{"id":2362,"date":"2010-08-14T22:01:53","date_gmt":"2010-08-15T02:01:53","guid":{"rendered":"http:\/\/drduru.com\/onetwentytwo\/?p=2362"},"modified":"2010-08-14T22:01:53","modified_gmt":"2010-08-15T02:01:53","slug":"elerian-25pct-chance-of-deflation","status":"publish","type":"post","link":"https:\/\/drduru.com\/onetwentytwo\/2010\/08\/14\/elerian-25pct-chance-of-deflation\/","title":{"rendered":"Betting on El-Erian’s 25% Chance of Deflation"},"content":{"rendered":"

Mohamed El-Erian recently quantified the odds of deflation at 1 in 4<\/a>, or 25%. His analogy to describe the dangers ahead seemed to be a recipe for inaction (and fear):<\/p>\n

“…ask yourself the following question: would you accept a lift from a person who has a one-in-four chance of getting into a really bad car accident?”<\/p><\/blockquote>\n

Well, the answer depends on your intended destination. Are you trying to get to the grocery store or are you about to miss the deadline to claim some amazing, once-in-a-lifetime opportunity? I think implicit in El-Erian’s case is that there is nothing too enticing waiting for you on the other side of that trip.<\/p>\n

The subtle irony of quantifying risks is that the process provides a structure and basis for action<\/strong>. The future remains uncertain, as it always does, but the response to current conditions becomes pretty clear. So, just for kicks, I decided to test El-Erian’s model on investing in the S&P 500.<\/p>\n

Let’s assume that the really bad car accident is the equivalent of the index retesting its March 2009 lows at 666 within a year. That scenario seems pretty extreme to me; only very committed bears are still clinging to that case. Let’s also assume that the most likely case is that the market has a very modest gain within the next year to 1250. I picked this number because it is Goldman’s end-of-year target that was reiterated last week<\/a>. As far back as December, 2009, perma-bull Abby Cohen placed a 1250-1300 range for the S&P 500<\/a>, and many strategists pegged the S&P to hit 1200-1350 by the end of 2010. So I will give a nod to the bulls in the crowd by assigning a 5% chance to hitting 1350 within another year. We end up with the following (simplistic) decision tree:<\/p>\n

25% chance of a 38% loss by August, 2011
\n70% chance of a 14% gain by August, 2011
\n5% chance of a 25% gain by August, 2011<\/p>\n

These one-year gains may seem large but note that the S&P 500 is down 3% for the year, it is flat with the highs from last September, and the most likely case is a mere 3% gain above the highs for the year. Thus, I think my estimates for upside are very conservative.<\/p>\n

Once we multiply this out we get an expected gain of 1% (=.25*.38 + .70*.14 + .05*.25). In other words, if someone presents us with this bet, we can expect for every dollar we put down, we will gain an extra penny at the end of a year. While the outcome is positive, it is hardly exciting enough to entice a nervous (aka risk-averse) investor to play along. <\/p>\n

The potential upside increases the more optimistic you are, taking El-Erian’s model as a given. So, even with this 25% chance of deflation, the raging bulls should remain in a buying mood. Otherwise, El-Erian’s implicit case for inaction seems to work out pretty well. <\/p>\n

Be careful out there!<\/p>\n

Full disclosure: long SSO puts<\/p>\n","protected":false},"excerpt":{"rendered":"

Mohamed El-Erian recently quantified the odds of deflation at 1 in 4, or 25%. His analogy to describe the dangers ahead seemed to be a recipe for inaction (and fear): “…ask yourself the following question: would you accept a lift from a person who has a one-in-four chance of getting into a really bad car … Read more<\/a><\/p>\n","protected":false},"author":1,"featured_media":0,"comment_status":"open","ping_status":"open","sticky":false,"template":"","format":"standard","meta":{"_monsterinsights_skip_tracking":false,"_monsterinsights_sitenote_active":false,"_monsterinsights_sitenote_note":"","_monsterinsights_sitenote_category":0,"footnotes":""},"categories":[86,135],"tags":[372,409],"class_list":["post-2362","post","type-post","status-publish","format-standard","hentry","category-investing","category-stock-market-trading","tag-deflation","tag-mohamed-el-erian"],"yoast_head":"\nBetting on El-Erian's 25% Chance of Deflation - ONE-TWENTY TWO: Trading Financial Markets<\/title>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/drduru.com\/onetwentytwo\/2010\/08\/14\/elerian-25pct-chance-of-deflation\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Betting on El-Erian's 25% Chance of Deflation - ONE-TWENTY TWO: Trading Financial Markets\" \/>\n<meta property=\"og:description\" content=\"Mohamed El-Erian recently quantified the odds of deflation at 1 in 4, or 25%. 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