Thursday, July 07, 2005

Pricing in the risks?

As an investor trying not to lose money in this wacky market, I am always cognizant of risks that are not priced in the security markets. Risks are not well documented and outlier or in other terms, out of the blue risks (the so called Black Swan) are the ones that you want to be cognizant about. Why am I talking about this when financial markets snapped back smartly off its low since the London attack this morning? Who Cares, right? Well, let me ask you how you felt this morning waking up and looking the stock futures down 150 points. Let assume for a minute that what if 150 became 200 then 500 and would you have reacted then knowing that markets may not recover all the time (history tells us that market crashes all the time bull markets such as the one that peaked in 2000 only come once in a lifetime). Would you have cared then, I bet you would.! Unless you are one of those that bury your head in the sand when sustaining losses, I can't help you.

So what is the Black Swan that is not priced in the markets. PLENTY. Unfortunately, it may not be oil price hitting $100 (like the recent Goldman Sachs' analyst predicted, didn't hear him say oil price would be $40 when it was trading at $14. It always bothers me when people use linear projection to predict future events). Events risk that are most talked about often has either the least probabilities of impacting the market and or least impact on the markets if and when it actually happens. For instance, housing bubbles that has been talked about for 3 years now and it hasn't burst, yet. I'm sure it'll burst when I start seeing Business Week headlines such as Housing Golden Years or Quit your day job! Learn to become a millionaire landlord! etc.

So what is out of the blue that people don't talk about. It could be anything that you don't get to watch on CNBC. Let's start with something simple, how about some Chinese banks collapsing overnight because its customer couldn't meet liquidity requirements due to the economy growing ONLY at 9% versus the required growth rates of 10% to remain solvent. This in turn set off a chain of events due to inter-connectability of global instituitions nowadays that force some serious selling of financial assets to meet margin calls. Think this is far fetch, not by much, considering how leverage the Chinese economy is nowadays. But this is THE kind of events that noone is talking about and hence the impact would be the greatest.

I certainly can't make money betting on Black Swan risks but I could stay away when the markets is overvalued, option pricing is cheap (VIX all time low) and Bull/Bear spread on AAII has not inverted for weeks. Sure the market so far has shrugged off the London attack but next time the Black Swan would be bigger and darker and I'm not sure investors are prepared for that. The worst thing is that I don't even consider terrorist attacks as the Black Swan anymore...


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