Friday, November 10, 2006

Dsicontinuity as the wrath of the Market God

The chart above depicts the price, in terms of cents on the dollar, participants in this market were willing to pay in order to win one dollar in the event the Republican won the Senate. As you can see, election bettors were willing to pay 70 cents to win a dollar if the GOP won the Senate right up until it was obvious they wouldn't, at which point the price collapsed. This is a great example of the limitations of markets, which, admittedly, have their uses, but are not nearly what they are advertised, and by virtue of the huge bets placed, need to be.

There is an old adage among traders that the market is never wrong. If one interprets that to mean that the price is always the price, I agree.

However, if one extends that interpretation to mean that markets don't exhibit, sometimes radical discontinuities, as Black and Scholes did in their option modeling or as the efficient market theory argues, then I don't agree.

Yesterday, the PBoC spooked the markets a bit by speaking of FX reserve diversification. While there are a range of options, from the extremes of continuing to add to their reserves at the current pace to dumping their reserves altogether, open to the Chinese Central Bank, the potential discontinuity is apparent. Even a small change in reserve management will have significant effects, and given the over hang of US$ reserves around the world, a tipping point could be found following even a modest policy change.

My point being that there is a huge discontinuity lurking in our financial future. At some point, the world will face the fact that there is no way that dollar holders will ever be able to convert them into goods and services at anywhere near current prices. I don't consider this so much a failing of the markets as a human misunderstanding of their limits.

Human understanding, which is the basis of all markets, sometimes moves in great strides. Today Iraq is a sovereign nation ruled by Saddam's Baath party, and the next month it isn't; today the British Pound is part of the ERM, tomorrow it isn't; today the World Trade Center stands at the foot of Manhattan, tomorrow it doesn't; these are discontinuities.

At some point, the US$ will cease to be the preferred reserve currency. At that point we will learn that Warren Buffett was right, the WMDs were not in Iraq, but in our financial system.

To borrow from George Soros, the premise that is false is that market discontinuities don't exist. They do. The way to bet against it is by buying Gold.

ps On the topic of discontinuities, remember the President's assurances that Donald Rumsfeld would remain as Defense Secretary until Bush's term ended.....oops. That decision apparently even caught some of his own party members by surprise.

If you think there will be fair warning of a shift on the US$, you might want to think twice. If I recall, the Brits were adamant that the GBP would stay in the ERM, right until they pulled it out.