Sunday, September 28, 2008

rumination on emotion in markets

I'm new to the blogosphere, but one thing I've learned is what weekend blogs are for, when one has nothing better to do - ruminating aloud about the long-run before voting instead for a short walk. Of my 50+ readers, I'm amazed none complain about the length or the blogs (only grammar & spelling); widespread agreement - so far, so good. So, emboldened, I ruminate on about emotion and gut-feel in the markets. One reason young traders are given a lot of money to play with is that they are better at short term returns, more profitable generally, in part because they don't ruminate and ask themselves why? Gamblers lose as soon as they try to analyse luck. Older heads underperform once they try to understand the big picture. Dealers are like cartoon figures running off the edge of the cliff, flying high until they look down! Markets and banks too may be accurately caricatured to behave like this. Recall Bradford & Bingley, one of the first banks whose Internal Capital Adequacy Assessment and Regulatory Capital provisions were formally approved by the FSA under CRD/Basel II, as it began falling off the cliff its Chairman and CEO said, by way of excuses, that they did not know the true position they were in; the accounting system was inadequate. B&B was not alone. Similar admissions came from other banks such as UBS and Bear Stearns. Many more banks are under pressures from the regulators to fill gaps in their risk accounting including profitable and eminently solvent banks such as Lloyds TSB (provisioning for its Life arm) and Fortis that has suffered from shorting and rumours of liquidity problems and additional capital buffer proisions insisted upon by the Dutch Regulator, DNB. Many banks have suffered from their accounts being disbelieved i.e. gut instinct emotions.
There is a literature about whether markets have emotions that is akin to that in zoology about whether animals have emotions. Commonsense says, of course they have, in fact that's often all they have. In animals, emotion overlaps with instinct. Instinct is tacit knowldege, what we know to do without thinking about it. For decades this is what computerisation means, automating tacit knowledge into decision-taking systems. In financial markets, chief dealers, market-makers, brokers have been disintermediated by algorithmic trading systems, and by chartism, risk gradings and general risk analysis, much of it supporting intra-day arbitrage. Chief dealers, in my opinion, remain far superior to automated trading strategies. But, do not underestimate the latter. The markets are staked out with kneejerk response trading algorithms that when TARP is passed will swarm over the up-tick (market pheromones) like ants on an apple-core, bees to honey, flies to shit or piranha to blood. The result may be instinct or emotion or both. But, gravity also rules and what goes up most sharply also invites a tacit response to take profit and expect a severe downward correction. Regulators and central banks may have to seek to choke off and try to stabilise the rate of rise to ensure general confidence is not again punctured and the I-told-you-so doubters claim the whole thing as merely a giant flash-in-the-pan. TARP's $700bn will not be an instant liquidity release, not if hedged about by disincentives such as penalties on bonuses and governance. TARP may take months to filter through bids and acceptances. But, if interbank and equity markets rise and remain on an upward ratchet, then I fully expect the shadow banking players to seek to deprive the Fed of as much of the medium term 'hold to maturity' price profits as possible (e.g. Goldman Sach's $50bn distressed assets proprietary investment fund). I do not expect more than 68% take-up of TARP's bad bank fund - that's my Fibonacci ratio forecast.

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