Friday, October 24, 2008

Financial futures freeze; but market opening calms down: Volatitlity is a fact of life

By now, most people have heard that the market future hit “limit lows” this morning, of -550 for the Dow.

Asian markets plunged 8-10% last night, and European markets have plunged today, as the prospects of recession seem to be much worse than first expected overseas. Crude oil prices continue to fall even though OPEC cuts production. This last drop does not seem sustainable.

CNBC has several articles, one of them talking about markets moving from “panic” to “despair”, but there is also a more balances story on CNBC: “Today’s markets: What the experts are saying,” here.

A couple of observations come to mind. Much of the panic selling is driven by arcane redemptions in hedge funds and derivatives, which come very suddenly. We’ve all heard a lot recent, including yesterday from Alan Greenspan (oops – don’t confuse the former Fed Chairman with Silicon Valley entrepreneur Aaron Greenspan), about flaws in the system that now cause freeze-ups and asset price crashes.

Volatility is a bit like a weak tree swaying in a thunderstorm. The weakest branches break and get thrown to the ground. Investors who are overly leveraged are brought to their knees. But so are people on Main Street, who borrowed too much and who are not flexible enough in the workplace with their job skills, and perhaps who do not have good connectivity with other people.

That’s why you hear the adage – to have six-eight months of cash for long term problems. That may be even more true in the fall (many market crashes happen late in the year) and at year end. Volatility ruins people who have to sell quickly because they don’t have enough cash to survive in the short term. They have to start over with nothing (and depend on others in quasi-intimate situations not of their choosing). None of this is nice to say (on the broadcast media or online) but it's true. It sounds like social Darwinism, but that seems to be how the system works. On the other hand, people who sell early and prophylactically, sometimes have major tax losses. If they think they have enough cash, they may be better off staying home (rather than “evacuating”) and riding out the financial storm. People with enough cash to go through a moderate recession, including some recent retirees, may tend to sit on things, spend very little and not try that hard to work, a process that helps feed the recession.

In the long term, people who can dollar-cost-average and who can keep buying come out ahead. Recessions, even depressions always make some people rich. That’s one reason why we have gaps between the rich and poor. They’re particularly beneficial for younger people with low debt and stable jobs. It’s a fact of capitalism, and it may make some people angry. But it’s life.

One job of regulators is to encourage some degree of confidence, that individually responsible behavior will be rewarded in the long run, and even within relatively short time horizons. Average Americans need some confidence that markets can come back to some kind of order in, say, a six month period, so they don’t have to sell out all at once. Likewise, the rule of law and confidence in the law is necessary for individual freedom and capitalism as we understand it to work. As we’ve noted, these are tied to social and familial values, which have caused major perturbations in what people believe as fair and just when it comes down to looking at individual people.

I’ve been particularly concerned about mutual funds and their invisible exposure to swaps, but I found this third quarter statement from BlackRock. CEO Bob Doll talks on CNBC this morning and hinted that today could be a good day for bargains. Several other experts predicted continued wild volatility through the end of October.

I can think of one other media measure that could help. Orpah got this started yesterday by inviting three young entrepreneurs on her show. But let’s get some more big time media outlets (like ABC 20/20) to interview some business people, especially younger ones, in Silicon Valley and talk about how they do make money in this kind of environment. There was no negativity on Orpah yesterday, and I thought that was interesting. What needs to happen, as Thomas Friedman points out, is to take the same kind of innovation that led to the Internet companies, many of which have done fairly well during the financial crisis, relatively speaking (we’re speaking of the companies that weathered the dot-com bust and came out winners) and apply it to renewable energy, and create an “energy Internet”. To help people on main street, we need to create real wealth, and that has to start with green energy. Unfortunately, we’ve squandered a lot of our mathematical imagination on financial, rather than real, engineering, and seen the folly crash.

As I post this, at 9:55 AM, I see that the Dow has recovered over 200 points from the futures low. Now the CNBC headline is “Stock sellout fails to live up to hype.” All that in the time it takes to write a blog post.

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