As a market observer and trader for the past 6 years, it often seems as though we sit at some sort of crossroads of great import where the market will either go one way or the other with definitiveness. My perception has been that we are on the cusp of some momentous and definitive event in the market that will determine something grand such as inflation or deflation, recession or expansion, bull or bear market. Since this perception is essentially ubiquitous, whereas momentous market events are rather rare, it has slowly dawned on me that the truth is probably deeper than the perception. While historic events are occasionally witnessed in the market (2008 credit crisis is an example), our perception and behavior is a part and parcel of these crises which makes passively predicting and observing them all but impossible!
The reality is that economics in general, and financial markets in particular, do not behave like a physically observable phenomenon such as an apple dropped from a tree. Since the observer is inextricably part of the system she observes, deducing future market moves is similar to an apple trying to deduce the law of gravity by observing itself fall out of a tree. Let me give one example: many people speak of the Fed and of big money interests as if they determine the fate of the economy – "the man behind the curtain." I would agree there is some validity to this view – but wait! What is one of the most, if not the most, important determinant of Fed policy? Inflation expectations. And who holds these expectations? The millions of people out there who are watching the Fed. So it appears as though we watch the Fed to see what they do, but they watch us to see what we do! The plot thickens.
This particular twist is salient in the inflation-deflation debate. If we’re always watching the Fed for signals, and they are always watching us for our expectations, then the reality is not a static picture, but rather more like a projector on a wall with constantly changing images. The most popular pastime for market observers is to look at past events and use them to speculate about the future. I am guilty as charged! The danger with this approach is that while the past can give us some guidelines, it is completely static and unchanging. There are no moving parts in the past, and our minds are therefore logically drawn to deterministic relationships. But what if emerging financial reality is not deterministic? What if in the very process of forming expectations of an event, we immediately change the probability associated with that event? What if events are largely driven by random factors? And what if the effects of both random events and those things we attach causality to are in fact to some degree unpredictable in their effect?
To take another example, think back to the housing bubble of 2003-2007. These days it seems that everyone and their grandma knew that we were in a bubble during this time, and lined themselves up to profit handsomely by shorting mortgage backed securities. "Oh, it was obvious." Well, maybe, but to many people it didn’t seem obvious at the time. I know I was bearish and figured we were in a housing bubble. But you know what? I was "wrong" for many years. I decided against buying a house in Seattle in 2003 precisely because I thought housing was in a bubble. I may look smart now, but how did I look in 2006, when Seattle home prices had essentially doubled from 2003? It is easy to look back now and say that housing prices were in a bubble. But on some level, it is still just a theory that may or may not be correct.
The final application of this point is to the status of the US dollar and to the sovereign debt markets. For years now I have waited and expected the demise of the US dollar, based on many things, but primarily the consistent deficits the US runs. For 6 years I’ve held the view that the US dollar will lose its status as reserve currency, and will depreciate by a staggering amount, and for 6 years I have been wrong. Although crude commodity prices such as petroleum and grains have essentially doubled since 2004, broader purchasing power and foreign exchange rates remain largely the same.
So we come to the critical question of what to expect regarding banking crises and sovereign debt crisis. While deterministic logic implies that an eventual default (real or through inflation) by many Western countries is inevitable, the non-deterministic nature of economics says that this view needs to be taken with a grain of salt. If the economy was governed by deterministic laws such as Newtonian physics, then this default would indeed by inevitable. If, on the other hand, economics is largely stochastic, and furthermore it is fundamentally altered by the expectations of market participants, we come to a different conclusion. In this case, a default only can be assigned a probability, and thinking of it as a certainty is an impediment to clear thinking. Perhaps the saying "markets can remain irrational longer than you can remain solvent" should be modified to read "markets are irrational – don’t become insolvent."
Market Wrap-up
Equity markets ended the day higher by approximately 1% as investor expectations for Fed juice increased. (As a result of this rally perhaps Ben Bernanke now will soften any message regarding additional quantitative easing in his congressional testimony tomorrow!) The two year treasury yield pushed to new intraday lows (0.56%) but rebounded by day end. Ten year bond yields were lower as well and also reversed late in the day. Crude oil and precious metals finished up roughly 1% as the risk trade retreated across the board. Natural gas finished up by more than 2% at $4.61 as hurricane worries and expectations of a low inventory number started to drive the market. My natural gas inventory model predicts an inventory fill of 49 BCF for Thursday.
