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FRONT PAGE CONTRIBUTOR

Chaotic Markets

Unclear Outlook

I’ve been trying for days to form a perspective on what’s happening in global markets, without much luck. And I’m not talking to or reading anyone who feels very differently.

Stock markets are plunging again in Europe and Asia, indicating a growing concern with falling economic output and a coming global recession. The dollar and yen continue to strengthen. Oil and gold continue to fall. US Treasury rates are lower across the curve, but not as much as one might expect.

US stocks are participating in the rout overseas at this moment, as they did last Friday morning. But I’ll stop short of predicting this will continue in New York today, because on Friday that turned out to be a bad call.

Markets are essentially in a chaotic state. There is no sustained pressure from economic fundamentals anywhere in the world. I can’t think of any prior period in history to compare this to.

One thing that can be said for certain is that the world is de-leveraging (“ungearing,” as traders say). When we get through this period of turbulence and people start looking at actual investments again, it will be harder and more expensive to do so with borrowed money.

This effect will be felt as a reduced amount of available capital. The financial Ferris wheel will come to rest at a considerably lower level than it reached over the last few years.

I believe that risk-management technology will also be significantly transformed. There will be considerably more “vertical integration” of risk-management practices, if you will. You’re not likely to see people taking on faith investment-grade ratings on asset-securitizations again.

That doesn’t mean that people will stop securitizing assets. There’s just too much benefit and efficiency in that process to give it up altogether. (Unless a misguided Congress tries to outlaw it.)

But it does mean that there will be a reduction in the efficiency and an increase in the cost of credit intermediation. This is part of what will make it feel like there is less capital in the world.

This much is for sure, but it’s also in the future. What remains is to understand the present.

The de-leveraging process is driving a great many investors (many of them hedge funds) to sell off large amounts of high-quality assets. I think there is a lot of people out there anxiously waiting for up-days where there is some positive news, so they can sell.

If that is a correct reading of current market dynamics, then it follows that there is significant risk of major crashes. That’s because a sharp decline on any given day could lead people to believe they shouldn’t wait to get out. And some of them won’t be given a choice, because they’ll face margin calls.

Someone is definitely stepping up to buy US assets. We saw that on Friday, which surprised everyone by being a bad but not catastrophic day in New York, after total disasters in Asia and Europe. What we don’t know is whether those assets are going into strong hands or weak hands.

Is there a value-based case for buying assets like stocks and corporate bonds?

Corporate bonds are so illiquid right now that it’s hard to justify trading them due to the extraordinarily high spreads.

And stocks are only valuable at these levels if you accept two assumptions: first, that there will be enough capital available in the coming de-leveraged world to bid stocks back up; and second, that corporate earnings will not be heavily impacted by a long recession.

The fact that an Obama administration might target corporations for big tax increases makes the outlook for earnings (and stock prices) even more uncertain.

Money and credit markets have been steadily improving in tone since the partially-coordinated moves to nationalize banks around the world that began at mid-month. It remains to be seen whether the improvement will continue.

You can’t do an analysis like this without mentioning volatility. As far as I know, no one has been taking nuclear weapons to large chunks of America’s industrial infrastructure. Farms, factories, logistical facilities, and other capital stock are pretty much in the same shape now that they always have been. So how is it possible that some very large corporations can swing in value by ten percent or more, in a single day, as has frequently happened in the past month? That reinforces the point that markets are being driven by something other than fundamentals.

The distinctive feature of chaos is that you simply have no basis for predicting what will happen next. You can’t reliably trade on any analysis in which a given outcome is more likely than any other.

The upside risk may be very large compared to the downside risk (which is limited by the fact that asset values can’t become negative). I wouldn’t be at all surprised to see US markets rise sharply from here. But I’d be just as unsurprised to see them keep falling.

At some point, everyone who is sitting on losses and has been trading with leverage will have to meet margin calls and get taken out of the market. When that happens, the financial world can start concentrating on finding a bottom. But because of de-leveraging, it will stabilize at lower levels than prevailed before the crisis.

And then we can start talking about how long it will take for the real-world economy to come back.

-Francis Cianfrocca

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