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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By definition, isn’t tail risk the type of risk that cannot be rationally priced in by the markets?

Posted by maynardGkeynes | Report as abusive

Come on Felix, I expect better from you! You write: “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, …..” Have you looked at a LIBOR forward curve recently? Future cash flows are certainly not being discounted at zero under the forwards!

I agree with everything else you say, but this one is a stretch I think.

Posted by Hookahboy | Report as abusive

OK, I won’t pile on … much.

The discount one picks to value future earnings is independent of current market rates. It’s a subjective exercise and I doubt that anyone is using today’s rates as a probable proxy.

Having said that, this was otherwise a very good post.

Posted by TomLindmark | Report as abusive

Agreed on the discount rate — best I can tell, the discount rate being applied to the probable income stream for equities is in the high single digits.

Posted by TFF | Report as abusive

Mr. Salmon, I’ve enjoyed your posts, and look forward to a reading and hearing you for a long time (pretty cool getting a gig on “Marketplace.”)

I wish you would talk to the terrible, weasley nature of markets during times of crisis. I’m watching the markets fall, and knowing that these major moves are caused by gigantic financial forces, forces that could make a stabilizing and investment stake in the immediate and future aftermath. I see Goldman Sachs, for example, give something like $6 million in donations, while I know they are pulling hundreds of millions of dollars from investment – increasing volatility and uncertainty in the meantime.

This isn’t to say that they should go in, given the market structure. But, this is definitely an example of the market failing to provide for society.

Posted by flerg777 | Report as abusive

I’m confused… Why again is it a disaster for society of the S&P drops a few hundred points?

Presumably anybody investing in the market understands the short-term risks. I would worry far more about another 15% drop in the housing market than I would about a 15% (or 50%) drop in the stock market.

Posted by TFF | Report as abusive

Most of the world economies are tottering and are very vulnerable to unforeseen and in some cases unpredictable calamities (be they due to human foibles or to natural causes). We have seen two prodigious examples of this in the last week or so.

Firstly, the Fed’s Ben Bernanke was worried about deflation, and he that that “a little bit of controlled inflation” would be a good idea. (I believe that Ben gets most of his great ideas while sitting on the toilet seat). Anyway, he printed and dumped on the world market an obscenely large amount of US dollars. While most of the effects of this action have not as yet played out, almost immediately world food prices soared. (This dollar debacle was not the sole cause of this, but it was certainly the precipitating factor.) Most of the population of the oil rich middle east and north Africa are poor and spend about 80% of their income on food. All of a sudden, due to this Bernanke foible, many could no longer buy food or eat. Some of the unintended consequences of this increase in food prices caused demonstrations, riots, and a civil war, and the ousting of governments that that were friendly (bought and paid for) to the US government. Of course, the CIA was completely surprised by this, and as a result of the CIA non-performance, the surprised Obama needed two or three days to get his act together (the situation was extremely complex).

Of course, the other great surprise was the Japanese disaster, which will have many still unknown drastic and long term effects on the US and other world economies.

The conditioned Obama administration response to these situations is “not to worry–we can handle it–we can manage the situation”. Yeah, sure they can!

Posted by gAnton | Report as abusive