A Few Observations on Financial Markets

These observations are nothing new.

Liquidity is not there when you most need it - In good times, there is liquidity for most people. Unless you are a giant player in the market, most of the time you can buy and sell without affecting the price much. You more or less know what something you own is worth. In times of poor liquidity, you have no idea what something is worth. When you are subject to regulatory requirements like banks or use high levels of leverage, you sell what you can sell as quickly as you can sell it.

Models are always wrong when they most need to be right - Models do not hold up under times of market stress. Maybe it is getting better, but knowledgeable people like Alan Greenspan basically say economic models are not any better than they were years ago. These models do not have much predictive power for the correlations between returns in situations of market stress. Remember that LTCM should have never lost so much money as it did in the history of the universe.

Similar things happen, but different enough where we don't know how to correct it in the future - All regulation tries to fix the last crisis in the markets. We never really know if a regulator was correct, but we know when they were wrong. We can never know the cost of lost opportunities due to excessive regulation and it is impossible for government to keep up with the dynamic free market. About every ten years, there is some new disruption in the market. Commodities in the late 1970s and early 1980s, leveraged buyouts in the late 1980s and early 1990s, Dot-com stocks in the late 1990s, and credit right now(also commodities and housing). Ultimately, we need creative destruction and it must be allowed to take its course rather than protecting everyone who lost money or might lose money.

Valuations come back to reality, but sometimes it takes longer than you can stand - Whether it is Dutch Tulips, Beanie Babies, or Internet stocks valuations will reflect fundamentals eventually. It is a question of when. Keynes said, "the market can stay irrational longer than you can stay solvent." Ask anyone who shorted Internet stocks in 1999. Within a bubble, many people know the prices do not make sense. They hope to make a profit according to the "greater fool theory" and get out before the prices fall back to reality. Not all bubbles could mean higher prices. The extremely low oil prices of the late 1990s did not seem to reflect the rising cost of exploration and production and the lack of new discoveries amid growing demand for oil.

I may develop these points in further blog entries with better examples and analysis, but this is a start.