How does the market react when commodity prices begin to rise steeply, a region of the world becomes unstable, and a massive earthquake shapes one of the worlds most important economies? Apparently, it shrugs in disinterest. That's the contention in a Bloomberg article today by John Detrixhe. He notes that, despite all of these "black swans," a popular term for unforeseen economic shock, the market just keeps rising. What's causing its resilience?

The Money Report

The Market Has Not Fully Recovered

For starters, it's important to note that the market has not recovered to reach its pre-recession levels. For example, the S&P500 stock index must rise more than 20% to reach its October 2007 high of $1,565. Meanwhile, however, other measures of economic activity have fully recovered. Inflation-adjusted annualized GDP hit a new high in the fourth quarter at $13.37 trillion, surpassing its fourth quarter 2007 value of $13.36 trillion. Retail sales are also hitting new highs this year. So economic activity and consumer demand have returned to their pre-recession levels, but the market has not. That's because new risks persist that weren't present in 2007. It's likely that stocks could have recovered even more quickly if new risks didn't surface this year.

Black Swans Not Completely Ignored

And that brings up the next point -- the black swans did have some effect. Here's a chart showing the S&P500 since November. The red line is actual performance; the green line is a world without the economic shocks that hit over the past few months (where big declines were taken out):

s&p black swans 2011-03.png

In fact, the S&P could be as much as 12% higher without these shocks. Now, granted, the increases might not have been as substantial without the declines. So the real outcome without the Black Swans probably would have been somewhere in between these two lines -- but the market would certainly be higher. For example, yesterday the market rose in part due to good news out of Japan, but other news the market interpreted as positive also helped. So these shocks are having an effect: they're slowing stock market growth to some extent.

Not Bad Enough to Cause a Double Dip

Yet the black swans are obviously not severe enough to cause the market to believe the recovery will fail entirely. If they were, then you would see a great deal of investment exit the stock market, as a double dip could result. This actually makes sense if you consider each shock separately.

Commodity Price Increases

To be sure, energy and food prices are a worry for the recovery. But at this point, they haven't risen by enough to endanger it. For example, oil prices were actually higher a few years ago, so we aren't exactly in uncharted territory yet. If these prices do continue to rise past historical highs, however, then the market will begin to worry.

Unrest in the Middle East and Northern Africa

As explained earlier this month, many sophisticated investors already account for the risk inherent in authoritarian nations in unstable regions. So when revolutions and unrest began to occur in the Middle East and Northern Africa, there were some worries. But this activity wasn't a total shock to the market. It's not like there was a massive revolution in several highly developed nations unseating their leaders, which would be action the market could certainly have not imagined. So the market was affected, but not debilitated.

Japan's Disaster

The earthquake and subsequent nuclear mess in Japan is a little harder to shake off. In this case, however, perhaps investors think it's isolated enough to Japan that it won't have a big enough effect on the rest of the world to thrust it into a double dip recession. While there was a massive loss of life and capital in Japan, from a global perspective it's just one country that others will sell fewer goods and services to for a time as its consumers recover. Although, in another sense, spending on the rebuilding effort may even make up for some of those lost consumer sales. It's hard to see very serious contagion resulting from the economic difficulties Japan will face.

Stocks a Ripe Option for Investors

Finally, stocks are a relatively good investment right now. Think about the market from an investor perspective. Gold has already increased in price by nearly 300% in the past five years. How much higher can it go? Fixed income securities are trading at relatively low yields, because rates are so low. They'll have to rise eventually, which will lower their prices. Even in a slow recovery, however, stock prices should rise as corporate profits gradually improve.

Moreover, it's likely that inflation will rise over the next few years. Even if the Federal Reserve does execute its exit strategy well to avoid very high inflation, it would have to do an incredibly good job to avoid above average inflation of 4% to 5%. What do you buy in response? As mentioned, it's hard to imagine gold climbing much higher. You don't want to buy debt as inflation rises, because its real return will shrink. That again leaves equities, which also act as a hedge for inflation. As prices rise, so do nominal corporate profits.

The market has managed to endure these black swans fairly well over the past several months. They have had some effect in dampening the recovery in stock prices, however. The test for the recovery probably won't come from investors, who understand these risks well. Instead, it will come from consumer sentiment. If consumers begin to worry about how these events could endanger the recovery, then their confidence could take a step back. A decision by them to pull back spending could be the greatest danger the recovery faces.

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