So what are the prevailing biases in markets?

As George Soros writes in his book The Alchemy of Finance, “I contend that financial markets are always wrong in the sense that they operate with a prevailing bias, but the bias can actually validate itself by influencing not only market prices but also so-called fundamentals that market prices are supposed to reflect.”

So what is the prevailing bias in the market today? There are a number of them and they differ based on the market participant. The prevailing bias in the equity market is that the current credit crisis will be short-lived and that the Fed will be able to bail out the markets. That is a reflection of the reaction whenever the Fed takes action and the fact that the year to date returns are still down only single digits while the rest of the world’s equity markets are showing strong double digit declines. The equity market have punished housing and financial stocks but are willing to believe that a bottom can be reacted quickly as evidenced by the strong turn in the financial stocks earlier in the year. The second bias in the equity markets is that no one wants to fight the Fed. Put differently, the Fed will be effective at getting the economy moving. This is not like Japan during the 1990’s. There will be no liquidity trap and at the worst asset inflation from rising prices will not be bad for stocks.

Fixed income markets are much more negative about the economy and the Fed. Perhaps this is related to the fact that the credit crisis has hit this sector much more that the overall equity markets. Here, interest rates have been pushed down to negative real rates and we have seen a flight to quality that has pushed Treasury bill rates significantly below 1 percent. The front-end expects more easing but the impact of a recession is viewed as more important than inflation at least in the near-term.

The currency markets seem to believe that the US problem can be localized and the rest of the world may be decoupled with the United States. The dollar has taken a beating that suggests growth in the rest of the world can still be strong.

Commodity markets, while off of their highs have been very resilient based on the view that the rest of the world will have high demand from continued growth regardless of what happens in the US.

These biases are embedded in prices so any major change in prices will be based on whether there is a change in the expectations concerning these views. The worsening employment situation only confirms the current biases; consequently, there has not been a strong reaction.

Innovation and Creative Destruction

One of the best books for 2007 was Prophet of Innovation: Joseph Schumpeter and Creative Destruction by Thomas McCraw.

Innovation and entrepreneurship is messy. By its very nature it is unexpected, so it is not easily modeled. While risk is countable, uncertainty is not measurable. Innovation is not measurable. There is no distribution of business creation. You cannot tell when it is going to happen, whether it will be adapted, or if it will be a success. You cannot plan for it. Innovation by its very nature creates new markets and products that did not exist. It is a “Black Swan” event. Yet it happens, and we are poor at forecasting these business prophets. It is this uncertain process of innovation is what drives economies. It takes a person who can see the existing system and envision an improvement or create a market that did not exist before. The very process is destructive because the status quo must change. Trying to explain this process requires not only an understanding of economics but the breath of history, cultural, and institutional structure. Only a remarkable man of intellectual power would be able to describe the environment required for innovation. Joseph Schumpeter was such a man.

His story is a complex one. He was a big ego who clawed his way up the academic world but was also exposed to government service and private banking. His failures coupled with a desire to be a great thinker makes for a fascinating story of a man and an idea. Schumpeter is not often taught in economic classes. The required need for true inter-disciplinary thinking makes him hard to read. The fact that there are no formal models for his thinking makes him out of step with mainstream economics, but he may be one of the most influential thinkers on business.

Even the current credit crisis should be looked at through the process of creative destruction. Innovation has changed the mortgage market forever. We will not go back to fixed 30-year mortgages regardless of how much regulation is imposed on the market. The development o many Asian economies is a result of creative destruction. Innovation allowed for countries to leap-frog the development process.

Thomas McCraw has been writing about innovation for years and he is able to bring the story of Schumpeter together as a lively tale of a man focused on bringing new economic ideas to the world. What McCraw will want you to pick up your dusty copies of Schumpeter’s works and read them for both the insight and enjoyment in a new light.

Credit crisis at half way point

We are already starting to see some historical analysis on the credit crisis and the paper,“Leveraged Losses: Lessons from the Mortgage Market Meltdown”, by David Greenlaw, Jan Hatzius, Anil K Kashyap, Hyun Song Shin; for the US Monetary Policy Forum Conference is one of the best. http://www.brandeis.edu/global/rosenberg_institute/usmpf_2008.pdf

“Leveraged Lessons” provide a good overview as well as a forecast of what may be the loss from this mess. The researchers are forecasting about $400 billion in mortgage loses. We have seen write-downs of about $230 billion. By this measure we are getting to about the half-way point of the problem. I view this as optimistic but as long as firms are taking a write-downs we are moving forward.

The authors look at the housing problem relative to some of the other regional crisis of the last 25 years and find that the foreclosure rates are consistent with the decline in housing. The behavior of housing in this crisis is not out of the ordinary. However, none of these other housing crises had the range of mortgage products that currently exist. This is what makes the crisis unique and provides new level of uncertainty so that any forecasts are suspect.

What is clear is the linkage between credit issues and the overall GDP. The housing problem will have at least a 1.3% or higher drag on GDP which is enough to put us on the cusp of a recession. It is just a matter of trying to predict the extent of the slowdown not whether we are in one.

Why I follow behavioral finance?

I have been following behavior finance for years. It has been an exciting area of finance but also has not always lived up to the hype of being able to identify ways of processing data to find Studying the mistakes that investors may make with decision-making has been helpful, but at the same time much of the behavior finance literature has not had a big impact on exploiting anomalies. Market anomalies exist but they are not frequent and do not always last. More importantly, they may be multiple behavioral explanations for anomalies that may seem inconsistent. I have not found ways to exploit the behavioral finance theories for money-making other than to accept that irrationality exists and can effect markets. So why spend so much time studying the behavior of markets. It is similar to why so much time is spent studying abnormal behavior in psychology. By studying the extremes or abnormalities in behavior we can better understand normal decision-making.

I have to go back to philosophy and the comments of Baruch Spinoza in Tractatus Politicus on studying subjects for the best reason for focusing on behavioral finance, “I have labored carefully not to mock, lament, or denounce human actions, but to understand them.” Study of behavior finance is useful not because we are going to find a rich new method for generating profits but because it provides a framework for observing and accepting the markets not for what they should be but for what they are.