12 May 2010

Perfect Storms Or Shitty Boats?

I'm beginning to think that these are not perfect storms. I'm beginning to think these are regular storms and we have a shitty boat.

Jon Stewart on the dramatic drop and recovery of the stock market last Thursday.

Econ Prof Rajiv Sethi has pointed his usual insight to this alarming blip by re-interating a key, but rather less catchy, insight: "A market dominated by technical analysis is always going to be vulnerable to this kind of instability."

In other words, when the stock market is dominated by "smart money," everybody else can very profitably get rich by autopilot, follow the leader trading strategies. But, if too many people are trading based only on what is happening in the market itself, rather than on real world information, then these trading strategies stop working because there isn't a leader anymore.

This observation is a nice caveat to the usual "efficient market hypothesis" that is the point of departure for most finance types on Wall Street and in the regulatory arena.

Index funds and "technical analysis" (i.e. making bets on the market based upon how the market behaves) are fundamentally forms of leverage that multiply the bets of smart money investors who are relying on economic fundamentals, and marketwide leverage, as we have repeatedly learned the hard way, is a classic form systemic risk.

Indeed, the problem with the markets now may be that the market is too transparent. Rather than having to think for themselves, market participants can just watch what everyone else is doing and react. Perhaps the stock market should follow the practice of mutual funds and require buying and selling decisions to be made a day before they are executed, so that investors have to think for themselves when making these decisions and so that the rewards associated with bringing information to the market are more fully realized by those who actually do so.

This would also make after the fact insider trading investigation much easier, because it would remove the static created by technical trading techniques that can look like insider trading because they can react to changes in stock price created by insider information before the trader is even aware of the underlying information.

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