By Susan C. Walker
So "Who knew?" as gambler Nathan Detroit sings to his sweetheart, Adelaide, in Frank Loesser's timeless musical, "Guys and Dolls."
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Who knew that subprime mortgages might not turn out to be the best investment – either by the mortgagees or the investors who bought securities backed by these kinds of low-quality mortgages?
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Who knew that this house of investment cards might come tumbling down when foreclosures started piling up?
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Who knew that when a few hedge funds took a hit for their leveraged investments in subprimes that their problems might begin to affect other financial institutions?
The PhDs who put together the computer models for the quantitative funds didn't seem to know. Apparently, the quant funds have been losing money hand over fist, because their computer models didn't foresee the unforeseeable. Or so the reasoning goes.
For instance, today's Washington Post runs an interesting story about how Wall Street's mathematics mavens miscalculated. The story includes some comments from Nassim Nicholas Taleb, the author of the currently popular book about unpredictable events, called The Black Swan, The Impact of the Highly Improbable. Taleb, who is a mathematical trader himself, says: "They are very smart in front of a textbook but not smart enough to understand very elementary things in reality."
Why? The reporter goes on to explain: "He says their algorithms don't adequately account for huge, rare anomalies, such as the current surprise credit crunch…."
The problem is, the credit crunch is not a black swan. Quantitative types might not have incorporated it into their formulas and models, but that doesn't mean you couldn't see it coming.
In fact, we here at Elliott Wave saw it coming long before this 40th anniversary of the summer of love. Bob Prechter devoted a few chapters in his business best-selling book, Conquer the Crash, to a vision of how the credit bubble would burst, bringing on a deflationary depression. Here's what he wrote recently, in his July Elliott Wave Theorist:
"Today the mortgage market is leading the charge in our scenario. The latest news reports tell not only of the devastation to debt portfolios but also of the worthlessness of the rating services for protecting investors and even their complicity in covering up the collapse in the true value of many mortgages.
"Conquer the Crash was finished in March 2002. Look at Figure 2 [Editor's note: Not shown, but see below to find out how to subscribe to the Theorist.and receive a free copy of Conquer the Crash.] and notice that the fewest debt downgrades of the decade occurred that year. As Conquer the Crash said, as an investor you cannot wait until problems are obvious to act; by then it’s too late. You have to anticipate problems and then get out of the way before they happen."
So, who knew? The way we see it, today's mortgage disaster and resulting credit crunch isn't a black swan. It's simply one of many markets taking a swan dive.
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