PLEASE NOTE that in this article reference is made to JPM/GS for illustrative purposes only.
Just before the start of the crisis, the US government came up with 1500 dollars tax credits and the cheques were sent to all Americans in the month of August 2008. Did it stop the crisis?
We can view those tax credits as one time event and its effect on the economy was very negligible. Stimulus is also one time event but of higher magnitude and spread over bigger period. Effect of that also will wane. Policy makers are banking on change in sentiments. If the consumer sentiment changes then the consumer will start spending... in turn factories will increase output expecting higher orders.... in turn taking more people on roll.. .and grand growth cycle will start. FED is trying its best to put the money in the wallet as trickle and not flood. Flooding will result in inflation.
Bulls are comparing performance of the indices today to the period 2002 to 2007. Bulls are pointing to similarities. In the year 2002, if you had taken view that Tech stocks would outperform then you would not have made money. It was because investing public (who were in dark about technology developments till the year 2000) had learnt how technology works and learnt to separate wheat from chaff. Initially, tech stocks did go up in the year 2002 only to fall back later.
Investing people need to be given some convincing arguments for the next Bull Run. This argument cannot be same as the recent Bull Run. In the year 2005, housing was convincing argument. People did not know how SIVs function. There were convincing arguments that house prices will go up.
All bubbles create jobs. FED needs to create another bubble to create jobs. If FED fails in creating another bubble, indices will fall and fall hard. At the moment, I do not see any sector pointing to the next bubble. If American policy makers fail to create another bubble, they will try devaluing dollar to keep unemployment down. This gives solid opportunity to EURO region. It will make sense for AIRBUS to grab as many orders for plane as possible even giving discount. They can try summer sale, BOGOF (buy one get one free). Further, it will make sense for all European tech companies competing with US tech companies to get in to long term sale agreement with buyers in emerging market. So, when US dollar falls it will not be the disadvantage. EURO’s recent fall has given this opportunity.
Now let us take a close look at the financial models.
The financial models essentially look at the past data and “theories developed” (which are again based on experience). These models are not deterministic as in science.
In the last few years, Credit rating agencies developed a model of “House Prices” based on the data for the last 70 years. And yes.....house prices have gone up on an average by let us say 3% in last 70 years (even accounting for recent fall). So, their model said that you can finance mortgages for houses because house prices will continue to rise. Things worked fine till house prices rose at an average price of 3% but when prices started rising astronomically things crashed. Looking back, could credit rating agencies have not alerted when house prices rose more than say 3% on an average? They may have alerted. But who would listen??
If I am a head of credit rating agency and put an alert, do you think anyone would listen? The reason is that all are a part of the system and it will be a herculean task to change the system. Deep within, everyone knows that there are dangers ahead. But can someone be realistic at top position? The answer is “NO”. If you talk constructive then you are in but if you talk realistic then you are out. So, if someone at top tries to be realistic, we will replace him. If masses try to blame bankers for the mess we are in, then they better blame themselves because this is the system that they adopted/voted.
Mark to mark accounting is one such area which needs a closer look. If we revert back to earlier system of accounting then almost all US banks would collapse overnight.
Fortunately, for traders this is an opportunity. Dance as long as music is ON putting strict stop losses. Be careful while putting stop losses as prices are most likely to jump stop losses.
All recent financial meltdowns were caused by failed models. Look at LTCM or 2008 meltdown. But, we see there is analogy in all systems. All systems give warnings, For example; cracks develop... if you do not take care then... it breaks.
Basically, world financial markets have given warning. Unfortunately, the magnitude of such warnings is going up. Recent earth quakes have given warning. I am not geo-engineer but it is quite possible that in search of oil/minerals we have dug earth so much that it is giving warnings.
The point is what if the financial models developed by JPM/GS do not take care of such eventualities? These models are not likely to have taken care as they are based on Normal distribution and not power distribution. So, we will have a situation where algos developed by GS, for stock trading start going wrong eventually resulting in GS filing for bankruptcy...and blame game will start. No one will lose job because they can blame the model. Deep within, everyone knows they can blame the model/system and escape.
-Shrihas Pandharkar,
DYOR.
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