Wildfires

It hardly instills deep confidence in our government officials when, after nearly a year, its prime modus operandi is to react to the latest financial crisis with yet another 11th hour solution. This is one of the longer term implications of the bailout plan for Fannie and Freddie.

For all the near term good that could be construed from the latest financial wildfire containment, it is hard to understand why after nearly a year Messrs. Paulson and Bernanke are still in a reactive mode. Given all the resources at their disposal and all the warnings that are plain for everyone to see, it is most disturbing to hear the hurried pitch for unlimited back stop funds for the two GSEs.

Investment Strategy Implications

The Nouriel Roubini scenario where the write-down contagion spreads both up (the quality spectrum, which in the case of mortgages involves Alt-A’s, near prime, and prime) and out (to other categories, such as credit cards, auto loans, and corporate debt) is the nightmare scenario that is threatened by the reactionary mode of government. The economic dangers that $1 trillion (on up) in banking losses would produce cannot be fully measured. But what can be assumed with a fair degree of certainty is that the deleveraging process that such a credit creation contraction would generate will exacerbate an already fragile global economic and financial situation, if not tip the global economy into a depression.

Getting ahead of the curve, being proactive with a well thought out plan would go a long way toward instilling far more overall confidence in financial institutions and, thereby, likely result in stable if not higher asset values (not to mention a better level of consumer confidence).

Putting out wildfires is necessary and helpful but hardly sensible forest management.

Smokey the Bear would not be proud.

Not So Fine at $4.09

“She’s real fine my 409”
Beach Boys



When the price of gas in the US hit $4.09 a gallon, the song that many consumers began singing was decidedly out of tune from the one the Beach Boys sang many decades ago.

Back in the day, 409 had a different, simpler meaning. Summertime, hot rods, muscle cars, and cheap gas. Today’s tune is, unfortunately, more about demand destruction than it is about how to pick up chicks.

Demand destruction is underway on several levels with high energy prices the central part of the scene. Deleveraging is also playing a major role in demand destruction via credit contraction. Then there is threat of greater regulation and more activist governments.

I have noted this more activist role several times before. And, while the US Congress is in recess this week, recent developments show the increased regulatory threat continues and is broadening. Take for example, the recent surprise announcements re CFDs.

Contracts for difference (CFDs) is a swap instrument that many hedge funds (and no doubt other institutional investors) use to establish positions without disclosing the true nature of the ownership. Within the past few days, however, certain rules changes have been instituted by the Financial Services Authority (FSA) that took most professional investors by surprise. Below are a few links re this story.

Investment Strategy Implications

The world economy is experiencing the dark side of both globalization and financial innovation.

Developing economies, led by China with its policies of excess money creation and subsidies along with hot money flows, continue to provide the demand fodder for high commodities prices, most notably oil. Coupled with capital market flows by major institutional investors away from equities and into commodities (as an asset class, often satisfied via swaps like CFDs), the unsustainably high price of oil will produce one of two high probability outcomes – stagflation (the lite version, most likely) in developed countries or a global recession.

The contraction of financial innovation is also underway as write downs and bail outs force business model changes for financial firms while the consequences of deleveraging produce a substantial cutback in credit creation.

Gas at $4.09 or higher is unsustainable to the world economy. Developed countries can attest to that. So will developing countries, many of whom are heavily dependent on exports to developed countries’ consumers.

The Bank for International Settlements is correct when it declared that the world economy is near a tipping point. For the equity markets, the relevant primary investment question might seem to be “Have the equity markets come to fully appreciate the danger?” In other words, have prices discounted the risks?

I would propose, however, the more relevant question to ask is “Do investors correctly see the complete picture?” In this regard, the answer is more likely no.

409 was in a simpler time. $4.09 is much more complex.

Enjoy the weekend and a happy fourth.

CFD related links:
Article 1
Article 2
Article 3

It's All About the Price of Oil

Does Oil Price Speculation = Manipulation?

