Reposted from Of Two Minds with author’s permission.
Is the operative phrase here “priced to perfection”?
With everything from stocks and bonds to ‘roo bellies rising as one trade, it may be a good time to ask: what’s priced into the market’s uptrend? We say “bad news is priced in” when negative news is well-known and the market has absorbed that information via the repricing process.
When the market has absorbed all the “good news,” then we say the market is “priced to perfection:” that is, the market has not just priced in good news, it has priced in the expectation of further good news.
Markets that are priced to perfection are fiendishly sensitive to unexpected bad news that disrupts the expectation of continuing positive news.
So what have global markets priced into this uptrend across virtually all markets?Just as a partial list, we might include:
1. The Eurozone’s sovereign debt/banking crisis has either been resolved or lowered to a simmer that won’t damage global financial markets.
2. The austerity resulting from the extend-and-pretend fixes to the Eurozone’s crushing debt and insolvent banking system will do no more than dent the Eurozone’s major economies in 2012.
3. The U.S. economy has dodged recession and is growing slowly but surely.
4. All the primary metrics of that growth such as employment, GDP and retail sales are all rising smartly and will certainly continue on that rising trendline.
5. The bursting China’s real estate bubble has had essentially zero effect on its growth as measured by GDP.
6. The slowdown in China’s largest export market, the Eurozone, will have a marginal effect on China’s overall growth rate.
7. The developing economies will continue expanding faster than the developed economies, and this rapid growth will continue pushing commodity demand and prices higher.
8. Geopolitical conflicts that might impact the supply of oil have all been priced into the price of oil.
9. Political developments in Europe will not disrupt global financial markets.
10. Global central banks (i.e. the ECB and the Federal Reserve) have effectively restabilized the global financial system via ample liquidity and massive expansions of money supply and balance sheets.
11. Volatility has been banished by this central bank-backstopped stability.
12. The strong yen will have negligible effects on the global economy or on Japan’s growth and stability.
This is just a partial list of all the “good things” that are priced into global markets.If all of these good things are well-known and already priced in, then we have to ask what other good news could possibly turn up to drive prices even higher? If “positive surprises” are priced in, then how can positive surprises drive prices higher?
Put another way: if everyone who could buy in has already bought in to ride the “good news” wave on expectations of more good news to come, then where is the new money coming from to drive prices even higher?
If markets are indeed priced to perfection, then the second line of inquiry is: what happens if expectations of enduring stability and good news are dashed by “unexpected” bad news? Could volatility suddenly return from banishment? Could prices suddenly decline as the market reprices in risks that have been dismissed as non-factors?
Bulls have been claiming that the “good news” is a powerful trend that will only continue showering us with positive reports of ever-rising GDP, sales, revenues and profits. If that story is called into question, then how does a market priced to perfection reprice this doubt and risk?
How does a market priced to perfection reprice a “black swan” financial event, that is, a low-probability event that comes to pass despite the low odds? What if the official suppression of risk over the past 4 months has greatly increased the pressure in the global financial system and thus the odds of a Black Swan appearing “unexpectedly”?
These are questions to ponder in the weeks and months ahead. Time will tell if this is indeed a market priced to perfection or a market that has barely begun its march higher.
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