most people will just sit out this stage of the economic cycle and invest their funds in safe, low-yielding assets. So, what kind of strategy might work here? My suggestion is that one needs to segment one’s portfolio, allocating some money to playing in the current market volatility, but allocating a larger share of the funds to potential future fundamental investment choices.
The smaller part of the portfolio can be allocated to playing both sides of various markets. Obviously, getting into the market near a “bottom” would be very profitable, but selling short near a “top” would also work. But, by all means consider any investments here as short term in nature because it is highly likely that the “bottom” may not turn out to be a “bottom” at all. Likewise for a “top.” So, one must be very agile in investing this way. Don’t hang onto losses, but let gains ride. Behavioral finance tells us that people tend to operate in the opposite way hanging onto losses hoping for the best and quickly selling gains to have something to show for their efforts. This is where discipline and focus are crucial.
Furthermore, remember that, on average, the expected returns on trading are zero: and there are still fees that need to be paid. But, using part of your funds in this way keeps you “playing the game” while still keeping the major part of your portfolio available for “value” investing to take advantage of longer run opportunities.
As research has shown, the fundamentals do apply over longer periods of time. Perhaps, however, it is not quite time to commit to some of these “value” propositions. People are worried about the potential inflation that may come about due to the large government budget deficits and the possibility that the Federal Reserve will have to monetize a substantial amount of the debt created. But, there are many people who think that deflation is going to be more of an issue in the near term. Hence, it is perhaps a little premature to put funds into investments that will prosper from a future period of high inflation. This part of the portfolio should be kept safe, but also should be able to be accessed when the time is right to commit to the longer run fundamentals. Research, however, has shown that it is alright to be a little early on these types of investments because the possible returns on such a commitment to fundamentals are substantial enough that being a little early is not harmful.
It is also important that an investor should stay in the areas of the market that they know best. If your skills lend themselves to the technology sector of the stock market then stay there. If your skills are in the government bond market then stay there. If your skills are in the foreign exchange market then stay there. Again, discipline and focus are all important.
Uncertainty is going to remain with us for quite some time in financial markets and commodity markets. The behavioral economists have warned us that this is a dangerous time to act in just an impulsive or instinctive manner. So, if being methodical is not your “cup of tea” then beware for the statistics are not with you. Chasing every “green shoot” or market reaction is not going to produce happy results. Acting in a focused and disciplined way may be very difficult for us to achieve but we need to try. That is what humans have learned they must do in activities like investing in financial or commodity markets.
These researchers tell us that this type of behavior is what has helped the human species survive. However, it is not necessarily the kind of behavior that leads to decisions or actions that are in our best interest when investing. “Relying only on intuition in finance can lead to very bad outcomes, not only for individuals but also for markets.” (This quote comes from David Adler’s new book “Snap Judgment”: see my post that reviews this book, http://seekingalpha.com/article/145660-book-review-snap-judgment-by-david-e-adler.) Yet we humans, individually and collectively continue to perform in this way.
Right now, the concern is whether or not the economy is bottoming out and starting to recover. We get “green shoots” here, but then some other indicator of economic activity comes in worse than expected. Alcoa puts up better than expected loss numbers but retail sales come in lower than expected. Sales of existing homes improve yet we get wind of another wave of subprime mortgage problems. (See “Subprime Returns as Housing Woe,” http://online.wsj.com/article/SB124709571378614945.html#mod=todays_us_money_and_investing.) And, what about the problems in commercial real estate, credit cards, and Alt A mortgages?
Then there is the question about whether or not there should be a second round stimulus bill. Paul Krugman has argued for a long time that the first stimulus bill was not enough. Yesterday Laura Tyson indicated that she thought that there needed to be a second round. Now the debate is all over the place. But, wouldn’t another stimulus bill add more to the government budget deficit going forward? And, there are questions about the possibility that the government has already committed to too much debt.