The US stock market could not have sent a clearer signal these past two days as to what it is obsessing on – the price of oil. For as important as the Fed’s actions are (with the same opinion being applied to the Financials and their prospective economically destructive write-downs and write-offs), the price of oil is numero uno in the mind of Mr. Market.

And in this regard, the debate rages over just what explains the high price of oil. For example, today Libya , in contemplating cutting production, joined Saudi Arabia in declaring that the physical demand for oil is being more than met by existing supply. Yet, free market ideologues continue to rant that it’s all about the physical supply/demand equation with references to the oil output crisis du jour be it Nigeria or questions re the true reserves in Saudi Arabia or impending hurricane season in the US or failure to build and update adequate refinery capacity or….well you get the picture.

The center of the oil price storm appears to rest with the battle between the US politicians and the free market ideologues. In this regard, it seems that both the politicians and the free market ideologues have got it partly right, but wrong in key aspects.

The politicians are right to focus on the speculators as they have tilted the supply/demand equation via speculative positions. Moreover, in a world where positions established cannot be determined (dark markets, OTC index and derivative related trading), it is anybody’s guess as to just how strong the demand is and to what end such demand is being established.

Where the US politicians have gotten wrong, however, is their implied (and often stated) conclusion that speculation = manipulation. In this regard, it is hard to support the view that speculation = manipulation if large asset managers (e.g. pension plans) move large sums of their investment capital into what they have come to accept as an attractive asset class – commodities. Moreover, it is hard to support the speculation = manipulation thesis when true speculators (versus large asset managers) piggyback on the speculative (not physical) supply/demand imbalance pushing prices higher. That is, of course, assuming that collusion is not occurring.

As for the free market ideologues, they are right to argue that markets tend to function best when regulation is minimized. Moreover, free market activities by speculators provide desirable liquidity, which reduces the cost of investing via smaller price spreads.

Where free market ideologues get wrong, however, is to argue that free markets are efficient markets. If anything behavioral finance has proven wrong is the unfettered markets = efficient markets thesis. In this regard, it is advisable to remember that not all speculators are price efficiency arbitrage operators. Many are momentum players joining the parade for the ride and tending to exacerbate an existing trend. Therefore, unfettered free markets influenced by large shifts of capital from major asset managers enhanced by momentum speculators allowed to establish undisclosed positions is rife for price exploitation.

Investment Strategy Implications

When it comes to today's stock market, it’s all about the price of oil. The economic havoc due to soaring energy costs has many parallels to the destruction of the credit creation process and broken business models of financial services firms and their effect on economic growth. If the US politicians and various experts are correct, the price of oil will decline once both regulatory (CFTC) and legislative action (closing the Enron and London Loopholes) take effect.

On the other hand, if the free market ideologues are correct, then demand destruction is the sole path to end of the current oil price crisis. However, that path will produce broad economic pain (how does a global recession sound?) and, therefore, significant and more onerous regulatory and legislative action, made more likely in a US election year.

On this last point: Investors operating under the assumption that the Democrats in charge of the US Congress will operate in manner similar to the way the Republicans have acted for a dozen years are sorely mistaken. Should the free market ideologues prove correct, investors will learn the real meaning of the slogan “change”.

The Death of Market Fundamentalism

commentary from this week’s “Sectors and Styles Strategy Report”*:

The US Congress was never been known for getting things done speedily. And for many years, under Republican rule, neither was it known for aggressive supervisory action. However, a decidedly more activist tone and tempo have emerged from the Democrats in charge. And the ramifications are likely to be quite significant.

The opening battleground centers on the speed and aggressiveness of the congressional Democrats (Senate and House) versus Wall Street, the futures industry, and the energy industry. Activist Democrats are on the move calling before congressional committees a steady stream of experts to testify on oil price speculation. Pressure has been brought to bear on regulatory bodies such as the CFTC. And laws are being submitted to pressure groups such as the energy companies to start drilling on the nearly 4,900 leases already granted of which less than 1,900 are in production (“Use It or Lose It”).

