Tuesday, August 17, 2010

Predicting Black Swans

Nobody expects the Spanish Inquisition
-Monty Python

Below is an excerpt ripped from the headlines, er, "borrowed" from a free email distribution from Casey Research. It gives a nice explanation of how the market "pre-acts" to major news events and how surprises are what kills the markets.

Stock markets always react to important events in one way or another. If the event was predicted, the impact on the actual event date will be minor. Market predictions adjust prices long before the event actually occurs. If the event is a surprise, the market will react sharply.
This important insight has many applications today. For example, yes, there are still sovereign debt problems out there. But how well is the market prepared? Everyone recognizes the PIIGS problem. This could mean that the danger is partially factored into current prices. Further, double-dip debates are constant in the media. A sudden downturn wouldn’t catch everyone by surprise.
In 2008, many triggers were far less predictable – such as the collapse of AIG, Lehman Brothers, and Bear Stearns. The first rejection of TARP also threw Wall Street a curve ball. So, while there are certainly black swans on the horizon now, I have a feeling that the impact of another downturn won’t be as large as 2008. The really dangerous black swans are overlooked possibilities, such as a major economy facing a debt downgrade or an expanded war in the Middle East. These events would certainly catch Wall Street off guard and lead to big trouble.
But for more predictable events, too many people are playing it safe and are watching for a double-dip. This expectation could cushion an abrupt correction.

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