Markets Win

A short post to make fun of AP and deflate Tim Geithner (but just a little) by offering evidence of markets responding ahead of regulators, again.

First, AP. See this article about Geithner's letter to congressional leaders. AP worked in the adjectives "shadowy" and "complex" to describe credit default swaps, obligatory words when trying to scare readers. Here's how complex and shadowy they are: they are puts, or insurance, on an entity's creditworthiness and are traded back and forth between banks, insurance companies, broker dealers and money managers all day every day. Unlike puts on the S&P 500, they are not traded on an exchange and unlike insurance the holder need not have a financial stake in the protected debt (for very good public policy reasons you can't buy insurance on someone else's life or home). They are shadowy in the same way your office is shadowy to me because I don't work there, but would be pretty easy to understand if I did.

On to Geithner. His proposal, in summary, is to create an exchange for CDS trading, just like the NYSE. Terms, reporting, pricing and capital requirements would be standardized and transparent to regulators and participants. It's a very good idea and I commend the administration for advancing it. Off exchange, or over-the-counter, transactions will still occur, as they do with other financial products but they'll have to compete with the very reassuring benefits exchange based trading provides.

However, markets are way ahead of Geithner. Assuredly, Geithner's vision and CME/Citadel's version differ, but in small ways interesting to the industry and few others. The point is, markets saw a need and acted long before regulators (just like in Enron, BTW and, of course, for different reasons). Private enterprise has taken quite a beating in the last year, much of it deserved. But it's this little magic, which gets much less attention and happens, oh, a few million times a day, that will cure what ails us long before the government does.

If Washington doesn't kill it first, that is.

S&P 500 vs. U.S. GDP Since 1950

Frank commented that the S&P 500 is a poor indicator of the economy's health and over very short periods (days, weeks, months) I agree. Over years and decades it's a pretty good barometer. The graph above charts the S&P 500 against quarterly GDP (in 2000 dollars). The S&P is adjusted downward by a factor of eight, a rough guess for the effects of inflation in the past 58 years (data are through 10/1/08).

I generally loathe market commentary and can feel my eyes roll into the back of my skull when politicians do it. THEY HAVE NO CLUE AND ONLY SPEAK ON THE TOPIC WHEN IT'S SELF-SERVING. In fact, I'll make a standing offer to any politician who fancies herself the next Ben Graham or Warren Buffett: sight unseen I'll take the other side of your trade in any market at any time (absent inside information).

Other than two recent rather painfully burst bubbles, GDP and Mr. Market are heavily connected (BTW, for stat geeks, R-squared for this model is a reasonably explanatory .84). Though I've made fun of the Obama administration for the market meltdown since Election Day I think it's silly to assign all blame, or credit, to a president for daily movements in the stock market. I'd argue that our current crash is related to the massive underpricing of risk starting in the mid-1990s which did not fully unravel even after the dot.com crash. While there's a good case capital is on strike while the administration's plans for protection, regulation, taxation and unionization unfold, when businesses can start making money again Mr. Market will follow.