The Independent Market Observer

6/14/13 – Price Discovery and Risk

Posted by Brad McMillan, CFA, CAIA, MAI

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This entry was posted on Jun 14, 2013 10:08:38 AM

and tagged Economics Lessons

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This is the last piece (for the moment) on the reemergence of price discovery in the market and what it means. We have talked about how market-based pricing of interest rates may affect the fixed income and stock markets, but what about other areas? And what about the wider effects of the retreat of central banks from economic manipulation?

I have written before that, in the future, the U.S. government will be forced to be less active in supporting the economy than it has been in the past 30 years or so. This will be driven by financial constraints, particularly the unwillingness and inability to run deficits to the same degree. We’ve also seen the start of the end of the era of central bank interventions, although we certainly haven’t seen the end of the end.

What this will mean for the economy as a whole is the absence of smoothing in economic performance. Much as we witnessed in more laissez-faire eras, such as the early 1900s, we will see increased volatility in most economic and financial areas. We won’t experience the same degree of volatility, as economic shock absorbers such as unemployment insurance and social security remain in place, but a lot more than we’ve become used to in the past couple of decades.

We should also see more diverse performance from financial assets. One of the truly annoying things about the past five years or so, from an investment perspective, is how many previously different asset classes moved together. As asset classes become more correlated, it becomes much harder to create a truly diversified portfolio, driving up risk levels for everyone.

Looking back, I think a primary reason for increased correlation was the suppression of price discovery at many levels by central bank intervention. Under the presumption, largely true, that asset markets would be supported by central banks, there simply wasn’t as much reason to differentiate between asset classes. With interest rates held down, and when the Fed has your back, why not just go for the highest yield? And that’s precisely what investors did.

Without the Fed’s support, investors will have to reexamine the risk profiles of the assets they are buying—and adjust their pricing accordingly. We have seen this at the asset class level in the past couple of weeks, with high-yield bonds and equities both showing increasing volatility as investors try to figure out the real risk level. We’re seeing the same thing at the level of individual stocks.

Despite the volatility, which no one enjoys, this is ultimately a very good thing. I said in a previous post that the whole point of markets, from an economic perspective, is that they allow prices to be set that generate an economically efficient outcome. With the pricing mechanism distorted, as it has been, economic efficiency suffers, making it harder for businesses, investors, and consumers to make the right decisions.

The reemergence of price discovery will give everyone a better view of the road ahead. Think of it as removing a film of fog from the windshield —you could see before, but now you can see more clearly. While I believe the Fed’s actions were, by and large, necessary and constructive, the fact that it’s now looking to back off is an indication that the economic recovery is well under way. It’s also an indication that investors will need to watch their backs, as the Fed won’t be standing behind them for much longer.

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