The Black Swan Egg

24 Jan 2008

In my earlier posting, I wrote about the Black Swan which is a super catastrophic event. In this instance, the event is the financial market. The sub-prime mortgage problem is like the Black Swan being pregnant while the market upheavals in the past week shows that the Black Swan has laid an egg! When this egg will mature into an adult Black Swan nobody knows.

The sudden drop and the equally dramatic bounce of the stock market world wide reveals two things. First there is nervousness and investors are looking at the slightest opportunity to sell. Second the world acts fast and nervousness spreads from US to the rest of the world pretty fast. The professional investors often need to stay invested .Perhaps they were the ones who sold off fast when prices are high and they are the first ones to buy back when prices are low. For the professional investors or traders, a fortune is made from selling and buying all within two days.

Professional investors act like a herd. This groupie thinking is what allows them to win over the retail investors. When they start selling, prices were high and because of their selling , prices start to drop. The retail investors start to panic and sell their shares which triggers even further drops in the share price. Prices can go almost into a free fall such as the Hong Kong market which dropped 9% in one day.

When prices are low, the pros start to buy and prices started to rise. Retail investors pick up the scent and followed suit. The suckers are the retail investors who sell low and buy high as compared to the professional investors.

Thus the recent stock market gyrations smacked of manipulation, not a pre-planned strategy but one that uses group thinking among professional investors. They can all smell the same thing. All the pros are waiting for is someone to trigger the selling in a big way and soon the herd follow suit creating a global crisis.

You can fool somebody some of the time but not everybody all the time. There will come a time when the professional investors and traders will be caught on the wrong foot. When they start to buy, the retail investors will not follow them leaving them with the baby in the same way as the banks were caught in thier own sub orime mortgage scheme! This tend will be the start of a long bear market!

But as I said the Black Swan has not arrived. It has arrived in the form of an egg. This egg has not hatched but is a matter of time before it hatches. This year will see more of such volatility ie when the egg hatch, when the Black Swan start walking then talk and when it reaches its teenage years.

The size of the US deficit is growing, like the Black Swan. It is a matter of time when the deficit will reach a level where no interest rates cuts, no increase in liquidity can save the lack of confidence in the US dollar. Notice that after the interest rates cuts, gold move up to US$900?
This is a sign that some investors are moving out of paper currencies into gold.

The US dollar now faces a depreciation problem. Who will want to put money in US dollar deposits when Euro deposits gives a higher interest rates with the added advantage of further appreciation against the US dollar? Initially, the US dollar depreciation will stimulate the markets and all appear to be well. But remember the US budget deficit and trade deficit needs billions to support its voracious appetite.What if it cannot find enough international borrowers to finance its deficits? Central banks will have to move in to buy US dollars until they reach a threshold of pain.

When it becomes obvious to the general population that the US dollar is a sinking ship, Governments will find it politically sucidal to continue to buy US dollars. Several events can trigger the speed at which the US dollar depreciates. High oil prices will mean USA have to use its dollar to buy the oil its cars are guzzling. Oil prices is forcasted to reach $160 per barrel in 2009. Another Hurricane Kratina will impose huge recovery costs in the USA. Or perhaps it can be a prolonged drought accompanied by forest fires. Or escalation of the Iraq war to Iran .

Events aside, the more serious problems are systemic. It is the breakdown of institutions and values. The most basic institution the family is resizing. 50% of all marriages end in divorce.31% of children live in single parent or no parent homes.The education system in the USA is crumbling. 60% of high school students cannot read their textbooks properly. One third of graduates cannot pass basic maths. The Enron , WorldcCom and Tyco debacles reveal corporate scandals on a scale never seen before.

The stock market volatility should be seen against this backdrop of institutional breakdowns in the USA and we will understand why it is so hard to fix.