Weekly Commentary

September 28, 2009

After closing at a post-recovery high on Tuesday of last week, the market headed south the next three days as investors assessed the impact of the Federal Reserve’s latest missive and digested some less exuberant economic data.

On Wednesday, the Fed said that, “Economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” This suggests interest rates should remain low for the foreseeable future, which may be healthy for the economy and the stock market. The Fed also said it was slowing the pace of its purchase of mortgage-backed securities. This program has helped stabilize the housing market. Unfortunately, the wording of this particular sentence made some investors think that the government will take away the punch bowl (i.e., the stimulus) a little sooner than expected. After pondering it for a few moments, investors decided it was a good time to book some profits and the market sold off shortly after the release of the Fed statement.

ONE OUTCOME OF THE FINANCIAL CRISIS may be that we have to “live with messiness.” Instead of a neat and tidy explanation for everything that happens in the markets, it may turn out that humans are sometimes irrational and, as emotional creatures, we occasionally let fear and greed cloud our financial decisions. After witnessing the current financial crisis, the tech stock bubble and burst from a decade ago, and numerous other financial storms over the past 20 years, it seems that when it comes to money, humans are still working through their issues!

In a very interesting September 2 New York Times Magazine article, Nobel Prize winner and liberal economist Paul Krugman discussed the development of economic thought over the past 230 years and how the current financial crisis has thrown economic theory into disarray. Without getting into his political leanings, Krugman makes a case that almost all economists, whether they be conservative or liberal, financial or macroeconomic, missed this crisis. Despite their impressive-looking mathematical formulas and hundreds of years of history, economists, in general, failed to predict the size and timing of our current worldwide maelstrom, and, worse yet, were generally blind to the idea that a catastrophe of this size could even happen in this (enlightened) day and age.

Krugman says economists, “Will have to acknowledge the importance of irrational and often unpredictable behavior, face up to the often idiosyncratic imperfections of markets and accept that an elegant economic ‘theory of everything’ is a long way off.” In short, he says we have to “live with messiness.”

From a practical standpoint, as an advisor, it reiterates the importance of knowing that the financial markets are not perfectly rational and that they do not always behave in the way that econometric models predict. One could argue that changes in the financial markets are simply a reflection of the sentiments, fears, dreams, and hopes of us – the market participants. The markets are not separate from us – they are us!

Since we humans are, well, human, then the markets may behave in a way that reflects human behavior and that can get quite messy. Some of us are rational beings while others tip the scale in the other direction. Knowing this helps us remain aware and on guard for extreme movements in the markets. We can’t guarantee that we’ll always be on the “right” side of extreme market movements, but you can be confident that we will sure try.  

-- Lao Tzu

Best Regards,