Saturday, October 25, 2008

What is the message the market is sending?

The interesting theme that emerged from last week's market mayhem is how the story driving market movements has suddenly shifted from banking problems to the overall economy. Until last week, every market move was traced back to banks or investment banks in trouble and the governments' attempts to bail them out. Last week, the collapse of the markets was almost entirely attributed to the recession that investors/economists see looming for next year.
While I am not dismissing the notion, it is worth looking at history to see how good or bad a predictor the market is, when it comes to the real economy. Someone far wiser than I once said that the market has predicted ten of the last seven recessions. I think that saying captures both the strength and the weakness of the market. Most economic slowdowns have been preceded by market declines but not every market decline has been followed by a slowdown. A drop of the magnitude that we are witnessing is signaling that economies will slow down, but we should be not so quick to jump to the conclusion about how steep that decline is going to be.
Note that embedded in every market slowdown are also the ingredients for the recovery of the economy in the future. While we should be worried about how quickly banks can return to what their real mission is - take deposits from savers and lend them at fair (reflecting default risk) interest rates to individuals and businesses - we should also take some solace in the fact that oil prices are down more than 50% from their highs, other commodities are also down steeply and interest rates globally are likely to stay muted. Many emerging markets have seen their currencies lose significant portions of value, making easier for their manufacturers to compete in a global market place. These factors will play a role in the recovery, when it comes.


Pensamientos Neoliberales said...

I'm just finding out that you have a blog now. Welcome to the blog community professor!! you have one more reader.

Mahesh Sethuraman said...

Nice balanced post amidst all the obituary writing on the economy that's occupying the press pages.

When Alan Greenspan is admitting he may have been flawed in his blind faith on self-correcting nature of free markets, and Stiglitz is feeling vindicated (not to mention Taleb), its amazing that you still have such confidence in the markets. Its your second post reinforcing the same point. I wonder what gives you this confidence on market solution?

Aswath Damodaran said...

I think it is that I trust the alternatives less. Experts are great at navel gazing, and some of them will always look right in hindsight after every crisis, but their forecasting skills are abysmal. Governments propose solutions to past problems, but these solutions in turn seem to create bigger future problems.

Kunal Kadam said...

I am obsessed with your books and teaching materials. I can't explain how thankful I am to you for sharing resources with students all over the world. I am feeling privileged to write comment on your blog.
About recent crisis, I want to relate those with the economic flow of the real goods and flow of monetary returns. I think, flow of financial goods bulged out of shape than that of the real goods and hence these crisis are evident of it's burst. Initially real goods or production output used to drive the financial markets. But recent past years control has shifted from real to financial sector and markets started driving the output of real goods. And what government is doing is that they are trying to stop the crank these crisis has produced on real economy.
When whole world is debating on the time-frame of these crisis, I am not that eligible to comment on it but what I expect is that American companies can take these crisis as an opportunity to restructure their operations to be ready with the global competition that they will face while revival.

Dmz_80 said...

I think the rapid rise of dollar in the last 3 months against the earlier predictions should come as a big relief for everyone. Logically, the dollar appreciation should boost the overall spending in US and considering that US economy is 70% consumer driven, it might just be the catalyst to avoid recession.

Anonymous said...

Hi Prof,
Greetings from Malaysia. My thoughts -
Conventional wisdom says that the market is a leading predictor of the economy.
Why is that?

Is it because the collective wisdom of all the fund managers have mistakenly trusted 'Joe the Analyst'(trademarked) who dilligently went on to recallibrate the earnings potential of a company in light of new economic data?

Well, when 'Joe and Jane Analyst' maintain or proceed to dramatically change their earnings expectation, a rational investor could be expected to get confused because if Joe and Jane Analyst can get it so wrong, what hope is there for fund managers and the investing public who had had blindly followed their advice.

Solution: Have a league table for analyst recommendation, relegate those who get it wrong, promote those who get it right!

Wenger Khairy

Unknown said...

The current economic turmoil has rattled both the developed and developing economies alike. The causes for this turmoil can be attributed to the systemic errors of the global financial system, and to a greater extend , the lack of prudent regulatory framework to curb asset bubbles. Now that we are in the middle of a full blown recession, points to a relevant question. Does recessionary behavior of Mr.Market shows some similarity with a teenager?

The market is an entity that is the consummation of all participants. Investors, speculators, financial institutions, regulators etc. The capital markets gives a premium price for efficient and profitable companies. There exists a strong correlation between the herd mentality of the market in believing asset bubbles, and subsequent bust which result in a recession. The causality of the irrational behavior of the market points to a major weakness , which is part of the capital markets; greed.

Greed forces institutions and individuals take extremely risky bets for higher returns. When greed takes precedence over prudent financial management, investment decisions become speculative in nature and evades scope for margin of safety. Creation of asset bubbles due to speculation by a sizeable chunk of the market always plays a great risk to the overall health of the economy. This always results in a situation where ; "Profits, I 'll take and Loss, we share "

All past recessions had kick started subsequent bull runs ,which takes our Mr. Market back in action with high optimism and exuberance. The swing between recession and a bull run shows a natural correlation with the mood swings of a teenager. It is high time that our Mr. Market mature and take wise decisions.