And it isn’t just the volume of action taken, but also the speed and a certain sense of media savvy that seems to be a part of the activist Democrats agenda. With Internet distribution of their message via organizations such as Move On and People for the American Way as well as mainstream media channels such as the “Countdown” program on MSNBC, mobilization of public opinion is moving with greater speed and power than ever before. And in the process the agenda for discussion is being set.

Republicans, in the meantime, reduced to a limited number of talk radio advocates operate in reactionary mode. The consequences of a decade of squandered opportunity.

Investment Strategy Implications

The investment implications of political matters fall into two categories: regulatory and legislative change, and public opinion. Both are being impacted by the activist Democrats. As noted above, the initial battleground centers on the price of oil. If the price of oil declines, the activist Democrats will feel emboldened as their first foray into a new era of power (speed, knowledge, informed spokespersons, and media savvy) will likely emerge. One near certain outcome will be a more aggressive regulatory regime. For free market fundamentalists, this will produce a fate worse than death.

The multi-decade era of market fundamentalism** is on the verge of ending. A more activist government appears almost certain to emerge. Bye bye laissez-faire, hello Mr. Regulator. After many years of detached government management, the pendulum appears to have swung. However, this may not be all that bad, as the detached government management style of the Bush Administration has produced poor administrative execution (e.g. Katrina) and more extreme developments in the markets (e.g. subprime). Of course, such a regulatory shift may be taken to an extreme. But that is not likely to occur for several years as political corruption takes time.

That said, it does seem probable that the death of market fundamentalism has arrived.

*subscription required
**A belief that markets are best suited to handle the trading and value of assets with as little regulatory intervention as possible.

The US Economy: The Video

If left unchecked, the mark-to-market madness is likely to produce the following effect. (Make sure the sound is on.)



P.S. Is that Bernanke and Paulson at the wheel?

Have a good weekend. (At least try to.)

Fed to Banks: It’s Your Fault

It’s hard to know what it will take for the central bankers of the world to come to the realization that liquidity conditions in the financial economy are in a very precarious position. One central banker, the ECB, seems hamstrung (or is it hidebound?) due to their single mission mandate of maintaining low inflation. Yet, it is the world's primary central banker, the US Federal Reserve, which does have the dual mandate of inflation fighting AND economic growth, that many look to for direction and support.

Since it is the US economy that is the real economy worry to investors, the Fed’s decision making should be understood as best as possible. In this regard, a careful reading of the recent numerous speeches made and congressional testimony given by Fed Governors appears to lead to the following conclusion:

The Fed is walking a fine and dangerous line between being supportive of the liquidity needs of the core of the banking system, the extent to which the US economy will slow, the risks of inflation due to the global growth story, and the moral hazard of bailing out bad banking and financial markets behavior. It does seem rather clear that its policy is to provide as much liquidity as needed to ensure that the core of the system does not collapse while at the same time allowing the market discipline to inflict a (hopefully) manageable level of pain on those who made the bad bets. It is this second part of the game plan that some investors misinterpret. For example,

There appears to be no way to interpret Fed Governor Krozner’s views as expressed this past Monday* other than to conclude that the banks got themselves into this mess and will need to find a way to get themselves out of it. As for solutions, Mr. Krozner notes that international banking regulators are "collaborating to understand the causes of the recent market turbulence and to identify steps to mitigate future problems". (Whew, glad to know that they are hard at work studying the situation.) Then there is his reference to "encouraging banks to maintain more robust liquidity buffers and develop contingency funding plans". Always good to hear words of encouragement.

Investment Strategy Implications

The market discipline philosophy apparently still lives at the Fed. For equity investors, however, the dangerous part of the Fed’s game plan resides in Soros' reflexivity - where the financial economy spreads to the real economy turning a moderate economic decline into a serious recession.

