Betting on Economic Recovery. Flirting With Disaster.

Markets were dallying last we checked, up a bit, but not enough to sway an opinion. The majors in the US are up on average 5% for the past month, aided, as far as we can tell, by slapdash political rhetoric, myopic investor optimism and cherry-picked data analysis. That said, a 5% gain is a good month by just about anybody’s measure. So why are we so dour?

The short answer is, “we’re not…we’re just cautious.”

In his terrific book, Fooled By Randomness: The Hidden Role of Chance in Life and in the Markets, Nassim Nicholas Taleb explores, among other things, something he calls the “zoology” of bullish and bearish sentiment. In one particular example, Taleb describes the scene in a New York office when he is asked to give his forecast on the trajectory of the market over the coming week.

Taleb answers that he thinks the market will rise. He gives it a 70% probability of doing so, a seemingly bullish outlook.

“But Nassim,” interjected one of his colleagues, “you just boasted being short a very large quantity of S&P 500 futures, making a bet that the market would go down. What made you change your mind?”

“I did not change my mind,” replied Taleb. “I have a lot of faith in my bet! As a matter of fact I now feel like selling even more!”

Taleb goes on to explain that, although he suspected that the market would move higher, it was preferable to short it because, “in the event of its going down, it could go down a lot.”

In other words, the possible upside of going long – even though that outcome was, by his own analysis, more likely – was marginal compared to the dire consequences of what would happen in the less likely scenario that the market tanked.

“How frequent the profit is irrelevant,” writes Taleb. “It is the magnitude of the outcome that counts.”

US markets are, on average, up some 50% since their lows just over a year ago. That’s an incredible bounce, to be sure, one for the history books. Nevertheless, the steps higher seem less and less resolute, more and more tentative. It’s as if a mountain climber, after a momentous ascent, suddenly remembers that he has an acute case of acrophobia. Where to now?

The markets might well rise a little in the coming weeks, in other words, but they might also fall…a lot. We’d rather miss out on a minor advance in stocks than suffer a cataclysmic retreat. There are a slew of worrying macro-catalysts that inspire more than a little trepidation in your editor’s heart. Here’s one:

China and Japan, the two largest foreign holders of Treasurys, are slowly, steadily, incrementally reducing their exposure to American government debt. Now, if you were sitting on $900 billion or so of US debt – as China happens to be – and you wanted out, you couldn’t simply bolt for the door. That kind of movement would spook the market, signaling a run on the dollar and decimating the value of your remaining holdings. Instead, you’d have to creep out very quietly…exactly as China and Japan appear to be doing.

Bloomberg reports: “China has been a net seller of Treasuries for three straight months, the longest such stretch since the end of 2007. Chinese officials have questioned the dollar’s role as a reserve currency and recently sought assurances about the safety of US government debt as the budget deficit widens to a projected record $1.6 trillion this year.”

The relationship between America and her foreign creditors is one built primarily on faith. China, Japan, Russia, Taiwan and the rest of world’s dollar holders rely on the “full faith and credit” of the United States government to stand behind its currency, the world’s reserve. But faith is a fickle thing. It takes a lifetime of monogamy to forge a faithful marriage…but just a single night of reckless abandon to destroy one.

The “recovery” may well deliver a few more sessions of stock market passion, in other words, but those tempted to flirt with it are advised to remember the wrath of a lover scorned.

Joel Bowman
for The Daily Reckoning