Handicapping Uncertainty

by Rick Lehman on November 27, 2012
originally from Cabot Wealth Advisory

Discounting Uncertainty and Handicapping the Discount

Time Characteristics of Market Uncertainty

Market Risk versus Potential Reward

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People, and therefore financial markets, do not like uncertainty. It is a known fact that most people will choose or accept a more certain return, even when that return is considerably lower than less-certain alternatives. That also translates into selling stocks when the uncertainty (i.e. risk) of holding them rises.

In the extreme conditions of the fall of 2008, people actually purchased U.S. Treasury Bills at prices that guaranteed a loss rather than endure the risk and uncertainty of equities that were declining in waterfall fashion.

In essence, we discount uncertainty, and handicapping that discount (i.e. determining how much is appropriate for the degree of risk) has become an extremely complex task in today’s world of complex global interrelationships, unprecedented government intervention in financial markets and the structural weaknesses that pervade our current economic system.

How much, for example, should the U.S. market react to the threat of Greece defaulting on its government bonds, or China’s GDP growth slowing? Even economists, analysts and other professionals find it difficult to quantify the effects of such global events, especially when there is no history or similar comparison to use as a benchmark.

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Uncertainty also has time characteristics. Long-term uncertainties, such as tensions in the Middle East, tend to create fears that gradually rise or abate as events unfold. Short-term uncertainties, such as those surrounding corporate earnings announcements, become acute in the days preceding an announcement and then all but evaporate once the announcement is made. Larger uncertainties tend to create the larger trends on the stock market, while the acute uncertainties tend to move the markets within those larger trends.

You can see an example of this in the chart below as the run-up in the stock market on Election Day simply created a countertrend movement inside the larger downtrend that has been in place since early October.

Cabot Heritage Corporation

I raise this point because the rally that we experienced during the abbreviated Thanksgiving week may have been just another countertrend move inside a continuing market adjustment for the risks surrounding the Fiscal Cliff and the prospect of another recession in 2013.

Much of the Thanksgiving rally occurred on little domestic economic developments and appears largely justified by the weakness in the U.S. dollar that occurred simultaneously. On the other hand, the latest rally could signal that the market has now discounted the Fiscal Cliff uncertainty and is ready to move up again. To help resolve this dilemma, we can gain further insight from the longer-term chart.

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If we go back to the major market low in March 2009, we can see how the market’s advance in 2011-2012 has proceeded at a considerably slower pace (i.e., slope) than the initial first year of the move.

This would be entirely consistent with the slowdown in the U.S. economy and the maturation of the advance from 2009. It also still shows that within the perspective of the trend established during the last two years (blue lines), the Dow is still near the upper end of the possible range.

A return to the lower part of the trend could potentially take the Dow down toward 11,000 again in this context, and it would still be in a long-term uptrend even at that level. This scenario would also be consistent with the high likelihood of entering another recession in 2013.

Cabot Heritage Corporation, Cabot Options Trader

My conclusion from this analysis is that the stock market may not yet have effectively discounted (handicapped) the potential downside risk of another recession in 2013, and that long-term risk appears greater than potential reward over the next several months.

As the next few weeks unfold, it will pay to keep an eye on this longer perspective, as a continuing rally may only skew the risk-reward ratio further toward the risk.

From an options perspective, that means keeping any long call purchases brief or exiting ones we already have, and beginning to look for ways in which we would position ourselves for further downside action. We are particularly focused on the level near 13,300 on the Dow Industrials, where the market peaked on Election Day. If the market gets above that level, it will likely mean that further downside is not materializing quite yet. More importantly, if the market breaks the recent low near 12,500, that will cause me to get very defensive and to expect another selling avalanche to occur.

Please feel free to e-mail me at Rick@Cabot.net with any questions or comments to this article, or to learn more about Cabot Option Trader.

Your guide to successful options trading,

Rick Lehman
Analyst and Editor, Cabot Options Trader

P.S. Options represent the single most effective tool available for managing risk in equity portfolios--bar none. The flexibility of being able to buy or sell put and call options at different times offers more risk control than even shifting assets to cash.

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