03/01/2011 04:50 pm ET | Updated May 25, 2011

Dangerous Games

Just a quick show of hands... how many of you have discussed the internal conflicts in the Middle East with your friends? Now, how many of your friends have concluded that this conflict in Egypt is good because they are pro-democracy and that this will be good for equities as even more of the world opens up to free trade?

I have heard this same discussion over and over but it's just not true.

To quickly bring you up to date, there are now demonstrations beginning in Oman. The Chinese Premier Wen Jaibao just pledged to punish the abuse of powers within China and to close the growing wealth gaps just as he limited any news of the Middle East protests from entering China. South Korea is dropping leaflets into North Korea telling the North Koreans of the revolts in the Middle East and suggesting that they control their own destiny and can over throw Kim Jong Il's regime. Secretary of State Hillary Clinton is reaching out to folks in Libya from various anti-Quaddafi movements and has pledged US support. Activists in Saudi Arabia are now demanding increased political rights and a movement toward a constitutional monarchy. The Tunisian Interim Prime Minister just resigned. Unions and other sympathetic organizations spread their protests across America.

Did you think that only Egypt is unstable?

I believe that events of this magnitude are neither random nor spontaneous. I also believe that these are not pro-democracy rallies because students of history know that democracies are not stable. And there are plenty of groups opposed to any form of republic or democracy and these forces are not sitting on the bench. If these demonstrations are the product of experimental social engineering, we must accept that we can't know what will emerge.

Promoting instability is a tricky avocation, much like a professional water balloon catcher. We assume that it is a good thing to support Libyan anti-governmental protesters but is it possible that those that have contempt for both Quaddafi and the West will ultimately see us as merely interventionists? We may be welcomed as some transitional facilitators but will continued intervention result in anything more that more Mubarak-like governments?

Of even greater concern is amount of change the world can tolerate at one time. This is the reason that I have great concern that many financial assets are currently significantly over-priced. Two huge risk factors are not being priced into the markets... uncontrolled instability and inflation... neither of which is easily modeled. We do know that returns based upon historically low interest rates do not reflect inflationary realities and these low returns completely ignore the unintended consequences of waves of protests and instability.

There was an interesting article by Chris Mayer last week discussing economic forecasting tools and their accuracy and relevance. He quoted the famous investor Peter Lynch as saying, "If you spend more than 13 minutes analyzing economic and market forecasts, you've wasted 10 minutes." Yet, at the extremes, mal-investments are more likely to happen. Financial assets are currently priced with exceptionally large presumed growth rates, low interest rates and low inflation rates. I cannot think of a time in recent memory where there was a worse matching of risk to return. In a world of real turmoil (with no clear-cut direction or winners in sight), we blithely accept forward Price to Earning's of 20+. We think all sectors are just about as likely to expand (OK, excluding retail). We compare actual performance to "expectations" without ever asking whose expectations are being used. We use data we know to be erroneous generated by the Treasury, the Fed and the Bureau of Labor Statistics.

Mayer went on to critique the use of performance statistics and their presumed accuracy. I have these discussions with folks all the time suggesting that no one can precisely measure expected returns, upon which all valuations are based, because contained within these returns are risk factor estimates, generally the product of our own governmental reporting and, yet, we must make an attempt.

Erring on the side of conservatism would seem natural yet today we continue to seek justifications for higher prices and solace in low metrics and low volatility. I would say it reminds me of the tech wreck in 2000 or the real estate bubble in 2007-8 but that would be unfair, as both of those "corrections waiting to happen" were not surrounded with worldwide political uncertainties.

The short answer is that you cannot truly measure inflation or unemployment month to month any more than you can put a specific risk factor on political turmoil. But you can say that these two factors are likely greater than the "official" reports and that worldwide turmoil at least deserves "a few hundred basis points" of consideration. I continue to see much more risk than the market is pricing in. If this is true, then a correction cannot be far behind.