Those who have not been a reader for the past 7 years now may not know who “Davidson” is or why his commentary fills these pages so often. His post, at the height of the panic on March 6th 2009 (the day the SPDR S&P 500 ETF Trust (NYSEARCA:SPY) bottomed) told readers he “I would be buying with cash hand over fist if I was not already in” and on March 19th said “The current market is an extraordinary buying opportunity!” proved both highly contrarian and highly accurate. Since then his contributions have soothed readers during short term volatility and provided a roadmap for rational thought.
FAS157 rule was responsible for exaggerating the relatively much smaller sub-prime issue
Brian Wesbury provided an excellent ‘look-back’ yesterday on his 2008 analysis that the Nov 2007 Mark-to-Market FAS157 rule was responsible for exaggerating the relatively much smaller sub-prime issue. It was during Congressional testimony March 2009 in which Chairman Bernanke said that FAS157 was causing misleading mark-downs of value at lending institutions and amplified fears in the financial system. Barney Frank ended the rule immediately. The equity markets found their bottom that day!!
What this says about markets is that they in truth represent a set of rules which we have implemented over time to ensure that fairness occurs. Rules are changed over time and the markets respond accordingly. If the basis for market pricing changes with our perceptions of which rules we should or not use, then market prices from one period to another are dependent on changing valuation perceptions. The rules are in constant flux as we perceive adjustments are required. FAS157 was one such rule. FAS157 came into effect Nov 2007 after the Enron debacle. We did not know how bad it would distort markets till it exaggerated the market correction in 2008-2009. Then we eliminated it. What does this say then about our use of mathematical analysis of markets?
Since the introduction of Modern Portfolio Analysis under Harry Markowitz in the 1950s, we have applied mathematical analysis to markets with a force of tsunamic proportion. Even with massive use of computing power applied no solution has been revealed where we avoid ‘Black Swans’. The reason for this is quite simple: Mathematical analysis of stock/bond markets does not work! The myriad number of CFAs, CFPs, MBAs and PhDs earned using the current academic based mathematical approach is misdirected. The answer to understanding markets is not found in mathematics, but found in behavioral observation and coming to an understanding that markets reflect human productivity under a set of ‘fairness rules’ which we change from time to time. This is precisely why mathematics cannot work to isolate a market solution.
- · Prices are human value perceptions subject to man made rules!
- · They are not and never will be mechanical measures of value.
- · Math can never be applied to human value perceptions to predict accurate times and prices!
- · Once one knows this, one becomes a better investor!
Add to all this the fact that there are various types of investors who basically fall into two categories, i.e. Value Investors and everyone else. It is the minority of Value Investors who truly know how to judge value. This is the basis for my SP500 Intrinsic Value Index. Everyone else is a market follower believing that the markets are ‘rational’. I hope we all understand that this is not so!! Markets are only rationally priced at the lows when those few Value Investors are buying. The rest of the investing world believes that some ‘Invisible Hand’ magically controls prices and these same investors believe that markets are “Efficient’, ‘Rational’ and therefore understandable through mathematical modeling.
Wesbury’s piece yesterday reveals just how subject markets are to our rules. He spotted this in 2008 as the crash was occurring. He was not alone in seeing this. He does write well about it in this piece and I encourage you to read it. This is why I give the type of advice I do. I obtain useful future insights through my review of market history.
I highly recommend that you read Wesbury’s The Myth of 2008 which is presented in its entirety below.
Brian Westbury’s Myth of 2008: FAS157
Below is Brian Westbury’s piece:
The Myth of 2008
Brian Wesbury Posted on Wednesday, May 28, 2014 @ 11:21 AM
Milton Friedman once said the main reason so many people believe The Great Depression was caused by excess speculation in the private sector, is that “the free market has no press agents. The Government has a great many press agents, and, the Federal Reserve has a great many press agents.” Unfortunately, this means they often have the ability to define history.
This is certainly the case with the Panic of 2008. The government wants you to believe a greedy, stupid and out-of-control free market banking system created the crisis. In reality, it was a simple, but corrosive, accounting rule, called mark-to-market accounting. This rule caused problems with subprime loans to become the first pure financial panic in over 100 years.
There is no arguing with the fact that bad loans were made. And, no one argues that bad loans shouldn’t be marked down. But, when markets froze (in large part due to the accounting rule), banks and other financial institutions were forced to mark-down cash-flowing, performing loans to artificially low prices. These marks amplified the actual losses from bad loans and, like wind on a forest fire, caused the flames to spread.
As Fed Chairman Ben Bernanke said in 2013, “the reason that many of us understated the impact of the subprime mortgage market was because the subprime mortgage market itself was quite small and if you assume that every subprime mortgage in the world went bad, the losses would still not have been in themselves that large.”
“The question, then,” he asked, “is what are the vulnerabilities that would transform what would be a relatively modest mis-valuation or move in asset [prices] into a much broader crisis.”
Ah, yes, that is the question! The Fed conveniently blamed it all on excess leverage and bad management. Fed Governor Kevin Warsh said in 2008 that financial institutions were threatened by “uncertain management teams, and unsustainable business models.”
Timothy Giethner’s new book tells the same tale. Every Fed speech does, too. And because the Troubled Asset Relief Plan (TARP) was pushed by Republican Treasury Secretary Hank Paulson, his book, and those who support him (including many journalists), repeat the same myth.
The only problem with this narrative of history is that it’s light on the facts. The Fed met 14 times in 2008, generated 559,000 words of transcripts, pumped a trillion dollars into the economy, and cut interest rates to virtually zero. But, the crisis went on.
In fact, after quantitative easing started and, after – after – TARP was passed, the stock market fell an additional 40%. Everyone seems to remember the day-to-day volatility of markets during Congressional votes over TARP, but the longer-term trend shows it did not save the economy. As can be seen in the chart above, the stock market continued to decline in spite of multiple and massive Fed actions. And these declines accelerated after QE started and TARP was implemented.
FAS157: QE and TARP added more than enough liquidity