How this drama will play out? Frankly, no one knows as we are in unchartered waters. As for equities, as noted on Tuesday, according to my Expected Return Valuation Model**, stocks currently reflect the deep recession scenario. Should it appear that a deep recession can be avoided, stocks will have the economic justification for a spring rally (listen to the Stovall interview).

*”Liquidity-Risk Management in the Business of Banking”
**subscription required

Mark-to-Market Madness

It’s March, which for college basketball fans means March Madness. In the financial markets, investors are experiencing their own version of madness – Mark-to-Market madness. The idea that nearly every asset that could be priced should be priced and that price represents its fair value is absurd. Let me illustrate with the following example:


Say a homeowner has a fixed rate mortgage. Now let’s say in the mark-to-market world the bank holding that mortgage is able (required?) to continuously determine the asset value of that home based on comparable sales in the area. Suddenly, due to weakness in the housing market, the comparable homes in our homeowner’s area decline in value. What if the bank were then able to go to the homeowner and demand more money as the loan to asset ratio declined below the bank’s requirement? Demand more equity capital for an asset that the market says has declined in value. Mark-to-market in action.

Apparently, the mark-to-market madness has infected the mind of Fed Chairman Bernanke. Consider the following two segments from a recent Bloomberg article, which includes an exchange between Senator Chuck Schumer and Bernanke:

Federal Reserve Chairman Ben S. Bernanke said in congressional testimony on Feb. 28 that accounting rules may be forcing banks to put artificially low values on little-traded assets when they mark them to market. The inability to value such assets on the basis of actual trades, Bernanke said, is "one of the major problems that we have in the current environment. I don't know how to fix it. I don't know what to do about it.''

Later in the article, this:

Bernanke was responding to a question from Senator Charles Schumer, a New York Democrat, who said he had heard "from many people'' that the valuations have been "artificially low.'' That leads to a vicious cycle, he said, in which the writedowns sap bank capital and "they can't do any more lending and everything's frozen up.'' Schumer suggested one response might be to have a six-month grace period on mark-to-market. "You really don't know the value of the asset, and if you undervalue it, you may be hurting things as much as if you overvalue it.''

Bernanke didn't buy that idea.

"The risk on the other side is that if you do too much forbearance or delay mark-to-market, the suspicion will arise among investors that you're hiding something,'' he said, adding, "This is really an accounting board responsibility.''

Frankly, I am speechless. I don’t know which is worse – to admit that you have no idea how to fix a serious credit problem or to pass off responsibility of asset valuation methods to FASB. No wonder equity values tanked after the Fed Chairman spoke.

Investment Strategy Implications

If you are unfamiliar with George Soros’ reflexivity principle, I strongly suggest you get acquainted with it. The self-fulfilling nature of reflexivity is the feedback loop between the financial markets and the real economy.

The real economy is set to experience a moderate recession at worst. However, due to reflexivity, should conditions in the financial economy continue to deteriorate driven in large part by mark-to-market madness (thereby generating a graveyard spiral in asset values) the real economy may be in for a deep recession, possibly global in nature, thereby turning the currently extremely undervalued equity markets into a fair value reading.

A Delicate Balance

To reiterate the point made on this blog one week ago today, “This Fed is attempting to walk that fine line between the real economy effects of the credit squeeze, the moral hazard consequences of a bailout, and the risks that inflation eminating from the global growth story poses.”


This is the essence of the debate investors are having.

The most vocal say the Fed is not acting with a sufficient sense of urgency, that the economy needs more liquidity to avoid what in their view will be a certain recession, that the Fed is taking a far too aloof ivory tower/academic view of the economy and, in the process, is far behind the curve.

Others, the less vocal minority, believe that the Fed should not bail out bad business practices, that the moral hazard consequences send precisely the wrong message, and that the economy will manage its way through a sharp slowdown but not a recession.

And even less vocal and smaller (but slowly growing) minority believe that global growth combined with a weak US dollar will push inflation higher here in the US, which, when combined with weak US domestic growth, produces a stagflationary scenario.

