MONEY WHERE THEIR MOUTHS AREN'T:

The future's so bright?: The markets are pricing in tranquillity as far as the eye can see. The commentariat begs to differ. (Lawrence H. Summers, December 26, 2006, LA Times)

THE YEAR 2007 will begin with a vast divergence between the popular view of global risks and the risks as priced in financial markets. While the commentariat has been more alarmed about the state of the world than global markets for some years, the gap increased in 2006 as markets became more serene and everyone else grew more anxious.

The headlines and opinion writers focus on how the U.S. is badly bogged down in wars in Afghanistan and Iraq; on an increasingly unstable Middle East and dangerous energy dependence; on nuclear proliferation that has already occurred in North Korea and that is coming in Iran; on the potential weakness of lame-duck political leaders; on record global trade imbalances and rising protectionist pressures; on increased levels of public and private-sector borrowing combined with record low saving in the United States; and on falling home prices and middle-class economic insecurity.

At the same time, financial markets are pricing in an expectation of tranquillity as far as the eye can see. Stock prices in the U.S. are at all-time highs. The risk premiums that corporations or developing countries have to pay to borrow money are at or near historic lows. In addition, estimates of the volatility of the stock, bond and foreign exchange markets inferred from the prices of options are near record lows.

Why the divergence between the headlines and the markets? Will the journalists or the investors be proved right about the state of the world? Or will the divergence continue?

Bet all those commentators are heavily invested in the market too.

Posted by Orrin Judd at December 26, 2006 9:46 AM