Ten Sigma Event(s)

Discussion in 'Economics' started by trader556, Dec 2, 2003.

  1. excerpts

    Freak Financial Waves

    For the financial markets, these freak waves are just as commonplace. Whether it is the 1987 stock market crash, the peso crisis of 1994, or Asia or LTCM and Russian in 1998, they are occurring with much more frequency. They now tend to follow one another in shorter succession. Chaotic patterns emerge which create outlandish swings of behavior that is translated immediately into action in the financial markets. With telecommunications now connecting the world, millions of computer screens and eyeballs are plugged into these same financial forecasts. Whenever a rogue wave appears without warning, an interconnected financial world moves collectively in the same direction. The problem lies when all players are resting on one side of the boat and a sudden shift or move to the other side is capable of producing an action that can capsize the boat.

    The reader may wonder what rogue waves and unexpected events may have to do with the financial markets. The fact is everything. The financial markets are operating under the false delusion that outliers and geopolitical events are just a sideshow or momentary event. Most experts vacillate between war and no war with Iraq. If war is considered the most probable outcome, then it will have a positive affect on the financial markets. The war is expected to be brief and in the end good for the economy and the financial markets. At best its impact is considered to be marginal. It reminds me of the Henry Hazlitt's explanation of discredited theories of "The Broken Window” and “The Blessings of Destruction.” Under this misguided theory, which permeates the financial and economic world, war and destruction create jobs, cause production to increase, and marshal resources for the output of war.1 Consumption increases since armaments are used, destroyed and have to be replaced. During war, common items of consumption may be rationed, so there is pent up demand that lies in wait until after the war is over. In short, theoretically, according to this thought process, there is nothing but good things to expect from the outbreak of war.

    Under the current state of delusion, which permeates much of post bubble Wall Street, there is always a reason to be bullish. To some, war is just another factor as to why you should own stocks. Any weakness in the markets this year has been attributed to unfounded worries over war that will clear up once the war is over. In 2001, 9-11 was blamed for the market's weakness. Last year it was corporate malfeasance. This year it is Iraq. So the reader should not be surprised at the number of articles, charts and comparisons showing war to be favorable towards the financial markets. The fact that war strategies don’t always go as planned or that deadly terrorist attacks may follow in their wake is quickly dismissed. Risk models have hedged and marginalized the risk until it is no longer significant or even nonexistent.

    History Proves The Point

    Yet history is replete with examples of exogenous events that change the course of war, the fate of nations, or the direction of financial markets. A Norman prince invades a country and changes the course of that nation. An archduke is shot and the world suddenly finds itself at war. German troops invade the Rhineland and the stage is set for conflagration. Bombs are dropped on Pearl Harbor and a reluctant nation is forced to bear arms. A well-heeled hedge fund gets overconfident, leverages its bets in one direction and nearly brings down the financial system. At the time these events erupted, no one expected them. Their genesis seemed small and insignificant, but isn’t it always this way? Suddenly a tinderbox is lit, a detonator is set off, a crisis follows and the world is suddenly different.

    The world and its markets are caught off guard when in fact they have been forewarned. Rogue waves appear more frequently under storm conditions.

    Prior to World War I, nations throughout Europe were caught up in an arms race. An assassination lit the fuse that led to war. In the 1930s war reparations and a change in politics steered Germany towards a course of confrontation. The German buildup of arms throughout the early 1930s was ignored until appeasement no longer worked. By then it was too late and another bloody war would have to be fought. In 1979 a new regime came into power in Iran through a violent revolution, changing the course of the Middle East and setting it on a course of war and a new reign of terror that continues to this day. The overthrow of the Shah and the taking of American hostages took American leaders by surprise. But that seems to be our pattern.

    America’s weakness is its foreign policy. We always seem to be caught off guard. Although our heritage is to accept pilgrims from every nation, we prefer to be isolationists. Americans have very little interest in the world outside our shores. We are thrown into military conflict reluctantly. When we fight and win, we just as quickly disarm. In the last century we were torpedoed into the first World War, bombed into the second, surprised by Sputnik leading us into the Cold War, and shocked by the invasion of Kuwait and the attacks on September 11, 2001. When we go to war and win, we naively think that we have defeated war itself. After winning the Cold War, we thought the world was safe and no other dangers threatened us. Once again we were surprised by the terrorist attacks of 9-11 and now find ourselves committed to a War on Terror and on the brink of war with Iraq.

    Financial Storm Warnings Are Ignored

    In the financial world, the pattern is the same. There are storm warnings, but like our foreign policy, they are ignored. In the 90’s a hedge fund was emboldened to leverage its bets and take large unmanageable positions in a market that had become more volatile. Its models reduced uncertainty to cold calculated odds that marginalized risk. Their models measured and confined risk to volatility. They believed their financial leverage gave them strength, when in fact it multiplied their risk of losing and made that risk more life threatening. Long Term Capital Management sailed right into a storm with no lifeboats on deck because the odds of sinking seemed so remote. In the 1990s investors stopped saving, started borrowing and spending. Surely, the good times will last forever. Sky-high market valuations and mania-like prices were dismissed as irrelevant and ignored until it was too late. 85% of investor tech portfolios have never reco