David's Macro Blog

Jon Stewart, one of the most astute and insightful commentators of our time, explains the May 6th 2010 Flash Crash in this video from the Daily Show: A Nightmare on Wall Street

If you are a day, swing, or momentum trader, how would you trade in this market? Did trading on May 6th blow through all the sell stops on the order books?

Well, I have one friend who is an accomplished trader and he related his strategy regarding this issue. He refrains from trading if the market moves too violently or if there isn’t a clear reason for the market movement (e.g. a war, terrorist attack, major corporate bankruptcy, etc.)

One supposed benefit of an electronic marketplace and program trading by black box algorithms (algos) is market liquidity that would prevent just this type of collapse. The October 19th 1987 Black Monday crash was supposedly caused by computer program trading. It happened again this time — did we learn anything?

Or, as the saying goes:

History is the same events happening to new people who experience it for the first time as though it never happened before.

Are you an expert if you make mistakes? 

Are you an expert if you make BIG mistakes?

Are you still an expert if you miss the biggest financial bubble in world history?

Let’s consider these questions while reviewing some quotes from the so-called “experts” just prior to the 2008 financial collapse and the start of the Great Recession.

“I believe that the general growth in large [financial] institutions have occurred in the context of an underlying structure of markets in which many of the larger risks are dramatically — I should say, fully — hedged.”

“Even though some down payments are borrowed, it would take a large, and historically most unusual, fall in home prices to wipe out a significant part of home equity. Many of those who purchased their residence more than a year ago have equity buffers in their homes adequate to withstand any price decline other than a very deep one.”

Financial innovation means “shocks may be less likely to result in the type of trend amplifying, self-reinforcing dynamic for sustained periods of time that can threaten the stability of the financial system… but it is unlikely to have brought an end to the periodic tendency of markets to experience waves of mania and panic.”

“Improvements in lending practices driven by information technology have enabled lenders to reach out to households with previously unrecognized borrowing capacities.”

“The use of a growing array of derivatives and the related application of more-sophisticated approaches to measuring and managing risk are key factors underpinning the greater resilience of our largest financial institutions …. Derivatives have permitted the unbundling of financial risks.”

“We’ve never had a decline in house prices on a nationwide basis. So, what I think what is more likely is that house prices will slow, maybe stabilize, might slow consumption spending a bit. I don’t think it’s gonna drive the economy too far from its full employment path, though.”

“In the financial system we have today, with less risk concentrated in banks, the probability of systemic financial crises may be lower than in traditional bank-centered financial systems.”

“The Federal Reserve is not currently forecasting a recession.”

“At this juncture, the impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained.”

Final Questions:

• Should an expert still be considered an expert AND be in a position of power and influence to repair the economy/financial systems after they didn’t even see it coming?
• Why do professionals with significant academic training, industry experience, and extensive access to real-time data mis-interpret the fundamentals and say things that look foolish in retrospect?

Perhaps the best quote to summarize the situation:

“The economy depends about as much on economists as the weather does on weather forecasters.”

What do you think? Do you have a favorite expert quote not shown above? Comment below and let me know.

See the 13-page report below for my predictions for 2010 and more:

• Stock Market
• Real Estate Market: The next wave of ARM defaults? Is it time to buy yet?
• Interest Rates: Stay low or heading higher?
• Currency
• Precious Metals
• Commodities
• Political: Will real reform be passed?
• The Blame Game
• Wild Cards
• What’s the real problem and what are the potential solutions?
• What would really shock me?

David’s 2010 Predictions

Related Post: 2009 Year in Review

Can good economic times last forever? Is it impossible to have “stable” economic growth?

This is the argument presented in Barry Ritholtz’s post: Galbraith: Financial Stability Creates Instability

Here are the essential points of the article.

• When the economy is good for a long time, people then think the good times will continue indefinitely so they take extra risk (e.g. debt).
• This additional risk eventually sows the seeds of the end of the economic expansionary period.

For example, during the 2000 real estate bubble, housing prices were thought to only go up, therefore the logical conclusion was for everyone to buy as much real estate as possible (by using financial leverage or debt) since this was an easy road to wealth.

