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Expect the Unexpected

Markets can change on a dime.  Since the lows were marked in March, the last 9 months have been filled with a reflation of the risk-taking trade.  Take money out of less risky assets (treasuries, the dollar) and put that money to work in riskier assets (equities, high yield bonds, emerging market currencies, etc.).

Then comes the game changing news items:

  • Default of Dubai
  • Better Employment conditions in the US (prospect of rate hikes in the nearer future)
  • Downgrade of Greece
  • German Industrial output -1.8% versus consensus +1%
  • Japanese GDP +1.3% versus consensus +2.8%

What does this all mean?  That investors are getting skittish again and a risk reversal has gained strength.

Risk Reversal as Dollar breaks out of its downward Channel

The dollar breaks out strongly from its downward channel

Gold breaks down as the fears over inflation go by the wayside

Gold breaks down as the fears over inflation go by the wayside

What is to be learned from this?  That markets are fickle and in this environment that is particularly justified.  The world economies are in highly unstable economic positions with massive government stimulus sloshing around.  I was asked by someone in the middle of the year what I expected in the years going forward and I replied, “a lot of volatility”.  It is naive for anyone to think that he/she can invest in these unstable markets and remain “right” for extended periods of time.  For that reason, I do believe that we are in a “trader’s market”.

The current economic conditions can only be compared to the great depression and the Japanese asset bubble, but even these comparisons are a far stretch.  The only parallel that I can draw is with the relative size of the market dislocations.  At no point in the US history besides the great depression did credit spreads gap out as wide and as quickly.  At no period in US history besides the great depression did we experience the annualized volatility of 2008.  Mix that idea in with the financial de-leveraging that Japan experienced to what we *need* to experience and I think we can at least make a case that our economic environment is in the that time zone as the other two massive historical dislocations.

For the sake of argument, let us assume that March was indeed our market low and the darkest part of this economic abyss, then what does that mean going forward?

Price Retracement was the Soup du Jour after the Great Depression and Asset Bubble

Price Retracement was the Soup du Jour after the Great Depression and Asset Bubble

Volatility remained highly elevated for nearly 8 years after the bottoms were reached

Volatility remained highly elevated for nearly 8 years after the bottoms were reached

The equity market volatility was over 30% for nearly 8 years after the bottom was reached during the great depression.  After the bottom was reached in Japan’s asset bubble, equity volatility was nearly 23% for 8 years.

Intuitively this makes sense to me.  After huge market and economic dislocations, it takes years and possibly over a decade to find stabilization.  Throw in a developed country default or a period of hyperinflation and even the smartest economist’s glasses become fogged over.  We should all begin expecting the unexpected as we go forward, because no one can predict how this game is going to play out.

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Continuing the Discussion

  1. PIIGS Back on the Upward March | SurlyTrader linked to this post on May 4, 2010

    […] act as if the end of the world has just been revealed.  Long ago, I said that we can “Expect the Unexpected” and bouts of higher volatility will continue to persist for many months and even years to […]

  2. Public Debt Risk Taking Center Stage | Top Equity News linked to this post on May 4, 2010

    […] equities act as if the end of the world has just been revealed. Long ago, I said that we can “Expect the Unexpected” and that bouts of higher volatility will continue to persist for many months and even years […]

  3. Public Debt Risk Taking Center Stage | Stocks and Dollars linked to this post on May 5, 2010

    […] equities act as if the end of the world has just been revealed. Long ago, I said that we can “Expect the Unexpected” and that bouts of higher volatility will continue to persist for many months and even years […]

  4. Six Days of Nonsense | SurlyTrader linked to this post on July 7, 2010

    […] has been about 7 months exactly since I wrote Expect the Unexpected.  The last six trading days have been a glorious example of unpredictable trading in the equity […]

  5. Volatility Probability | SurlyTrader linked to this post on April 25, 2011

    […] country governments – I would call this less than a normal time.  This is why I continually expect the unexpected.  The risk flare can come from an earth quake, turbulence in the middle east, a missed payment by […]

  6. Loss of Cabin Pressure | SurlyTrader linked to this post on May 16, 2012

    […] overnight or even in half a decade.  I often refer back to a very old Dec 2009 post titled “Expect the Unexpected“.  Specifically I refer to the last two graphs that show the one month volatility of the […]

  7. Flattening of the VIX Futures Curve? | SurlyTrader linked to this post on January 30, 2013

    […] volatile rather than less volatile, but I will stick to an economic environment driven approach.  Many moons ago (Dec 2009) I admitted my ignorance in forecasting levels of the market, but thought there was one thing that was nearly certain – more volatility rather than less […]



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