What tends to be lost in all this global macro debate is the calendar.

2008 is not just a US Presidential election year, it is also the year when all members (so, that's what they are called!) of the House of Representatives are up for reelection and many in the Senate are as well. The balance of power is at stake. Well, you tell me – Will the US Congress sit idly by while the US economy rolls over into a recession? Or will earmarks and other pork barrel projects inject a fair amount of stimulus into a moribund economy?

Now, let’s also consider this issue – China. Will China sit idly by as its moment in the global sun (Olympics) becomes clouded as its primary export market, the US, slips into a serious recession? Or will they take central bank and sovereign wealth fund action to provide the necessary liquidity to ensure that its primary customer remains in decent if not excellent shape?

Investment Strategy Implications

There is every reason to believe that the Fed’s balancing act will work. However, the innovative approach taken by the Fed and other central bankers may not sit well with certain market players who want the game that was to be reinstated*. Frankly, that won’t happen. That game is over. A new financial innovation game is being molded, with several of the key components from the old game, namely lots of liquidity, as an integral part of it. To the extent that this creates uncertainty, as all transitional phases do, so be it. Uncertainty produces opportunity - for those who can see through the fear.

Bottom line: Stay fully invested. And be on the lookout for Lunch Money** trades.

*see blog postings "Squealing Away", December 12; “Searching for the Magic Formula”, November 29
**see Topics Discussed "Lunch Money"

A Cake Not A Soufflé

Re the subject of the day, everyone has an opinion so here’s mine: Fed cuts Fed Funds rate ¼ point, cuts the discount rate cut by a ½ point. That, or some version of it, is what is baked into the cake. What is not in the ingredients is a little something extra that the Fed might stir into the mix, perhaps re the terms for loans at the discount window or some other creative, unforeseen way to ease the credit risk pressure. And this may make today’s decision and accompanying language that much more interesting and informative.


Clearly, the Fed’s task goes far beyond what will appease investors. It must strike the balance between a US economic slowdown morphing into a recession and solid global growth with still considerable levels of excess money creation. For example, according to the IMF, the BRIC countries' money supply growth ranges from the upper teens (India) to over 50% (Russia). And when you include the money created by the financial innovation wizards of Wall Street, an abundance of dough is still sloshing around the world.

All this excess liquidity (along with strong global growth) points to the lingering and potentially growing risk of global inflationary pressures in the midst of a US economic slowdown/recession. For the US, this is stagflation on a global scale. And definitely unmanageable by any one central bank (with domestic considerations at the top of its to do list).

Therefore, if the Fed can continue to find the right mixture and progress in appropriate steps and if the market discipline is allowed to continue to do its part, the world’s markets might be able to work their way out of the current mess. The alternative (global stagflation) is unacceptable, let alone highly dangerous.

The Fed wants a cake, not a soufflé.

Citibank Becomes Deputy Dawg

If I've got this right, the Fed’s innovative discount window action taken last week will have the effect of “deputizing” the commercial banks that come to its discount window with collateral from sources that are unable to tap the Fed for emergency funds. The key point of the discount window deal that has not been discussed in the media is what happens when the 30-day loan is due?

Unless I am mistaken (and if someone knows otherwise, please feel free to comment), as far as the Fed is concerned it is the commercial bank, and not the institution requesting the loan through the commercial bank, that is on the hook for the money when the 30-day loan is up. Therefore, since in the eyes of the Fed the loan is owed by the bank (and not the hedge fund or mortgage banker or investment bank, etc.) one can assume that the bank accepting the collateral for the loan will be very diligent in assessing the quality of the paper it will present to the Fed as collateral. It is logical to then assume that the commercial bank will insist on strong assurances that the paper they accept and will present to the Fed for the discount window loan is good. Two things should occur from this arrangement:

• Temporary liquidity is provided where needed
• Transparency is improved

By deputizing the banks, the Fed may help further clarify the real credit risks in the system without compromising its market discipline philosophy.

