Sunday 3 April 2011

Are You “Black Swan” Proof?

Bryan Rich

The first quarter of 2011 has come to a close. And while it was good for the stock market, it wasn’t good for the world. In fact it came with an unimaginable cocktail of economic shocks.

First it was floods in Australia. Then it was an earthquake in New Zealand … social uprising in the Middle East and North Africa … an intensifying debt crisis in Europe … and then the toxic combination of a record earthquake, a massive tsunami and an ongoing nuclear fallout in the third largest economy in the world.

Economist Nassim Taleb defines an event that is high-impact, hard to predict, rare and beyond the realm of normal expectations in history, science, finance and technology as a “Black Swan.”

We haven’t just seen the rare black swan, we’ve seen a flock of them!

In financial markets these events are coined “tail-events” that have an extremely low probability of occurring.

When Wall Street-ers are projecting how great the economy and stock market will be going forward or how much risk is on the table at their company or bank, they make a gratuitous allocation to account for these “tail risks.”

And as you might expect, the modeled impact of a shock event never projects a debilitating scenario for a company, much less something systemically threatening.

But as we’ve seen, those models don’t work. They don’t do well at predicting crises, nor do they do well at measuring the ultimate fallout.  Moreover, the rare events that are said to be precisely “accounted for” tend to show up with greater frequency in crisis environments. And they tend to be very destructive.

In normal times, any of the recent events would be deemed magnificent in isolation, much less in clusters — like we’ve just seen. But these are hardly normal times! This cluster of global shocks occurred in the midst of a feeble recovery that is following the worst global economic crisis on record.

Meanwhile, the markets have time and time again, shrugged off the unimaginable. And because markets have seemingly shrugged it off, government officials and policymakers have too. They’ve been emboldened … going right back to the business of forecasting robust recoveries, telegraphing rate hikes, removing fiscal stimulus and talking up the outlook.

Similarities to 2007-2008

What we’re witnessing today should give pause to anyone who simply looks back to the events that unfolded in 2007 and 2008. Because the punches then were coming fast and furious too, and with a scale that no one had a reference point for.

Advertisement

Yet like now, the markets back then seemingly shrugged it all off! Investors kept building more and more risk. And public leadership showed the same sense of denial and arrogance, until the wheels came off.

Much like 2008, despite all of the growth-damaging evidence, policymakers in Europe are ready to pull the trigger on rate hikes. This time, the Bank of England might be next. And the U.S. Federal Reserve is telegraphing hawkish moves too, which my colleague Mike Larson wrote about yesterday.

Don’t forget, less than six months ago the fear of deflation was the big risk. Now, it’s inflation. But it’s not demand driven. It’s not because the average person has access to “easy” money.

Instead, it’s the combination of China’s commodity hoarding binge in 2009 and 2010 and the recent negative supply shocks in oil and food commodities. Nonetheless, it’s flipped the switch for central bankers.

But given the fragile nature of the global economy, combined with the added immeasurable impact from the events of the first quarter, a premature tightening from global policymakers could not only solidify another global economic downturn, but exacerbate it.

Some private sector economists are starting to see the writing on the wall …

Forecasting firm, Macroeconomic Advisors just revised its U.S. Q1 GDP estimate from 4 percent down to 2.3 percent — that’s huge! It appears Goldman Sachs will have a sharp revision coming down the pike. This week they warned of “significant downside risk” to their 3.5 percent growth estimate.

Meanwhile the Fed, ECB and BOE are still hanging on to the hope that they were able to bridge the gap between the worst economic crisis since the Great Depression and a robust economic recovery.

But history shows it’s not likely …

The most extensive study on historical debt crises suggests that the decade-long build-up in credit that fueled this global economic downturn will take at least a similar amount of time to unwind.

And we’re less than halfway through it.

Regards,

Bryan

Bryan Rich began his currency trading career with a $600 million family office hedge fund in London. Later, he was a senior trader for a $750 million leading global hedge fund in South Florida. There, he helped manage and trade a multi-billion dollar foreign exchange options portfolio. Today, Bryan is the editor of World Currency Trader, a service designed to give you everything you need to trade currencies that offer the greatest profit potential with the least amount of risk.


View the original article here

No comments:

Post a Comment

Note: only a member of this blog may post a comment.