Probability Scenarios

After a blistering rally on Friday, the markets will be very interesting to start out the week. The way the market rallied would leave one to believe that there is more upside in the very short term but I wouldn't bet on it. I haven't really seen anything out of Europe yet that would suggest investors fears will be diminished. It may still be coming but it is much harder to bail out a country than to bail out an institution within a country. The reason is that those outside the country with different nationalities have to do the bailout. That is an extremely hard sell on every psychological, game theory level.

Without that type of bailout though it doesn't seem the problem in Greece, and correspondingly the rest of Europe will go away. This from the economist:

TAX-COLLECTORS and customs officers in Greece have already walked out in protest against planned austerity measures by the government. On Wednesday February 10th it will be the turn of civil servants, doctors and other state workers. A much bigger strike is expected later in the month and past experience suggests that protests could turn nasty. Yet unless Greece gets a grip on its public finances, the government will struggle to finance its loans. Similar anxieties are emerging elsewhere in Europe.

The initial gut reaction is probably, "those lazy Greeks. They don't want to take responsibility for their own actions a their own debts. There going to cause massive problems world wide bringing down Europe in the process." That was my initial reaction anyway but thinking about what if the same thing was going on in the U.S? Would I be doing anything different than the Greek people? No. I have been screaming that our path is leading to destruction. The government has made decisions I have opposed. Why would I reap their consequences and why would I give up my comfort to save an unsaveable system? I would probably be protesting or more likely converting into gold and moving. When you sit back and think about your reaction may be much different.

So to putting on positions. I had some limit short order that were hit on the hard bounce up on Friday. Thinking about it over the weekend there are basically three scenarios that I see as possible in the short term.

A) After maybe a few more points and a day or two the rally is over and we will be moving down extremely hard. Basically moving down to the 900s in the S&P within a week or two. I put this at a 40% chance.

B) Europe is oversold, there will be some words of reasurrance, we will get a several day bounce back up to 1080 to 1100. This week will be an up week and will put alot of doubt in bears. It will be only a few days and the smooth comments from Europe over the weekend will be forgotten shortly. After which we will start heading down hard. I put this at a 40% chance.

C) This is August 2007. The banks started showing signs of strain, there was a mini panic in the markets. The Fed took some steps, the markets rallied into November of 2007 making new highs before rolling over for good even as debt did not rally with the equity markets. Likewise, today some words or actions are done out of Europe. The market unexplainablly buys it (they bought the government stress test for banks, don't think it can't happen) Europe rebounds but stays much lower than its January 2010 highs while the U.S. diverges and heads to new highs before rolling over again in a few months. I put this at a 20% chance.

I think of everything in probabilities. Showing you how my mind thinks. Because the last one is the most deadly to me, that is the one I have been thinking about almost exclusively. Basically all combined it is not a favorable risk reward set up to do anything and so when that occurs I do nothing. It is almost always better to do nothing than something. As new details come out, the probabilities in my mind will change and I will reassess taking a course of action. There is still some short exposure I wouldn't mind adding if the risk reward tradeoff in the short term shows it is a good entry point.

Fundamentally, long term, we are headed down as we are stuck in a cyclical deflationary cycle. In the end that is all that matters.