03/18/10 Taipai, Taiwan – 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
Joel Bowman
Joel Bowman is managing editor of The Daily Reckoning. After completing his degree in media communications and journalism in his home country of Australia, Joel moved to Baltimore to join the Agora Financial team. His keen interest in travel and macroeconomics first took him to New York where he regularly reported from Wall Street, and he now writes from and lives all over the world.
The Daily Reckoning is your premier source for making sense of the news Washington and Wall Street generate. Each business day, The Daily Reckoning calls on its stable of world-class writers and thinkers to show you how to get ahead.
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Joel,
Great, well reasoned article, but, we don’t need China and Japan to buy our debt, we can buy it ourselves by printing the money, giving it to some central bank and having them buy it!
Anyway, the Bears are starting to bore me as they keep underestimating the power of the Fed to inject liquidity into the markets for however long it takes to prop them up. Who else is buying these markets? There’s no volume. Keep predicting the fall, and like a stopped clock you’ll eventually be right.
In the meantime, stand back and simply marvel at the Fed’s ability to literally print, print, print our way to new found prosperity via free cars, free houses, free credit card defaults, free health care, cradle to grave unemployment and free anything else needed to create a government generated economy where expectations are always beaten and green shoots grow, blessing our homeland forever!
Joel,
FDR knew something you obviously never got, if you do not give the masses a bone they will not allow the rich to completely screw them over, hence without some “socialism” there would be no capitalism. When you speak of countries where the people cannot demand any redistrubution of the wealth it is because those citzens as a collective are weaker due to poverty. What would satisfy your greed Sir? The Western world awash with shantytowns so that one-tenth of once percent of the population can live in luxury and everyone else can struggle to put food in their mouths? Where is your humanity? Finally, expats leave the US for things like heathcare, proper vacations, and tax money spent on clean cities, public transportation, and no homeless; instead useless b-2 bombers and 40,000 toliets. Stick with finance, you know nothing of politics and your totally misguided. Funny, that you travel and don’t get it, have your tried India?…you live in your own dreamworld.