Are we pricing risk accurately?

ON ASSET ALLOCATION

Any electric guitarist knows about feedback. Step too close to the loudspeaker and you create a perfect loop where the same noise is picked up, amplified, picked up again and amplified further until it turns into a distorted, deafening, ear-splitting screech. Markets seem to be suffering a similar effect.

It has been a summer of discontent: disruptions to supply chains following the Japanese earthquake, Chinese inflation fears, revolution in the Middle East, political wrangling over the US debt ceiling and fears of a double dip recession there, and finally, the muddling along of the eurozone crisis. Markets can overreact in the short term and it is healthy to ask whether they are pricing risks accurately or we are experiencing feedback – with problems amplified by the media and technical analysis, leading to stock market overreaction, which is amplified leading to yet further reaction. ...