Singularity events 1 comments

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A singularity in mathematics is defined as "a point where a mathematical function goes to infinity or is in certain other ways ill-behaved" (from Wikipedia); in astrophysics it is normally associated with black holes and the like. In other words, the term is associated with extremities that alter and distort the normal trending behaviour of the system beyond recognition.

I guess you can probably see where I'm coming from in applying this term to the stock market. It is the ultimate nightmare of the investor and more significantly, the trader: an overnight event that completely transforms market fundamentals and sentiment (for the worse).

It is the ultimate nightmare because the best thing about stock markets is their liquidity: it allows the trader to cash out into a liquid market with ready buyers as and when he feels uncomfortable. But if an unfortunate event happens overnight there is no exit strategy except to pray to God that the price gapdown on opening will not be great, and that there will be sufficient buyers. For the investor who buys on trends (like me), it is important to gauge the fundamental impact of such singularities and whether they could mark a turning point in the trend: if so, time to reallocate the assets!

The most recent memory of a singularity event would be 9-11, of course. The sight of two planes crashing into the Twin Towers during US office hours (hence Singapore nighttime) on TV was enough to send the STI down several hundred points the next day, while the markets closed in the US hence depriving traders of the opportunity to liquidate. Overnight, all gains made previously can be lost, and then some.

As is my general belief that share prices are driven by the triumvirate of market, sector and company, the effect that a singularity event can have on market prices can be country/market-wide, sector-wide or company-specific. Quite often macroeconomic events and political/regulatory events turn out to have the strongest secular(medium to long-term) impact on the stock market. 9-11 brought to global consciousness the grim reality of security risks and terrorism, the 1973 unitaeral quota restriction of oil exports by OPEC highlighted overnight the geographical demand-supply imbalance of oil and triggered the 1970s cost-push inflation, the 1997 Asian currency crisis and subsequent Indonesian riots highlighted first the financial and then the political risks of investing in Southeast-Asian emerging markets, CLOB brought to Singapore investors a sudden realisation of the political risks of buying Malaysia stocks. How does one guard against such singularities? One method is to avoid countries with non-business friendly environments and histories of tight government control and sudden policy U-turns (eg. Russia); there is a reason why certain countries are trading at low market PEs. The second is to watch for orange lights before the final red light, but this is typically difficult for macroeconomic events/government policies, in the same way that economists seldom get their market forecasts right. The third is to do damage control after the event: to assess the medium-term impact of the singularity event and decide whether to continue to hold or even to pick up bargains. My view is that market/country singularities are the greatest danger in a bull market (as it is now), since (1)it can never be eliminated for the active investor (how does one anticipate a tsunami, for example); (2)defies the efforts of good sector picking or stock picking; (3)most often leads to drastic and sustained declines, or even illiquidity (a drastic case being CLOB).

Sector-specific and company-specific singularity events seldom happen overnight and are easier to pick out, so one should monitor and anticipate developments the way one monitors price-volume charts; tensions accummulate and then breakout (similar technical language) and one learns to watch warning signs. If one learns how to pick growing (but not frothy) sectors and fundamentally strong companies, he should be able to mitigate potential problems of running into such singularity events. Again, risk is always there, as epitomised by scandals like CAO, ACCS and Citiraya. No risk, no reward; that is why I prefer to stay fully invested, monitor events and "play mahjong" (ie. reallocate) if need be, rather than liquidate stocks and go to cash, in a bull market which has equal upside potential of charging further and downside risk of retracing its steps.

Afternote: I was reminded of this book Fooled By Randomness (click on the link for my book review) by Nicholas Nassim Taleb while reading the Sunday Times today (they did a book review on it). It is a great book to read up further on the singularity events that I was writing about above, what he calls the "black swan" event.