The world’s global financial markets are wonders of sophistication, risk control and, most importantly, conduits of capital. Yet, in a world of fiat currencies (paper money not backed by gold or silver), the lynch pin of this financial system is confidence. And, as much as investors, traders, regulators and politicians would like to believe the lynch pin to be beyond reproach, the fact of the matter is that, at times, the system will be put to the test.
Ask any securities trader worldwide the definition of liquidity and more than likely the response is some derivation of “how fast I can buy and sell something.” This trader mentality, in my opinion, goes a long way toward explaining the market volatility of the past few weeks.
However, for investors, if history is to be any guide, the implications of rising market volatility are quite different. You see, average investment returns come with a caveat—standard deviation. That is, the ups and downs of returns above and below the average return over time. Which is precisely why investors embrace and remember at times like this the concept of diversification so, unlike the trader, not all of their assets are moving the same way at the same time.
In the markets’ short-range memory, it was not long ago that investors faced financial disruptions from the collapse of a large segment of the nation’s savings and loan system or the 1998 Russian debt default, which precipitated the implosion of Long Term Capital Management.
Each time the confidence of the system was tested and each time it survived, only to come back even stronger. However, each time, the prospect for recovery hid behind terms such as
“lack of visibility,” “bleak” and “contagion,” as asymmetric information flows fed by a less-than-informed media challenged the very construct of confidence in the system itself. Given this history, recent events may tempt some to invoke the well-worn phrase, if it happened then, can’t it happen now?
Perhaps; but as I see it, such assumptions imply that the past is prologue and financial markets do not evolve—for the better.
Today, the fundamental strengths of the U.S. economy—personal income and corporate profitability—sit at record levels and show no developing signs of faltering. Additionally, for the first time in decades, the world’s economic growth is not solely dependent upon that in the U.S. And, perhaps most importantly, despite what recent appearances may suggest, the U.S. capital markets, are the largest, most open, liquid and active markets in the world—fully capable, I believe, of working through the current subprime disruption and fully justifying the high level of confidence it has earned.
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