a parallel: 1932. Everyone talks about the Wall Street Crash of 1929. In actual fact, the market went down in 1929, recovered in 1930 and 1931 and then crashed to 11% of its peak value in 1932. The equivalent today would be the Dow Jones Industrial Average free-falling from its current level of 12 500 to 1 500 which would be a catastrophe. We have two flags for this scenario. The first one is a sudden jump in the interest rate on US 10 year treasury bonds to somewhere between 4 and 5%. This would indicate a loss of faith in the way America is handling its budget deficit. Right now this flag is down as the interest rate is below 2% since most investors prefer American to European paper.
The second flag is a default by either Italy or Spain on their national debt as such an event would have much bigger repercussions for European banks and pension funds than a Greek default. The financial numbers are much larger and the markets would probably freeze like they did in 2008. We give this Black Swan scenario a 20% probability in light of the present Eurozone crisis. The odds are now high enough for the flags to require extremely close monitoring, particularly given the risk of contagion in Europe. Remember, you can do nothing once the lightning starts except go indoors! Hence, the best option is to make sure your financial situation remains fairly conservative, so that you can survive the storm if it hits.
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