Markets: Sometimes you just have to love them (Part 2)

Over the past sev­eral weeks, as dis­cussed in last week’s col­umn, Amer­i­cans have expe­ri­enced the upside of world­wide mar­ket activ­ity in the energy sec­tor. Specif­i­cally, despite the notion that Big Oil can manip­u­late activ­ity in both the short and long run to their advan­tage, mar­kets are far too big and adapt­able to allow such self-serving activ­i­ties to con­tinue for­ever. While they may not be per­fect, they seem to do an out­stand­ing job over time bring­ing together buy­ers and sell­ers in a way that is mutu­ally advan­ta­geous to both groups.

In this atmos­phere of com­pet­i­tive mar­kets, busi­nesses must always be on the look­out for new oppor­tu­ni­ties and ways to adapt to chang­ing mar­ket cir­cum­stances. When they do this prop­erly, they will gen­er­ally be rewarded with higher prof­its. How­ever, should their activ­i­ties prove unwise, mar­kets will pun­ish them with an unwanted out­come which may fun­da­men­tally change the way they do busi­ness thereafter.

A few exam­ples of these unwanted out­comes have been exhib­ited within the Amer­i­can busi­ness com­mu­nity of late.

Per­haps the most vis­i­ble is the deba­cle at JPMorgan-Chase. Through an incred­i­bly com­plex deriv­a­tive finan­cial instru­ment known as a “credit default swap,” Chase stood to make huge prof­its if mar­kets moved in the antic­i­pated direc­tion. So con­fi­dent were Chase oper­a­tives in their abil­i­ties to see what oth­ers could not that Chase took posi­tions (which Chase said was for hedg­ing pur­poses) amount­ing to some $100 bil­lion. Unfor­tu­nately, mar­ket move­ments did not occur as planned and mas­sive losses resulted.

Ini­tially, the losses were reported to be approx­i­mately $2 bil­lion. As time has pro­gressed, how­ever, more infor­ma­tion sug­gests some of these deriv­a­tive instru­ments may have a life that extends out to 2017 and could cause losses — depend­ing upon future mar­ket move­ments and whether Chase nets out of the posi­tions quickly — that might mul­ti­ply to within the $5 bil­lion to $8 bil­lion range.

Pay­back! Mar­kets can be bru­tal to those who guess wrong. In this case, while the num­bers seem astro­nom­i­cal, Chase prof­its may off­set such losses in a quar­ter or two. But with the hor­ri­ble pub­lic­ity that comes with this episode and the loss that share­hold­ers will see from the reduc­tion in Chase stock prices, the poor deci­sion mak­ing by involved senior exec­u­tives may be dealt with bru­tally. And all of this will be done by the nat­ural func­tion­ing of mar­kets. No doubt, par­tic­u­larly in this elec­tion year, politi­cians will get involved and may even­tu­ally fine the com­pany for engag­ing in “risky” activ­ity not per­mis­si­ble under what is known as the Vol­cker Rule. But any gov­ern­ment actions will be chump-change com­pared to the size of the mar­ket losses and the dam­age to the rep­u­ta­tion of Chase.

Another exam­ple of mar­ket pay­back may be occur­ring for a major U.S. retailer: J.C. Pen­ney. Ear­lier this year, Pen­ney decided to forego the usual retail prac­tice of seem­ingly never-ending sales and stick with every­day value pric­ing (with “sales” occur­ring only rarely). To date, it seems as though the effort is not being well received by poten­tial cus­tomers. The lat­est monthly fig­ures (on a year-over-year, com­pa­ra­ble sales vol­ume basis) are falling at double-digit rates even as many of their com­peti­tors are book­ing pos­i­tive year-over-year sales results. While it is cer­tainly far too early to declare this huge retail gam­ble a fail­ure, the early results are not tremen­dously encour­ag­ing and could sug­gest the mar­ket­place is not yet ready for such every­day value pric­ing on an on-going basis within a retail set­ting. Appar­ently, con­sumers love sales.

Finally, the recent Ini­tial Pub­lic Offer­ing (IPO) of Face­book shows the power of the mar­ket­place and its inabil­ity to be manip­u­lated on a large scale basis. For months, news reports pro­claimed that buy­ers were hun­gry for Face­book stock and share prices were likely to surge. But just before the IPO, Gen­eral Motors indi­cated they would not be pay­ing for future adver­tis­ing (about $100 mil­lion) and some 50 per­cent of Amer­i­cans indi­cated in a sur­vey they thought Face­book would be a pass­ing fancy. Come IPO day, the ini­tial price was set at $38 per share. For a short time, prices did go up that day, but then came down near the start­ing price by day’s end. And since then, the price has not gen­er­ally been treated kindly within the marketplace.

The moral to these sto­ries is that mar­kets are effi­cient and will deter­mine where they want to move regard­less of the beliefs of seem­ingly intel­li­gent busi­ness­peo­ple or inter­fer­ing politicians.

Next week: the proper role of government.

Dr. James New­ton serves as chief eco­nomic advi­sor to Com­merce National Bank and is an aux­il­iary fac­ulty mem­ber in eco­nom­ics and sta­tis­tics at OSU-Marion and OSU-Newark. Dr. Newton’s views do not nec­es­sar­ily reflect those of Com­merce National Bank or OSU-Marion/Newark.

Posted by Jim Newton on May 29 2012. You can follow any responses to this entry through the RSS Feed. Comments can be made below.