Even Nobel Prize winners in economics can be wrong. Very wrong.
And be careful with the advice of market analysts. Be skeptical with the pronouncements of central bankers, especially when they're acclaimed as financial geniuses in the media and are whooped up in books such as Maestro by Bob Woodward, a Pulitzer Prize-winning journalist who may know everything about presidents but has no expertise in economics.
Indeed, even acclaimed academic experts misread markets. One can sometimes get more truth on the market by reading humor columnist Dave Barry.
That's what one thinks after reading the series of compelling essays in the book Panic, which details and analyzes various market panics from 1987 to today's mess. The latest crash happened so fast that it's easy to forget that just a year ago some prominent financial analysts were saying that things were OK and we could ride out a market downturn without much damage.
"Bear Stearns is fine. Do not take money out of Bear." That's what Jim Cramer was saying on his show on CNBC in March 2008 when Bear stock was at $62. Soon afterwards, Bear Stearns was almost worthless-or worth about as much as Cramer's famed stock for TheStreet.com, which virtually tanked overnight in the dot-com blowup of 2000.
Some of the essays in Panic are by editor Michael Lewis, who also selected pieces from Fortune, Time, The New Yorker and Bloomberg News, as well as a delightful piece by humorist Barry. Lewis begins with a simple proposition-that a popular options pricing model, acclaimed as brilliant and still used in many quarters, is wrong.
The idea, devised by Nobel prize-winning finance professors Fischer Black and Myron Scholes, is that institutional investors can avoid risk by taking a short position and increasing that position as the market falls and this will supposedly help them weather market storms. But the quickly accepted model has helped spur crashes going back to 1987.
"Managers," writes Lewis, explaining the idea, could create "put options for themselves, cheaply, by selling short the S&P as it falls, and thus in theory be free of all market risk."
Both Scholes and professor Robert Merton, who wrote a paper about the Black-Scholes model and also won a Nobel Prize, parlayed their insights into big money in the hedge fund world. Big institutional investors and traders ate it up. They believed it would save them from down markets. Indeed, the theory held that derivatives would prevent protracted down markets.
It became the received wisdom of the trading and hedge fund industries. To question it, said one trader, was to invite ridicule. "If you try to attack it, you're making a case for your own unintelligence," Lewis quoted one trader as saying. But even though Black-Scholes worked great in the classroom, it turned out to be a disaster in the marketplace.
When a market crashes, no one buys. It creates a vicious cycle. A market declines and more people must sell. As more people sell, there are fewer and fewer people who buy. Soon, the market goes into a freefall, which was what Black-Scholes was supposed to avoid.