A Thought Experiment

Jack McHugh engages us in this delightful thought experiment:

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"Let’s try a little thought experiment to examine just how well stock prices reflect what’s happened this year. 

Imagine it is January 1, 2007, and you have just been given the following information about what would unfold during the first 8 months of the year:

– Oil prices would rally back to over $75/bbl;
– The dollar would drop against every major currency;
– Corporate earnings would benefit from the greenback’s slide and continue to post double digit gains;
– The housing industry, instead of bottoming, would continue to slide all year;
– Home prices would actually be down in many major cities;
– Over 90 mortgage lenders would cease operating and the survivors would be on life support;
– The origination of subprime mortgages would all but cease;
– All but prime, conforming mortgage loans would be either hard to get or very pricey;
– Private equity deals would soar in the first half, but come to a halt after July 1;
– Some prominent LBO deals would have to be "eaten" by commercial and investment banks;
– The leveraged loan market would see stress;
– High yield bond spreads would widen markedly;
– Commercial paper would come into question and ABCP conduits would be in jeopardy;
– T-Bill yields would plummet into the 2% area before rebounding to fed funds minus 85 bps;
– LIBOR would actually rise from +10 bps to fed funds to +45 bps to fed funds;
– Loans for all second tier credits would either be very costly or unavailable;
– Prominent hedge funds would either blow up, face losses, or have investors seek redemptions;
– Volatility, as measured by the VIX, would triple from 12 to 37, before settling in the mid 20′s;

Given the above information, where would you expect the major stock averages to be in relation to their closes on December 31, 2006?  Ah, you need more information about how the authorities responded, right?  Well…

– The fed funds rate would still be at 5.25%, but the discount rate would be down 50 bps

– Regulators would be seeking ways to allow delinquent borrowers to remain in their homes

Now, given this admittedly limited information about market moving events and governmental responses to them, where would stock prices be?  Down 10%, 20%, perhaps? 

The answers are:

* The Dow is up just about 8% for the year
* The S&P is up just about 6% for the year
* The NASDAQ is up just shy of 10% for the year

If you are surprised, you are probably not alone.

As to whether stock prices have fully factored in the withdrawal of credit described above, it may depend upon whether or not the promises made by Chairman Bernanke and President Bush ever come to fruition (and how quickly). 

Judging just by the price action to date, however, it seems Mr. Market has decided there is little or no chance that either the markets or the economy experience anything but peace and tranquility for the rest of the year. 

Then again, the old gentleman didn’t see all the housing troubles coming in the first place. How can we be sure he so clearly sees the proper solution(s) will be applied in the future?"

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Great stuff. Thanks, Jack.

Category: Credit, Derivatives, Investing, Markets, Trading

Recursion, Reflexivity, Feedback Loops & the Fed

Category: Credit, Derivatives, Federal Reserve, Inflation, Investing, Markets, Psychology

Million+ Monthly Page Views

This month is a milestone of sorts: Its the first time we have passed a million page views in a given month:

August_2007_2

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Category: Weblogs

Five Reasons Why the Fed Will Cut Rates

Category: Credit, Derivatives, Federal Reserve, Inflation, Psychology, Real Estate

A Demon of Our Own Design

I previously mentioned A Demon of Our Own Design in a linkfest a few weeks ago. I enjoyed the book a great deal, and just about finished it over the long weekend.

The opening paragraph just reached out and grabbed me: 

Bookstaberdemon_jacket"While it is not strictly true that I caused the two great financial
crises of the late twentieth century—the 1987 stock market crash and
the Long-Term Capital Management (LTCM) hedge fund debacle 11 years
later—let’s just say I was in the vicinity. If Wall Street is the
economy’s powerhouse, I was definitely one of the guys fiddling with
the controls. My actions seemed insignificant at the time, and
certainly the consequences were unintended. You don’t deliberately
obliterate hundreds of billions of dollars of investor money. And that
is at the heart of this book—it is going to happen again. The financial
markets that we have constructed are now so complex, and the speed of
transactions so fast, that apparently isolated actions and even minor
events can have catastrophic consequences."

Terrific stuff.

Indeed, I enjoyed the rest of the book. Bookstaber was on the scene in the early days of many of derivatives now contributing to market turmoil. He rather deftly makes complex issues readily understandable, regardless of how much advanced mathematics you may have under your belt.

And, he names names. LOTS of names. All the usual suspects come under scrutiny, as well as a lot of folks who probably assumed they were not int he public eye. There will be a lot of people not very happy with his blunt, insider descriptions of the analytical errors made by major players — many of whom are still around today and in positions of authority and power. 

He also accepts a lot of responsibility for many costly errors he himself made.   

Overall, a fun, very informative read.

I was intrigued enough by the book that I contacted Bookstaber (the author) and Wiley (the publisher), and asked for their permission to reproduce the first chapter. They graciously sent me a pdf and text version, which you will find after the jump: All of chapter one, in both text form and PDF. I also included some mainstream media reviews after the chapter. 

I have pretty good relationships with many of the publishing houses — they all want to get a book or two out of me. Anyway, if it turns out you guys like this idea, perhaps we can offer up a book or two that I am reading every month in this same format. Maybe we can have an online reading group club — it could be a good place to have a full discussion. Share your thoughts.

Enjoy chapter one.

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Disclosure:  No, I don’t accept money for this — it was my idea, and I approached the publisher and author about this — not vice versa. Please don’t start bombarding me with offers to promote books I am not already reading. They will be unceremoniously deleted without response.

As noted in our disclosure section, we don’t do payola here (if you click thru and buy it on Amazon, I do see some scratch).

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Category: Books, Derivatives, Federal Reserve, Hedge Funds, Markets, Psychology

Look who’s blogging: Alan Greenspan

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Foreigners and US stocks: the ultimate contrarian signal?

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Asset Class Returns

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20 Timeless Money Rules

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