current market turmoil

All of the talking heads are up in arms over the selloff in the markets over the past few weeks. The current scapegoat is subprime lending, but what has really happened is that the investing community, including many who consider themselves professionals, have awakened to the realization the market has risk. Like a pendulum, markets tend to overreact one way or the other (add in a slower summer market which exaggerates moves) before settling. For years now, investors, fuelled by an overly accomodative Fed, acted as if risk, particularly credit risk, didn't exist or could be insured away (the subject of another post). Hedge funds and dealer prop desks, using generous amounts of leverage, hired quants to develop complicated models that increase the speed and efficiency of executing a specific sttrategy. The problem is the models generally don't work when markets become nervous and people don't want to bid on securities (I would refer you to 1998 and Long-Term Capital for a more in-depth discussion). It is very difficult to value liquidity risk (the ability to transact and at what level) but, in times of turmoil, it is the most important component of risk. The bottom line is that the excesses are being wrung out of the market, as they should be. Maybe the free ride is over and investment professionals will have to go back to plain old hard work to make a living. At some point in every market (that point has been reached in some), attractive relative valuations will return. But, remember the pendulum.