For regular readers of this blog, you know it to be one that has a qualitative bent. That is, a dialogue dedicated to provide some amount of insight garnered from years of experience in the fixed income markets. This is not to say that I ignore quantitative methods. In fact they are quite useful to me, but that information, ex proprietary models, is readily available elsewhere and is used by the author to help draw a conclusion. I have no interest in producing that kind of information, as it would put me into a coma. The basis for what is written here is common sense. In general, if something doesn't meet the "smell" test, there is usually a problem.
Having prefaced this post with the above, it is my contention that the current troubles in the financial markets were caused by an over-reliance on quantitative models, the abandonment of common sense, as it were. Common sense and experience acts as a check on models that can't possibly account for variables like liquidity and fear of loss accurately. Certainly Long-Term Capital could have used more common sense back in 1998. Certainly, the guy that made the highly questionable statement about his model, as mentioned in a previous post, having several 25-standard deviation moves (once-in-100,000-year event). I guess that model will be pretty boring over the next million years!
Unfortunately, it remains to be seen if anything has or will change given what has happened over the past two months. I don't want this to sound like sour grapes (those of you that know me know that I have felt this way for years) but if the job boards are any indication, it looks like the financial world is ready to pile back into the models. If you have a PhD in physics, there plenty of positions open, some with seven figure compensation (guess what I'm telling my son to major in). Physics, however, won't help you when there is no bid. I've had more than one intelligent colleague tell me that the theoretical value of this or that is higher or lower than where it is trading. Sometime anomalies do exist, and there is a definitive reason for them. Market efficiencies usually take care of them quickly. The theoretical value usually doesn't take into account intangibles. That is where common sense comes in. We can hope that fear has instilled some common sense, but I wouldn't bet on it.
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As I have said many times before, you can't reduce the markets, any markets to mathematical equations. Unlike science, markets, investment vehicles and market participants do not react in the same fashion each and every time. The markets are made up of human beings hwo have many emotions, including fear and greed. When these take over logic is thrown out the proverbial window.
Quantitative models cannot acount for this. This is almost akin to trying to win a war and occupy territory without having boots on the ground. It can't be done. One needs the eyes and ears of the foot soldier who is permitted to deviate from the stated battleplan (improvisation. Quantitative methods allow for no such improvisation. At best the are an "all elese being equal" strategy. Anyone who has been in the fixed income markets, or Wall Street in general, for any length of time (17 years for me)will tell you that nothing is ever equal.
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