Commentary on “The Uncertainty of Financial Markets”
by Harry Markowitz
The following observations amplify Professor Timmermann’s recent article.
1. Financial economists frequently do not have explanations, but sometimes have fairly good hypotheses: good in the sense that they fit both the micro-observations of what market players are doing and the macro-observations of what is going on at a market-wide or economy-wide level. The so-called “market break” of October 19, 1987 is an example. At that time Leyland, O’Brien and Rubenstein (LOR) and other vendors were selling “portfolio insurance.” (This is to be distinguished from “portfolio theory,” a.k.a. modern portfolio theory, or MPT, which is quite another matter.) Portfolio insurance had participants buy when the market was rising and sell when the market was falling. This positive reinforcement of stock market swings were highly destabilizing. On the Friday before Black Monday, the Dow fell about 100 points, a hefty fall given the Dow level at that time. The Presidential Report issued later says that portfolio insurers were supposed to sell on Monday $10 billion of their $90 billion “insured” positions. By the time Black Monday was over, they had succeeded in selling $5 billion — and the market was in shambles. (This view of the Presidential Report was confirmed theoretically by a simulation analysis published by Gew Rae Kim and me that showed how destabilizing a relative few portfolio insurers can be.) Portfolio insurance not only proved to be unhealthy for the market, but also extremely unprofitable for its participants. Between rapid action by the Federal Reserve the next day, and the realization by portfolio insurance's institutional participants that they would have done much better if they had chosen a reasonable portfolio from portfolio theory’s risk-return tradeoff and stuck to it, portfolio insurance rapidly faded in popularity, the market volatility which it promoted subsided and 10/19/87 became a distant historical event.
2. Portfolio insurance was based on option pricing theory, which typically assumes continuous liquid markets. On Black Monday, the markets turned out to be anything but continuous and liquid. But 10/19/87 was not the last time that this continuity assumption of option pricing theory failed those who took it too literally. Specifically, Long Term Capital Management (LTCM) — that included Robert Merton and Myron Scholes, recipients of Nobel Prizes for their work in option pricing theory — went broke because (a) they were extremely leveraged, and (b) when push came to shove, there was no immediate market for the stuff they needed to sell to reduce their highly leveraged position.
3. So what does option pricing theory and its assumption of continuous markets have to do with the current financial crisis? Option pricing theory is the principal tool used by “financial engineers” (again, no relationship to MPT-ers), to create new financial instruments from old, lately by slicing and dicing things like mortgage pools into tranches (French for slices, roughly) which now even divvy-up flows from other tranches until nobody has a clue as to who has the bad paper. The Fed has treated the banking crisis as if were a liquidity crisis. It has inflated the currency until oil costs nearly $150 a barrel, gasoline is over four dollars a gallon, and corn and wheat are out of sight. And we still have a crisis. As Allan Timmermann noted, and as Milton Friedman used to say, the Fed is almost always off with its timing. I personally think there is merit in Friedman’s view that we would be better off without a Fed, that is, without a fine-tuning, decision-making Fed. Just set modest inflation goals, like 3 percent per year, and stick to it — whatever. Those who try to set their price or wage goals above that would soon become underutilized. Inflation expectations would take care of themselves.
But what about those who suffered from this “information crisis,” including its indirect effects like nobody wanting to lend — even when they have money — because they don't know who has the bad paper? Concerning those who leverage greedily: tough! Those who bought second homes at little or nothing down and now find their second home “under water?” Walk away from your mortgage. The system sold you a free put, so put it to it. What about the ignorant folk (including more-schooled ignorant folk as well as less-schooled ignorant folk), who were talked in a really bad deal. I’m truly sorry. If fraud was involved, the perpetrators should be prosecuted. Other than that, next time please recall: There's no free lunch; If it’s too good to be true, it’s probably not true; You would be wise to buy and hold a diversified portfolio including bonds as well as stocks (the latter via an index fund or Exchange Traded Fund, or ETF); and, most important of all, remember there are sharks out there whose motto is, “There's a sucker born every minute.”