Technical Thursdays: Any Port in a Storm

"There is nothing, in my judgment, that we should be doing in terms of guaranteeing market participants against losses or in terms of restraining risk taking."

Henry Paulson
article by David Wessell, Wall Street Journal, August 16, 2007



In its darkest hours as the market discipline exacts its pound of flesh from non-bank lenders and other high risk, leveraged players, certain technical indicators are flashing an interesting short term buying opportunity.

The above chart of the S&P 500 shows that the price decline in this second down wave of the current correction is not being matched by Momentum*. And with MACD right around oversold, a bounce in certain market segments is now highly probable. Among those market segments is none other than the beleaguered Financials (second chart), which is exhibiting the same such technical conditions as the S&P 500 yet with a surprising better MACD reading.

While this potential bounce will likely not resolve the current correction, it should help provide some relief to portfolios taking a beating and afford traders and speculators so inclined with an opportunity to scalp a trade or two. Any port in a storm.

*Note: this is an important non-confirmation which could be swamped in very short order should selling pressure intensify dramatically in the next few days producing a lower low in Momentum thereby confirming the decline, Nevertheless, given the rapidly rising fear factor plus the fact that the longer term moving averages have not turned bearish (see blog entry August 2, 2007), the odds favor the signal holding up. It should be noted, however, that while the Financials may be signalling a bounce, their moving average indicator has turned decidedly negative as price is below both moving averages, the 50 day crossed the 200 day, and both moving averages are pointing south. Beyond its bounce potential, definitely not a pretty picture.

To view a larger version of the above charts, simply click on the image.

Don’t Do It, Ben

excerpts from this week's report

"$400 trillion.

That is the estimated notational value of over-the-counter credit derivatives. It is the iceberg that lies beneath the surface of the increasingly (yet not fully) visible sub prime tip. And it represents a potential force that could precipitate a massive financial, and ultimately economic, contagion. Yet, it remains largely beneath the surface in both actuality and in investor’s consciousness. But that is sure to change.

With each passing week, it is becoming increasingly evident to many investors that there is much that lies beneath the surface – unseen and little known. Gradually, however, in drips and drabs, the risks taken during the now deceased era of the “Great Moderation” are ever so slowly revealed through corporate bailouts and hedge fund blowups. And, in the process, bit by bit, the market discipline of the Bernanke Fed does its work. Despite the howling from the mansions in East Hampton..."

also in this week's report

• Current Blue Marble Research Fed Valuation Model
• 2Q07 Earnings Update
• Blue Marble Research ETF Model Growth Portfolio
• Key Economic Indicators

Note: To gain access to this week's report (and all previous reports), please click on the Blue Marble Research Services link to your left for info.

Will Bernanke Blink?

The pressure is building as the cold turkey effect of the Fed and Treasury's mantra, the market discipline, is being felt with greater intensity with each passing week and cries of "rescue me" can be heard (see Cramer's tirade from last Friday on youtube for a good example of bellyaching at its best).

As the sub prime debacle evolves into the tipping point for the larger mortgage market mess unfolding, most importantly, the tip of the much larger credit derivatives iceberg still remains well below the surface of understanding. And therein lies the real danger to the global financial system and, ultimately, the world economy. Can the global financial system de-leverage itself without precipitating contagion? Which brings us to today’s FOMC decision.

Those expecting today’s Fed announcement to contain the easy money/Greenspan elixir are sure to be disappointed. Should the Bernanke Fed back off its market discipline philosophy however, then the financial markets will almost certainly celebrate the return of the Greenspan put. If, on the other hand, the Bernanke Fed sticks to its philosophical guns and withstands the pressure to bail out bad behavior, then the risk adjustment process will continue and the balancing act of stability and growth versus contagion will continue.

With growth (global GDP and corporate earnings) still strong, inflation becoming more of a concern, and the absence of the financial contagion reaching beyond Wall Street (broadly defined) and into the traditional banking system and the real economy, my bet is on the other guy, not Bernanke, blinking – as in blinking away their tears.

