thevicenarian.com

Confused Crisscrossing Markets

Posted by T.W. Hanson - Mar 12th, 2008 at 21:03

Since the current financial trouble started in the summer of 2007, stock, credit, currency and commodity markets have moved severely. Interesting is the lack of coordination. The past 48 hours are a good illustration of this phenomenon. Equity markets found the $200 billion in lending from the Fed to be fabulous news while the bonds of some of the very same equities didn’t really move. Traders in the currency markets were convinced early today that the Fed action would fail in its purpose, and pummeled the dollar. It took the equity market until the end of the day to react in a seemingly similar fashion. What is the cause of this confusion?

Analytics and quantitative models have lost the faith of the market. Tools used to value everything from the value of a mortgage to probabilities of corporate defaults are coming scrutiny. The equations, machines and historical correlations that have typically governed market behavior broke down over the summer. The variations of models used to value everything from bonds to mortgages to credit default swaps are more disjoint, leaving traders with less uniform valuation techniques. Think of a heard of buffalo all losing their sight while barreling across the Serengeti. One example was the lack was the lack of any consolidation of opinions on what the quantitative impact of the Fed’s $200 billion infusion will be.

Without the unifying models and historical correlations, specialization in training on Wall Street becomes another force decoupling the markets. As my former superiors in investment banking liked to say, “The days of the generalist are over.” Foreign exchange, corporate credit and equity people work on separate floors; it is even rare to see them at the same social functions. With all of the current turmoil, each of these worlds is interpreting data differently. For example, credit analysis often focuses on the past performance of a company while equity markets usually value securities based on future cash flows. The equity world is much more likely to forgive big write downs and look to the future while credit investors have their attentions squarely on the trauma of the past half year. We have seen more than a handful of days in 2008 where equities have traded higher while bond spreads have increased, truly irreconcilable moves in “efficient markets.”

What this will bring in the weeks ahead is volatility. Until it is somewhat clear in what direction the economy is moving or at least what the general effect of Fed policy will be, the markets will continue to move in confounding directions. Rumors will continue to fly, which have already almost brought down institutions like Bear Stearns.

Tomorrow, we get to see how the markets will interpret retail sales numbers. Consumer spending makes up over 2/3 of the economy. The number isn’t likely to be pretty, but how much of that is already priced in to the market? Wait, how much of that is priced into which market?