It didn't seem when dawn broke in New York today as if the stock market would spend some time during this first post-summer session fighting to record a positive mark on the close. The S&P opened up 1% higher, partly because Chinese economic data was modestly stronger-than-expected, but mostly because hot money types sought to use the thin overnight session to try and create the impression that returning investors were flocking to buy "these cheap levels."

But whatever the proximate cause of the overnight rally, it was met immediately with selling and three hours later the indices were flirting with unchanged on the day before a late charge produced a +0.4% finish for the S&P. I don't think the turnaround had anything to do with the fact that Israel fired ballistic missiles into the Mediterranean as a test of anti-ballistic-missile technology last night - that information was known when we walked in, although there was some confusion about whether the U.S. was involved or not and whether it was supposed to be secret or not.

Indeed, the whole U.S. market seems far more interested in whether the Employment number this Friday is 160k or 180k than whether the U.S. or Israel attacks Syria, prompting a response from Iran and/or Syria on Israel and generally provoking the situation in the Middle East like a Mentos candy dropped into Diet Coke. This is why 10-year notes were down on the day, despite the fact that the terribly low float outside the Fed means any flight to quality could be explosive.

The odds of a flight to quality may be low, but the expected payoff is (probability of event) * (value given that event happens), the latter of which is quite high. This is one reason I would be more comfortable being cautiously long bonds at this point. I guess the counterargument is that any taper will have a disproportionate effect on the sectors with less float, but I would think that should be mostly priced in by now. Well, perhaps the Syrian conflict is priced in as well...after all, little is likely to happen very soon, unless Congress acts quickly to validate the President's request for authorization of military action. The President doesn't seem to be looking for a quick answer and would probably like the whole issue to just go away, so probably the most likely event is still that nothing happens in Syria that impacts U.S. interests very much.

But do keep in mind that the part of the value of a particular strategy that comes from a particular state of the world is, as I said above, (probability of the state of the world) * (value given that state of the world happens).[1] For many financial options, the value of the option is determined not by the likely or median outcome, or even the distribution of likelihood of outcomes around the strike price of the option, but rather the outcomes in the tail, where there is very low likelihood and very high value. These are all "unlikely" events, in the sense that their independent probabilities are less than 50% and in most cases markedly less:

• a hot war in the Middle East,
• an abrupt taper from the Fed, or a decision from the Fed to increase purchases,
• Merkel's party loses the vote and is unable to form a pro-Euro coalition,
• the Yen suddenly collapses,
• the US borrowing ceiling isn't extended without fierce brinkmanship (in mid-October, the US won't be able to pay for everything it wants to pay for, although it will still have plenty to make debt service and entitlement payments and so is not in even remote danger of an actual default unless the Treasury simply refuses to direct its ample revenues to debt service),
• ...and others.

How does your asset allocation perform under each of these scenarios? Are there tails you have unhedged? If so, then you are doing what hedge funds have been doing for the last couple of decades: selling implicit options, earning a better return today as long as a bad event doesn't hit. In hedge fund land, we talk about being short implied credit or liquidity options, but even retail investors have this sort of position on. What happens to your portfolio if oil goes to $200, or the US suddenly drops into recession, or the Euro breaks up over the weekend? What about if inflation goes from 2% to 6%? (Interesting fact: over the last 100 years, inflation accelerated by at least 4% from one year to the next fully 10% of the time. And the probability that inflation is over 10%, given that it is over 4.5%, is 37%...so in other words, the inflation tails are very long).

Don't ask me for answers about what you should do in these cases - my purpose in these articles is not to distribute free answers to intricate questions that depend on your personal situation. My purpose is to present the question, and the question is, have you thought about how your portfolio will perform in the case of unlikely events?

If not, spend some time doing so. My fundamental belief is that a 70% or 80% equity position is almost never the right answer for any investor. If you are sufficiently wealthy that you could lose that 80% and have it not affect your lifestyle, either now or in the future, then you truly can plan for the long haul and ignore such risks (although even then I would not ignore valuations because you can add to your long-term returns by paying attention to them). For everyone else, "long term" is probably 10 years or less, and severe impairment of the portfolio does not admit to a certain 10-year cure. Just ask the people who had most of their retirement assets in Enron, or for that matter in the NASDAQ circa March 2000.

Watch your tail. The next month or two will be interesting.

[1] Technically, this is only true if all of the enumerated states of the world are distinct. To the extent that they are not, a covariance structure comes into play...for our purposes you can think of each separate event as creating option value, but you can't simply sum those values.

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