Bye, Bye Greenspan Put. Hello Market Discipline.

You may recall that the Greenspan Fed had the tendency of acting preemptively, seemingly at the first sign of danger. Moreover, the Greenspan Fed was far more inclined to view nearly all difficulties experienced by financial institutions as a reason to step in and provide whatever liquidity was needed to avoid contagion from erupting. Both facets gave the impression that the actions of the Greenspan Fed relied heavily on the artistic judgment of the Fed chairman.

Contrast that with the Bernanke Fed, which appears to take a more deliberative and detached approach to action preferring collegial confirmation to prescient preemption. This is not to say that the Bernanke Fed will not act preemptively if it has to. No doubt it will. However, preemption does not appear to be first option taken. Then there is perhaps the single most significant difference of the Bernanke Fed versus the Greenspan Fed: it’s reliance on the principle of the “market discipline”.

Time and again, the market discipline mantra has been espoused. By Fed heads and Treasury Secretary Paulson. However, the implications of this point are often ignored by equity investors possessed with animal spirits, too much liquidity, and the pressure to perform (see prior comments on the issue of hedge fund and traditional equity managers and the pressure to perform).

Investment Strategy Implications

There is a two-fold difference between the Greenspan era and the current one under Bernanke. First, unless the circumstances warrant it, the Bernanke Fed is far less likely to act preemptively. Second, the Bernanke Fed is more likely to let the markets exercise a market discipline, which has been defined as the first line of defense against excess risk. In other words, there is no Bernanke put. You play, you pay.

The larger issue that remains to be learned is just how effective the new regime (both meanings) will work out when (not if) a major financial or economic crisis hits. Put differently, can the Bernanke Fed manage a crisis without resorting to a flood of liquidity, which has the unintended consequence of generating the next bubble? And that will be the mother of all tests for the professor turned Fed chairman.

Why Stocks Are (And Will Remain) Undervalued

“Risk can now be sliced and diced, moved off the balance sheet, and hedged by derivative instruments.”

Remarks by Chairman Ben S. Bernanke
May 15, 2007: Regulation and Financial Innovation

Chairman Bernanke’s remarks yesterday to the Federal Reserve Bank of Atlanta's 2007 Financial Markets Conference highlight an issue that I have written about on numerous occasions – the degree of uncertainty brought about by financial innovation. As with Globalization, financial innovation has produced many benefits. However, what is often ignored is the downside, the risks that accompany our brave new world. As Mr. Bernanks goes on to say:

“Indeed, the need for better risk sharing and risk management has been a primary driving force behind the recent wave of innovation. But in some respects, new instruments and trading strategies make risk measurement and management more difficult. Notably, risk-management challenges are associated with the complexity of contemporary instruments and trading strategies; the potential for market illiquidity to magnify the riskiness of those instruments and strategies; and the greater leverage that their use can entail.”

A major component of the Fed’s plan to deal with this complexity is a reliance on what is known as market discipline. Harry Paulson cites it often and Mr. Bernanke referred to it in yesterday’s speech as follows:

“…part of an effective risk-focused approach is the promotion of market discipline as the first line of defense (emphasis added) whenever possible.”

Investment Strategy Implications

Isn’t the first line of defense the one that bears the greatest risk? If credit derivatives and other financial innovations that have sprung up over the past years have become so complex that most professional investors have little full knowledge of their consequences (a point referenced time and again at the hedge fund seminars that I have conducted), then shouldn’t stocks always reflect that enhanced risk* and, therefore, never close the valuation gap to fair value (see Fed Model to your left) thereby remaining undervalued for the foreseeable future? I think so.

*Along with other macro risk factors such as the unknown consequences of Globalization as well as geo political issues.

Note: Chairman Bernanke’s remarks can be found at http://www.federalreserve.gov/boarddocs/speeches/2007/20070515/default.htm