The Rational Market

It is probably a good thing that the masses don't follow/care/understand the fixed income market in any great numbers. If they did, perhaps it to would be infected by manic depressive response that is pervasive in other markets. Not to say the bond markets haven't been volatile, but after the initial illiquidity-driven shockwave, that markets' actions have followed a pattern that is rational. The variables in the fixed income markets have all been reassigned different weightings in the value calculation mix, but, in general, it is the response expected given what has happened. Credit risk, fear of loss, the value of liquidity have all pushed their way to the front of the line after a long hiatus (Some have said that since this author has removed himself from active participation in fixed income, the market collapsed. I would say that is just speculation and coincidence, albeit uncanny.). The same cannot be said about other markets.



I can hear it already, what about the auction rate market, what about the muni market. Here is the response. The auction rate market isn't a true bond market. It is a bond market disguised as a money market. Money markets have had their own problems, particularly with how to value credit risk. While they are comings to grips with it, money markets may never return to the manner in which they had previously operated. The muni market is, and has always been, a completely different ball of wax than the rest of fixed income. Buyers are motivated by how much they can avoid paying to governments rather than sound financial judgement. The market even made it easier for investors by trying to stamp a AAA imprimatur on every security, reducing the investment decision to one based on tax rates. When the credit risk leg was kicked out from under the muni chair, the market searched frantically for a floor. Given the wide variety of muni issues and issuers, widespread mispricings overcame the market. When absolute (non-tax adjusted) yields reached rational levels as compared to other fixed income investments, buyers emerged providing that floor. In munis, the game has changed for the better, in the long run, as the market and its investors will need to value securities on the same basis as other fixed income investments. No longer will an outside guarantee, regardless of who is providing it, be looked at in the same way as before. Better credits will come out ahead, as the market will reward them for fiscal discipline and sound management. The rest will need to adjust their priorities to reflect the new market reality. From my standpoint, the credit crisis of the past year will end up being positive for the muni market. The old way of doing business there will end. Entrenched constituencies won't like it, but that has been the case in every market change to date.

I have spent many postings addressing the commodities and futures markets. They are both far from rational these days. They can be likened to rush hour at Penn Station. As soon as the track for a train is posted, everyone rushes to the stairs, trying to squeeze through the doorway. Getting through the door early means getting a seat, a valuable commodity for those facing an hour train ride standing at the end of a long day. The futures market is like that doorway; everyone that passes through pushes up the value on the remaining train seats for those still waiting in the station. What the gate rushers seem to forget is that there are usually more seats than riders, some are only going a short distance and will get off, and there is another train leaving in a few minutes. Still, the rush is on. What the riders seem to forget is that sometimes the train breaks down, or is taken out of service, then the rush is to get off the train. What's worse then is that there will be two train loads on people trying to fit on one train. When the speculative bid is removed from the market, and that will happen, it will be like the people leaving that train, scrambling for any way home. Some will get on the next train, some will take a car, and some will go to the bar and wait for a later train. Either way, it will cost the riders/investors something. Nine years ago, oil was at $10/barrel. When the pundits say it can't go down, watch and see the rationality flow back to that market.

Finally, the equity market has been on a roller coaster ride during all this. What is strange to me, but not surprising, is that all of the experts that have been going out of their way to say the US is in a recession are dumbfounded when corporate earnings come in weaker than expected or negative. Why? Of course they are weaker. By their estimation, there is less economic activity so they should be weaker. The problem here is that the people making the estimates are the same ones that are surprised when the estimates are inaccurate. In this market, you have to be a long-term investor or a short-term trader (you can be both, if you can mentally and physically separate the two). The long-term investor doesn't care week-to-week or month-to-month action. The short-term trader is usually a technician, in and out at predetermined level over a very short period. The equity market, however, has been dominated, publicly at least, by the analysts, making a living forecasting quarter-to-quarter earnings. With the uncertainty around credit markets and economic activity, the old rules are less applicable. In the Sarbanes-Oxley world, no company wants to overstate anything. In a perverse twist, the quality of corporate earnings have declined as a result of that legislation. When I first started trading European corporate bonds, it was difficult to get a handle on a company's earnings as they were able to hold earnings in reserve against nothing specific, which they would then reverse during a bad reporting period. This is no different really. There is enough uncertainty surrounding valuations to get away with it. Given that expectations are so low anyway, does it really matter that earning come in a little lower? I guess you can't blame equity analysts too much; it is just garbage in, garbage out. However, the market's rationality and the analyst's raison d'etre will remain in question for some time to come.