Tuesday, 22 February 2011

A textbook example of increasing risk

One can only have sympathy for the protesters in the Arab countries, demanding democracy and the most basic of personal freedoms. The stories continue to dominate the headlines and the TV screens.

But when it comes to the effect on the financial markets, there has been a strange silence. It is as if the events have no real impact on the rest of the world and we can treat it with the same indifference as if it was a Soccer World Cup final. It makes us feel good, but Monday everything is back to normal.

I shall not try to guess where the Middle East is going. But if we look at the influence on the financial markets, a few remarks are necessary.

The risk is not skewed in the direction of a positive outcome for the stock markets. If we see a quick return to orderly conditions, possibly with democratic governments, civil rights, and rule of law, it will make us all feel better. Best of all, it will give us the same stability in terms of oil deliveries as we had before the whole thing started in January.

In terms of impacts on the stock market it is not good news that things remain unchanged. In fact, It is no news at all.

On the other hand the situation can also escalate in ways that could seriously impact us all. Trouble in Saudi Arabia, supply disruptions, new regimes with limited democratic credentials but with a serious grudge against the Western world. Now that is a situation that would make itself felt in the stock markets.

Facing a choice between several outcomes, where the best is a return to status quo ante, and all other events are worse, it simply translates into an increasing risk for trouble in the financial markets in the short term.

If we add that risk willingness has clearly been increasing in the past months, we have a convincing case for limiting exposure to the stock markets. It is interesting to see that this message obviously has not yet made it to the stock markets. The reason for this appears to be clear.

The whole chain of events has unfolded quickly. The financial markets were in a sweet spot and economists and analysts have been busy improving on their outlooks for growth and earnings, and now reality suddenly shows its ugly face. Right when we were busy doing other things.

For investors interested in timing their exposure to the stock markets, it may still be too early to exit (unless you are a high-risk, high-leverage, high-everything hedge fund manager in which case you probably already have left). The rest of us are just waiting for the stock markets to wake up. And panic.

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