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Extreme events? Time for extreme caution in financial markets

“New York Times newspaper” by Markus Spiske on Unsplash

At first sight the confluence of major market peaks, extreme but apparently unrelated events followed by subsequent market reversals may seem like just a coincidence. Often though the best contrarian indicators in financial markets are those that are either completely ignored or ridiculed.

Peter Atwater of the research firm Financial Insyghts offers some compelling examples of recent instances where confidence in the markets is at extremes and the timing has been reflected by desperate acts. Atwater believes that when our mood is high, we take bold chances, underestimating risks and discounting all potentially negative consequences.

The first of two recent examples Peter gives are earlier this year when former Russian spy, Sergei Skripal, was nearly assassinated — investigators suggested that his poisoning was the work of the Russian government. This coincided with multi-year highs in the Russian stock-market.

The second example came just days after Brent crude prices also hit a multiyear high. This time Jamal Khashoggi was killed in the Saudi Arabian consulate in Turkey.

Its not just Atwater that believes that broader confidence in the world around us affects behaviour. Back in May 2011, writing for the “The Socionomist, Mark Galasiewski shared:

The assassination of al-Qaeda head Osama bin Laden on May 1, 2011 was a result of the cooperation and success accommodated by the positive social mood trend underlying the global stock market advance since 2009. Bin Laden had been fighting two inverse trends: the increasing commitment of the intelligence analysts pursuing him and the decreasing commitment of his own followers. The increasingly positive social mood behind the stock market advance encouraged those trying to find bin Laden, while the waning negative mood deprived him of many of his traditional sources of support, thereby undermining his security.

These extreme events also relate to the common knowledge game. The basic idea is that there is private, public and common knowledge. Private knowledge as it suggests is what only a small sample of people know about something. Public knowledge is when everyone knows it. Common knowledge is public knowledge with a twist. Common knowledge is when everyone knows that everyone else knows.

This concept is central to game theory but once you understand it you see it in all aspects of our lives from financial markets to celebrity scandals. For knowledge to make the transition from public to common you typically need a mouthpiece (the media for example) or an event that pushes it into the public consciousness so that no one can be in any doubt that everyone else now knows it too.

Why does this relate to the over-confidence brought on by financial markets given in the examples above? Well, emboldened by the notion that “this time is different” the chief protagonists push things too far, make a mistake, talk to the wrong person.

As sentiment becomes stretched sophisticated investors on the other side of the market look for evidence of a shift. The common knowledge game illustrates how that shift can take on a life of its own — everyone now knows that everyone else knows that sentiment is extreme, and markets start to reverse.

For investors these mood connections are critical to understanding the world around us. Extreme events suggest extreme sentiment, cautioning that a major trend reversal is likely.