Of course this speculation led to massive over construction of residential and commercial real estate. The resulting overcapacity caused falling prices which, as we now know, completely destroyed our financial system and the economy.

Interestingly, classically accepted econimics says that the economy can remain in a steady state – yet it never does, does it?  Ritholtz’s article explains what really happens.

Key Quotes

McCulley was referring to economist Hyman Minsky’s concept that long periods of stability cause people to take on ever more debt and ever more risk, leading to a gigantic meltdown.

Systemically-speaking, the Ponzi phase is one of risky behavior crowding out prudent behavior in a world free of regulatory controls. If risky behavior is temporarily rewarded with profit and this temporary period is long enough, then risky behavior wins and drives out good behavior.

Think we’ll remember this during the next bubble?

Related Posts

• What Bubble Are We In Now?
• Market Cycles: From Euphoria to Despair (and Back Again)

Before I share with you my 2010 predictions, we should first take a look back at the prior year’s predictions and the actual results. The main thing I keep in mind is humility. It is extremely difficult to predict the future in regard to specific targets and time ranges. Instead it is much easier to make general predictions based upon the fundamentals.

This reminds of one of Warren Buffett’s well known quotes:

“In the short term the market is a popularity contest; in the long term it is a weighing machine.”

What Happened in 2009?

• Stock market bottom and recovery
• Intraday low on the S&P of 666 in March and year finish at 1115.
• Real estate prices fall but show some stabilization
• Residential prices plummeted but leveled off in most markets. Some price appreciation at the very low end in growth markets like Phoenix and San Diego.
• Commercial real estate price continued to fall because rents and occupancy are down and loans are difficult to qualify for.
• Unemployment rose above 10% (from just 4% in only 2 years).
• Any decrease in unemployment is due a reduction in the workforce participation rate, not new people actually getting jobs.
• Credit crunch still in place but has loosened some.
• The main question is what will happen when the Federal government stops all support of the credit markets (Fannie & Freddie, FHA, commercial paper, FDIC), and many other programs to buy debt.
• The Federal government has a trillion dollar budget deficient and of course over 10 trillion dollar debt.
• State governments have deficits and debts and the problem got worse.
• TBTF – Too Big To Fail – became mainstream language
• “Privatize the profits and socialize the losses” became apparent to the public
• Failure to pass sweeping national health care reform
• Failure to pass sweeping banking regulations

Essentially the US and the world have avoided Financial Armageddon so far. The government, the Fed, and the Treasury deserve credit for the short term fix. However the main problem is still there: there is more debt than can be serviced. Many of the debts just got moved from the private sector to the public sector (i.e. Privatize the profits and socialize the losses).

Most Accurate Predictions from Last Year

“There will be a surplus of government intervention to combat mass unemployment. I expect we get close to 10% unemployment (U3) by year end.”

Right on, December’s unemployment was 10.0% (U3)

“Defaults grow beyond comprehension and models for these debts” (mortgages, credit cards, other loans)

Look at the charts and you’ll see defaults are beyond any models considered accurate just 2 years ago.

“Debt monetization and bail out of the FDIC (which wouldn’t be allowed to fail).”

Had you ever heard of “debt monetization” prior to last year? The Fed has monetized the debt through quantitative easing plus the FDIC was given an unlimited lifeline to additional funds.

Least Accurate Predictions from Last Year

“The markets have been in an uptrend since the market low in November around 748 on the S&P. This appears to be a bounce/retrace of the October market crash. A standard 50% rebound would have the S&P peak between 1000-1100. Naturally I expect this rebound to be short lived and for new lows in 2009 as companies report very low earnings.”

Well, much of this was correct, the market did retrace over 50% to the 1100 range but essentially I predicted a fall back to the market lows which never occurred. Thus, this is definitely a miss.

“Economic growth in China turning negative.”

Totally missed this one. Even if we don’t trust the numbers from the Communist government, the growth rate didn’t go negative.

“Unemployment will peak at 8.5%” under the Obama rescue plan

OK, this wasn’t my prediction (it was President Obama’s), but it just shows how clueless politicians are in general about the economy and perhaps that they are willing to say anything to be politically popular.

Quotes of 2009

“The ego has landed.”

“I had to hold my nose and stop those firms from failing.”

Also check out: Favorite Videos of 2009.