Why market aftershocks will continue

By Felix Salmon
March 15, 2011
Neil Hume asks whether the stock-market plunge in Japan is an "overreaction", as markets around the world are exhibiting enormous volatility and uncertainty for obvious reasons.

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Neil Hume asks whether the stock-market plunge in Japan is an “overreaction,” as markets around the world are exhibiting enormous volatility and uncertainty for obvious reasons.

My feeling is that what we’re seeing in the markets today is entirely rational, and that a 3-day move in the Nikkei of less than one annual standard deviation is actually pretty modest given the enormity of what has happened in that country since the earthquake hit early Friday morning.

The main way in which the world has changed since Friday is that tails have got a lot fatter. It’s far too early to tell what the long-term effects of the earthquake and tsunami will be on the Japanese economy, on the future of nuclear power as an alternative energy source to fossil fuels, on the size of Japan’s holdings of foreign securities, or just about anything else. But the effects will be real, and there’s a significant chance that they will be large.

In general, markets do two things in the face of uncertainty: they fall, because reliable predictability is valued more highly than the unknown; and they become more volatile, because it’s that much harder to value future income streams. And both of those effects are magnified when you’re in an economic environment of zero interest rates. That’s because the discount rate at which you value future income is very low, with the result that modest changes to a value here or a rate there can have extremely large effects in terms of present value.

That helps explain why the Nikkei plunged so dramatically in the fall of 2008, going from 12,000 to 8,000 in the space of a month. By those standards, a fall from 10,500 to 8,500, as we’ve seen in the past three sessions, is pretty much in line with what happens to Japanese stocks in the face of a major market event.

The most likely outcome here is that Japan will spend a lot of money to rebuild its economy, but not so much that the national finances will be disrupted massively. There’s still a long-term fiscal problem in Japan, but the short-term liquidity situation is solid, and a major natural disaster like this one is a no-brainer of a reason to put fiscal worries on the back burner and stimulate the economy with much-needed reconstruction spending.

That said, however, there are definitely less likely scenarios out there as well which are much more gruesome for Japan and indeed for the entire world. With the probabilities attached to those scenarios being impossible to calculate, expect to see continued volatility in global asset markets for at least as long as the news out of Japan remains in flux — and possibly for quite a while after that, as well. This earthquake literally shifted the world’s axis: there’s a good chance it’ll do so metaphorically as well. If you’re a bold macro-fund manager who can see five moves ahead and loves to play in volatile markets, this is heaven for you. The rest of us are just going to suffer from aftershocks for a while.


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