The Summer's Gone

With the passing of labor day the summer has gone and market participants are wondering if the rose that is the equity markets is set to fall. There has been much debate during the past week of whether or not there will be a V-shaped recovery. Before this question can be answered, we must first agree on what will experience a V-shaped recovery, the financial markets or the economy.

Market participants, investors and economic cheerleaders tend to treat the economy and the equity markets as being one and the same, or at least as being reflective of each other. This is not the case and history supports this. If markets were always efficiently prices, by that I mean reflecting economic conditions and business prospects of companies, we would never have bubbles and corrections. Volatility would be at a minimum and investor angst would be reduced, but so would opportunities. Of all the mistakes made during the past two decades has been the effort to reduce investing to mathematical equations. Markets and market pricing is not an exact science. Human emotions, such as fear and greed, play an enormous role in the pricing of assets. Nobel laureate economist Paul Krugman is of this opinion as well.

These are strange times when I am in agreement with a Keynesian such as Mr. Krugman. As my readers well know, I am no Keynesian (even Keynes wasn't a Keynesian later in life), but I must concede that Mr. Krugman made several valid points in his article published in the most recent edition of New York Times Magazine. In the article entitled "How Did Economists Get It So Wrong" Mr. Krugman states:

"During the golden years, financial economists came to believe that markets were inherently stable — indeed, that stocks and other assets were always priced just right. There was nothing in the prevailing models suggesting the possibility of the kind of collapse that happened last year."


Mr. Krugman is spot on. Assets can be overprices by greed and undervalued due to fear. No model can discern the truth. Only careful analyses of the facts can properly value assets.

He continues:

"As I see it, the economics profession went astray because economists, as a group, mistook beauty, clad in impressive-looking mathematics, for truth."

Mathematical models are only as good as the input data. Because future occurrences are not yet known, the data used is backward looking. Although mathematical models can tell us how markets and assets MAY perform under certain known conditions (providing people (remember them?) behave the same way each time), they cannot help us forecast or deal with new, never before experienced conditions, many of which were actually caused by blind adherence to the very models designed to cover all bases.

Mr. Krugman makes more valid points when he states:

"Unfortunately, this romanticized and sanitized vision of the economy led most economists to ignore all the things that can go wrong. They turned a blind eye to the limitations of human rationality that often lead to bubbles and busts; to the problems of institutions that run amok; to the imperfections of markets — especially financial markets — that can cause the economy’s operating system to undergo sudden, unpredictable crashes; and to the dangers created when regulators don’t believe in regulation."


Although I am not in favor of heavy regulation, banks and investment banks behaved much in the way critics predicted they would in a less regulated environment. Banks took on huge amounts of risk, moved the most risky off balance sheet and kept what they thought were the better assets on their balance sheets. After all, the models don't lie. They may not lie, but they are limited. It is because markets are inefficient I believe that the recent stock market rally is not indicative of a V-shaped economic recovery, but of an asymmetric V-shaped stock market recovery.

There are too many headwinds holding back the economy. Critics blame the banks' lack of lending for holding the economy back. Banks are in fact lending, but only to those who are creditworthy. The problem is that the economy is built on consumer spending which is only possible through dramatic wage increases or large quantities of leverage. Neither is poised to occur.

In fact, it is joblessness which may be precipitating another leg down for the economy. The Wall Street Journal reports that mortgage and credit card delinquencies among prime borrowers are increasing at a faster pace than among subprime borrowers. This is due to the large number of unemployed borrowers who simply cannot make their payments. This will hold back the economic recovery and bring more losses to banks and investors of some asset-backed securities.

We may yet see a V-shaped economic cycle, except that the V is inverted and we are near the peak.