jmorace

More Thoughts on Mohamed El-Erian's 'When Markets Collide'

dlaw's liquidity comment is interesting. It seems to me all of modern portfolio theory is predicated on the assumption of an ever expanding amount of money which inevitably pushes up the price of something. So, Central banks pump liquidity into the system and a bull market(or bubble) forms. Even when the bubble bursts, the next effect on wealth is that it has increased in the system as a whole. And so a portfolio allocation method like QPP makes intuitive sense. It’s trying to capture the sweet spots where the next expansion will happen.

But here we are in a situation where 'liquidity' is contracting in spite of central bank action (or error in the case of the ECB.) All the institutions are delevering. El Erian discusses this. Of course it becomes a vicious cycle. And it is a key question for the moment. What happens to the QPP modeler in a deflationary environment when prices of all assets go down? Granted these periods are rare, but that's because the central banks have inflated each and every asset (financial or hard) they can, now there are none left to expand. Maybe they can get them to expand again. But it is just as likely that they will fail in this effort So we must think through the possibility of asset prices deflation on our portfolios.

Sounds crazy, I know but deflation is not a rare thing. It’s rare just in our lifetimes. The thirties, post panic of 1907, civil war period. There are many other examples. So it can happen, and it is a not a ’black swan’ and how do we model for this possibility now?