When you look at today’s global market rally, it seems that the bottom of the global financial crisis has already reached. In reality, the global economy had not improved by many measures. It had merely become less bad, compared to the precipitous decline in the second half of 2008. Financial markets tend to anticipate the future by recovering before the actual recovery of the real economy. That curious phenomenon should not be interpreted as foresight. Instead, the market has the habit of jumping the gun- the presence of bear market rallies is a testament of that fact.
This bottoming makes the market more vulnerable to Black Swans. Currently, we see two Black Swans that the financial market has not yet factored in. This is probably the time to put in their contingency plans for adverse reactions from the market (e.g. hedging, stop-losses, etc), especially for traders.
The first one is very well-known- the probability of a swine flu pandemic. In the 1918 Spanish Flu pandemic, killed anywhere from 20 to 100 million people. Half the world’s population was sick. Nobody knows how this swine flu will turn out. Should the virus reach Asia, the crowded and unsanitary conditions make it an ideal ground for further mutation and proliferation. Medical experts pointed out that the world is overdue for a pandemic. Since we have more faith in medical experts than in financial market pundits, our belief that this time round, the death toll may not be as bad as the Spanish Flu pandemic. Whatever the death toll of this potential pandemic, we believe the bulk of the economic damage will be caused by disruptions on daily life and the human fear factor.
The second Black Swan has received less prominence from the media- the situation in Pakistan. Last month, the Taliban had captured the Buner district in Pakistan (not Afghanistan!), which is merely a few hours drive from Islamabad, the national capital. Other reports revealed that the Taliban had advanced to within 96 km of Islamabad. This event is part of the bigger picture of the Taliban’s consolidation of control of north-western Pakistan. With the Pakistani army larger than the US army, the audacity of the Taliban shows how internally weak the Pakistani government is. The situation is so bad that the US Army’s General David Petraeus commented that “there may be just two weeks left to prevent the Taliban from overthrowing Pakistan’s Government” (see “Two weeks to save Pakistan”).
This is a very worrying situation because Pakistan is a nuclear-armed nation. The control of Pakistan’s nuclear weapons by the Taliban is a very dire scenario. Not only that, such an event can potentially fracture the huge Pakistani army (the Pakistani population is fractured too). India will be very worried because they have their own insurgency to fight in the Kashmir region and are always at odds with Pakistan since independence- the Taliban will be a much less rational and predictable enemy. China shares a very long border with Pakistan and will be very worried too. The US and its NATO allies, already having difficulty containing the Taliban in Afghanistan, may lose Afghanistan to them. The Taliban, who shares the same Wahabi school of the Sunni Islamic fundamentalism, is at loggerheads with the designs of the Iranians for influence in the region. Iran almost fought a border war with the Afghan Taliban a few years ago. Worse still, the Taliban is allied with Al-Qaeda, which will surely turn Pakistan into a haven for terrorists.
Gold will thrive in these two Black Swan conditions. But it is something no one will welcome.
