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Economics and Finance, when Theory meets Reality

November 2, 2013

Economics cartoon

When I first arrived at college to enroll in the economics program, I was often greeted with a similar public view as shown above. While in school I found most economic theory to be enlightening and sensible. Only after stepping into the real world of financial markets did it become clear to me that there was a visible disconnect between economics and finance. To this day, nearly all models employed be economists don’t fully reflect reality because they either omit crucial inputs or they assume rational behavior at all times.

This week, an interesting interview exchange occurred between Rick Santelli and Nobel Economics Prize winner, Eugene Fama. In case you don’t know Professor Fama, he is clearly one of the most renowned economists in the world. In my judgment, his theories are flawless and groundbreaking while crisp and precise. Yet, in this interview the academic disconnect from reality becomes clear once again. When asked the impact of the Fed ‘Tapering’ or even selling down its $4  trillion in assets, Fama calmly says “it’s basically a neutral event… It’s No Big Deal!” In other words, according to Professor Fama, the Fed has two choices to unwind the biggest monetary experiment in history. It can either “retire”(monetize) the debt that it created which has historically always led to a collapse in confidence of the currency. Or, the Fed can just sell back $4 trillion worth of debt into the markets which would profoundly impact the bond market and interest rates. On paper, Professor Fama is correct, his thinking works with small numbers but in case of $4 trillion(25% of all US equity capitalization), it is at best presumptuous to assume little or no market reaction whatsoever. By the way, my different view of Prof. Fama on this particular subject does not diminish my enormous respect for his work but is meant to illustrate the danger of reliance on economic theory alone in order to predict financial markets. Watch the interview and judge for yourself: http://video.cnbc.com/gallery/?video=3000211021&play=1

Nobel_Prize_Winner_Eugene_Fama-

The Markets

Nothing much has happened in recent weeks in the financial markets as the status quo of major inputs remains unchanged. Once again, I would like to point to the difference in view regarding the stock market depending on time frame. As a trader, the stock market looks technically solid and healthy and there is no reason to assume calamity in the near future. As I pointed out before, as long as the Federal Reserve adds $85 billion a month to the financial markets, the risk of a sell off seems remote at best and is reflected by benign market conditions. Watch the Fed carefully for when they stop the printing press as that is the primary driver for all financial markets today as shown below:

S&P500FedBS

For the investor with a longer time frame in mind, I would like to share the following chart with you that John Hussman tweeted

Schiller PE

Clearly, the stock market is richly valued and likely to drop significantly in the next down turn. Therefore, short term gains at the expense of long term pain are the probable outcome for buy and hold investors. In my view, the Fed is unlikely to decrease QE anytime soon as that would lead to an immediate recession. However, should the market decide to raise interest rates on the Fed while QE is still in place, we would then find ourselves in a crisis in which monetary policy is without effect and government efforts difficult as the public fiscal conditions are “unfavorable” to begin with. Yet, this is an assessment of the future based on what I know here and now.  As of today, the trend points up and hopefully the wealth effect the Fed is aiming for will materialize. Good luck!

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