Risk-Asset Rally to Continue?

The ECB is loose and has put the sovereign-debt crisis on pause, thereby reducing considerably the extreme downside risk of a disorderly chain of defaults; at the same time, the Fed has loosened and the US economy has improved over the past few months; and so I wonder whether risk assets could have a serious upward move. Arguing against this view are the situation in Europe, which is likely to get ever worse on account of austerity; and the weakness in Asia, visible in China’s property slowdown and the general buildup of inventories. But markets react to turning points, and with the chance of a near-term blow-up in the Eurozone receding (ex. Greece, but I expect the immediate problem to be resolved with some kind of debt write-off), and as long as the Asian slowdown can be seen as a consequence of weak developed-world demand, it is reasonable to expect the market to believe that a turning point has been passed. US stocks ought to be the main beneficiary of any rally.

Incidentally, we heard a view last week that reasoned from the need for investors to put money to work to the conclusion that equities could well rise. I cannot subscribe to this way of thinking. It is my job to predict the movements of markets and thus the behaviour of market players; but the “money to put to work” view does not give an account of why investors put money to work at one time rather than another. It takes shifts in investor behaviour as exogenous shocks and then works through their implications for financial assets. I need a set of models or modes of thought in which investor behaviour is endogenous — otherwise, there is no way I can do my job.

Confidence Levels

I was talking to a biologist friend over the weekend and the conversation turned to confidence levels. My friend said that the standard of proof required in particle physics (for example, to declare the discovery of the Higgs Boson) of five standard deviations (or 99.9999426697% for a Normal Distribution, according to Wikipedia) was a remarkable standard for a biologist, who would more likely rely on a 95% confidence level. I said that, since I take it as given that I need to take a view on why the markets are doing what they are doing, I would be wrong to use such a high standard of proof. I try to work out what it is most reasonable to think, given the available evidence, and that means that I might implicitly use a confidence level as low as 51% for a binary question, and lower for a question with several possible answers. This way of thinking allows the elucidation of two kinds of mistake that an investor might make. First, he might think it is too easy to acquire knowledge: he might imagine that it is reasonable to attach 95% confidence to opinions that he has in fact reached on the balance of probabilities, and thus be too slow to change his opinion in response to new evidence. Second, he might think is is too hard to acquire knowledge: his inability to reach a 95% confidence level for any market opinion might lead him to give up in despair. The first mistake was made, for example, by bears who failed to anticipate the rallies of Spring 2009 or Autumn 2010. The second is made by those who claim that investing is impossible and will accept no method except buy-and-hold index tracking.

Short AUD/CAD?

Is there an argument for shorting AUD/CAD? The Australian economy is weak, except for mining, and Canada should be expected to benefit from exports to the strengthening US, and from any embargo on Iran. On the other hand, it is not certain that the Australians will cut rates, or that China will slow enough for them to be able to do so. Still, this might be a good way to play a slowdown in Asia while also benefiting if there is a further rally in the oil price.


The US Q4 GDP number was 2.8% QOQ annualised, as a against a market expectation of 3%. However, there has been quite a lot of gloomy comment about it. Inventories made a positive contribution of 1.9%, after detracting significantly in Q3, but this means that real final sales grew by only 0.8%, a decrease from last quarter in the rate of growth. Government spending detracted, as it can be expected to do for the rest of 2011.


Advance GDP 2.8% d.e. Q4.
Revised Michigan sentiment 75 b.e. and rose.