When Volatility Strikes

All market predictions are foolish, and any prediction in a market as crazy as this one is right now is particularly foolish. The Epicurean Dealmaker knows this better than most, but still he ventures a few well-hedged thoughts.

For what it is worth—not too much, I know—I do not think we are on the brink of Armageddon. I do think the damage to investor portfolios and the institutional health of financial entities is far from over, and I think we will continue to see slow-motion wreckage (some from surprising quarters) for some time to come. And the contagion is not over, either. (I predict we will finally see the end of the incredible market-defying levitation of luxury real estate in New York, London, and other financial hotbeds, as more hedge funds close their doors and investment banking bonuses get slashed.)
On the positive side, the sheer breadth and diversity of hedge fund investment strategies must mean that there are a bunch of guys out there making a killing in this market. (It might not be the obvious suspects, though.) Furthermore, people have been paying hedge fund traders 2-and-20 for years on the assumption that they are simply better at trading than mere mortals and can deliver better than market returns in periods of market distress. Now is the time for them to deliver, or go back to scalping client tickets on the govvie desk. Also, there was a day when volatility was an investment bank's friend. We will see if any of them are able to counteract the carnage in their principal portfolios and their margin books with healthy trading results.

I'm inclined to agree. We're not on the brink of Armageddon, as Brad DeLong explains:

The nightmare scenarios always involved a simultaneous collapse in the dollar and in consumer demand, and a Fed that couldn't decide whether to fight the inflation coming from rising import prices or the unemployment coming from collapsing consumer spending. Neither of those show any signs of happening.
Yet.

Indeed, the one asset which has emerged relatively unscathed from all this volatility is the dollar. Maybe the rest of the market is just catching up with the big collapse in the dollar from mid-June to mid-July, but I'm more minded to think that the credit crunch was exactly what put an end to that sell-off.

As for New York and London real estate, TED is quite right that it's very closely correlated to financial-industry incomes. The question, then, is whether banks and hedge funds are going to profit from this volatility, or rather get hit by it, make smaller profits, and start laying people off. It's the trading desks, not the loan originators, which have been driving banking-sector profits for years now, and so it's possible that the crunch might be less harmful to Wall Street than some fear.

In the case of the hedge-fund industry in particular, I would actually be very happy right now if I were a hedge-fund manager. In the present environment, a good trader can make money the old-fashioned way, through volatility, rather than having to rely on loads of leverage to eke out painful profits from illiquid assets. Besides, the whole point of hedge funds is to make money when everybody else is sinking. This could, and should, be hedge funds' finest hour. If it turns out not to be, then I think it could mark the beginning of the end of the whole asset class.

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