This morning everyone is focusing on the recent diagnosis of a NYC doctor with Ebola. We first heard word about the possibility of an Ebola case in America’s biggest city late yesterday afternoon. On the news, they immediately clocked the S&P 500 for 12 handles. I saw many dire predictions about the possibility of a 30 to 50 handle drop if the patient was confirmed to be carrying the deadly virus. But last night when the Ebola diagnosis was made official, the S&P 500 dropped only another 13 points. The initial reaction proved to be the low.
I am not sure how to discount the Ebola worries. On the one hand, I understand that the chances of it spreading in a modern Western society like it does in Africa are extremely low. I get it that the odds of it breaking out throughout our cities is a poor bet. In the days to come, the chances are that we will have various scares as poor fellows like this NYC doctor are diagnosed, but that they will be contained. But what if they aren’t? The economic consequences of an ebola outbreak are simply astronomical. The last big economic slowdown, the 2008 crisis, was completely self induced. The only reason we had a slowdown was because we lacked confidence. There were no physical reasons for the economy to slump. If we were to get an Ebola outbreak, it would result in an actual physical loss of economic output. Stores would be closed, businesses would shut down, school classes would be cancelled. The economy would grind to a halt. And simply trying to shore up confidence in the financial system would not help. An ebola outbreak would not merely be a financial crisis where wealth was redistributed between debtors and creditors, but an actual massive loss of wealth for our economy.
So how do you go about discounting that outcome? I would guess that in a full fledge ebola outbreak the S&P would easily go down by a third, with an outside shot at a halving. But the chances of that happening are really remote. So how much do you sell it today to discount that possibility? When you do the math, a 20 point S&P drop is probably about right. It is assigning a less than 1 in 100 chance of it getting worse. That seems about right to me.
The real problem is going to be when there are more reports about possible transmission of the ebola virus. If all of a sudden the market starts discounting the odds going from 1 in a 100, to 1 in 50 or lower, the stock market is going to quickly back up. The nature of the severity of the low probability outcome being so high makes this a difficult period to trade.
If I had to guess, I would say that the headlines are going to get worse before they get better, but that those betting on Ebola spreading through Western society are making the wrong bet. But if I am wrong and the virus does somehow mutate to become more easily transmissible, then do not catch any falling knives. Whatever reaction the market has on that news – it probably won’t be severe enough.
I am especially worried because I haven’t seen Dustin Hoffman in a long time, and I am not sure who else is going to be able to catch the monkey to make the vaccine.
Right for about 10 minutes
A couple of days ago, I sold short the big up day that finished at the highs. The next day the market sold off and it looked like I might actually know something. But then the Market Gods made sure to remind me of how tough this game actually is.
I was a little bit taken aback by the strength of yesterday’s rise. I did not expect the market to push up to that level so quickly.
I have mentioned that I thought many fast money types were much too bearish on the way down. I am watching these guys closely for signs of capitulation. So far, many are licking their wounds, but staying true to the idea that the new trend is lower.
From a short term trading point of view, I wonder if we aren’t going to get the roll over until these guys cry uncle. Markets seem to always go where they will inflict the most pain, and I am scared that a continued rise is the route to maximizing losses for everyone.
I am going to make sure that I trade with a position size that enables me to sit through a scramble from the last remaining shorts. We are approaching the point where they might cover, and when that happens – even though things will appear like the trend upwards is set to resume, it will probably be time to get out the pink tickets.
Part of the reason we are rallying so hard is because of continued massive program buying. Last week I expressed relief that the days of the continual grind higher were over, but it looks like I spoke too soon.
The stupid relentless buying is back. I sure hope it goes away because it takes all the fun out of the game (and I am too much of a chicken to ride along with that sort of buying.)
Some quick updates
I made some changes yesterday. I have had a good run in my Bund short, but I decided to turn my short into a long put position.
I also bought a tiny little bit of EUR and Yen calls. I know that this is catching a falling knife, but I think the hedge funds are pushing their luck on their long US dollar trades. I also bought some out of the money gold calls.
Finally I covered my short US two year position.