More on Decoupling: Real Economy vs "Mr. Market"

I was recently challenged by market professionals why I would still argue for the decoupling theory while the global equity markets all suffered huge losses in the threat of imminent U.S. recession. Some clarifications are necessary. First, when referring to "decoupling", I meant real economies rather than equity markets. Second, I don't think the global economy operates in a binary fashion - coupled vs. decoupled. The argument is not "this time is different" because there has never been a first time, but rather I view that real economy and stock market each follow their own separate paths, up or down. However the paths might resemble in shape, they are distinct. For those more physics inclined, these cyclical waves have different phase velocity and wavelength. George Soros, the legendary Quantum Fund founder, made such a reference when interpreting boom-bust cycles in his book "The Alchemy of Finance". He called it the Theory of Reflexivity.

Without a fancy name like Reflexivity or other quantum physics mumble jumble, we could understand this notion intuitively. Imagine a father hiking on rolling hills with his 4-year-old son. The trail moves up and down gradually as the landscape changes. The father follows the trail at a predictable pace and in one direction; the son run back and forth around his father, getting excited sometimes and running ahead, and then getting exhausted and falling behind. The father and son travel along the same trail but the path patterns they travel are unique. Sometimes in the same direction and other times opposite; sometimes the child runs too far ahead and other times falls far behind. Now think the father walks the path of real economy and the erratic child walks the path of the market. Ben Graham more vividly described this manic-obsessed childish character "Mr. Market" in his book "Intelligent Investor".

In today's Financial Times, Mohamed El-Erian, the co-chief executive and co-chief investment office of PIMCO and former president and CEO of the Harvard endowment, also made the clarification on "decoupling": while markets might be highly correlated the economies might not.

Can other countries "decouple" from the problems of the US? Here, it is important to distinguish between market valuations and economic trends. An increase in the overall level of risk aversion around the world makes it hard for markets to decouple. Economic decoupling is a greater possibility, supported by underlying productivity trends and the larger degree of policy flexibility in some other key countries.

Interestingly, the FT editors also put a commentary from George Soros right next to that of El-Erian, where he refers to reflexivity:

Boom-bust processes usually revolve around credit and always involve a bias or misconception. This is usually a failure to recognise a reflexive, circular connection between the willingness to lend and the value of the collateral.

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Although a recession in the developed world is now more or less inevitable, China, India and some of the oil-producing countries are in a very strong countertrend. So, the current financial crisis is less likely to cause a global recession than a radical realignment of the global economy, with a relative decline of the US and the rise of China and other countries in the developing world.