So the Dow Jones average goes up from 6500 and looks very strong approaching 9000 and then goes into a swoon. The price of crude oil was approaching $40 a barrel in February and then shot up to above $70 but now has returned to the $60 range. The yield on the 10-year treasury issue was nearing 2.00% in December 2008, jumped up to around 3.90% in the middle of June and traded at 3.30% yesterday. An index relating the value of the dollar against major currencies was around 70 in July 2008, popped up to the mid-80s in March 2009 and has since declined to about 77.
When the economic indicators seem strong the price of oil goes up as does the stock market and the price of bonds and the value of the dollar decline. When the economy seems weaker we get just the opposite movements. And, my bet is that it is going to continue this way for a while. So, uncertainty, and hence volatility, rule the marketplace.
This is the short run. Recently, however, I have been writing more upon the long run, what deficits do to long term interest rates and to the value of the dollar. Over the longer run, historically, some patterns repeat themselves over and over again. This, of course, brings to mind the statement made by John Maynard Keynes, “In the long run we are all dead!” Still, we need to take the long run into account.
This is where we need to take heed of what the behavioral economists advise. We, as investors, must not rely on intuition or gut reactions. We must not over react to the environment we now find ourselves in. Research has shown that acting in this way is not necessarily in our best interest.
The research also indicates that investing based on fundamental economic reasoning does work. Therefore, it seems as if now is a time for discipline and hard work. And, it is a time for patience.
But, this does not mean that one needs to totally ignore the short run. It is perhaps impossible to expect that most people will just sit out this stage of the economic cycle and invest their funds in safe, low-yielding assets. So, what kind of strategy might work here? My suggestion is that one needs to segment one’s portfolio, allocating some money to playing in the current market volatility, but allocating a larger share of the funds to potential future fundamental investment choices.
The smaller part of the portfolio can be allocated to playing both sides of various markets. Obviously, getting into the market near a “bottom” would be very profitable, but selling short near a “top” would also work. But, by all means consider any investments here as short term in nature because it is highly likely that the “bottom” may not turn out to be a “bottom” at all. Likewise for a “top.” So, one must be very agile in investing this way. Don’t hang onto losses, but let gains ride. Behavioral finance tells us that people tend to operate in the opposite way hanging onto losses hoping for the best and quickly selling gains to have something to show for their efforts. This is where discipline and focus are crucial.
Furthermore, remember that, on average, the expected returns on trading are zero: and there are still fees that need to be paid. But, using part of your funds in this way keeps you “playing the game” while still keeping the major part of your portfolio available for “value” investing to take advantage of longer run opportunities.
As research has shown, the fundamentals do apply over longer periods of time. Perhaps, however, it is not quite time to commit to some of these “value” propositions. People are worried about the potential inflation that may come about due to the large government budget deficits and the possibility that the Federal Reserve will have to monetize a substantial amount of the debt created. But, there are many people who think that deflation is going to be more of an issue in the near term. Hence, it is perhaps a little premature to put funds into investments that will prosper from a future period of high inflation. This part of the portfolio should be kept safe, but also should be able to be accessed when the time is right to commit to the longer run fundamentals. Research, however, has shown that it is alright to be a little early on these types of investments because the possible returns on such a commitment to fundamentals are substantial enough that being a little early is not harmful.
It is also important that an investor should stay in the areas of the market that they know best. If your skills lend themselves to the technology sector of the stock market then stay there. If your skills are in the government bond market then stay there. If your skills are in the foreign exchange market then stay there. Again, discipline and focus are all important.
Uncertainty is going to remain with us for quite some time in financial markets and commodity markets. The behavioral economists have warned us that this is a dangerous time to act in just an impulsive or instinctive manner. So, if being methodical is not your “cup of tea” then beware for the statistics are not with you. Chasing every “green shoot” or market reaction is not going to produce happy results. Acting in a focused and disciplined way may be very difficult for us to achieve but we need to try. That is what humans have learned they must do in activities like investing in financial or commodity markets.
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