torsdag 9 oktober 2014

5 reasons the current stock market rout is NOT your garden variety correction

The last 6 years every investor and his dog have been conditioned to "buy the dip". No matter if there has been a war, political turmoil, weak economic data or poor company earnings, rising or falling interest rates or what have you, every dip has been a buying opportunity.


So, why should it be different this time, specifically in the third quarter of 2014 and forward? Okay, I don't profess to actually know that we have seen the peak and are now looking into the abyss of a 50 percent fall in average stock market values. However, here are five good reasons why that is actually the case:

  • No real people left in the market; just 10% real trading means nothing holding us up
  • It's all central banks and they are close to the end of the magic rope. Confident?
  • Debt works until you can't pile more on top and the Ponzi scheme topples
  • The bull has run farther than normal; the pendulum swings back when momentum fades
  • Valuations are extreme but hidden in averages and behind debt tricks and deficits.
It's like a house of cards, where one volatile variable seems to support the other and the very height is the house's worst enemy - but is taken as proof of the house's stability. Sanity check?

Let's go through the variables in more detail:

1. There are no real people left in the market. Since the peaks of 2000 and 2007, market turnover has fallen by more than half. At the same time algorithmic trading ("robots") has increased its share of trading from 10-20 per cent to 80 per cent. That means that "real" trading has fallen by 90 per cent! That is part of the explanation why the market has been so technical, so trending, so smooth on the surface, so easy to manipulate and so easy to "rescue" when needed during sudden bouts of weakness. The flip side is that there is no bottom, nothing to hold prices if and when the robots decide to get out or even to play the downside. Then 80% of the market will disappear or even start selling instead of buying.

2 It's all central bank magic and castles in the sky - without any mechanistic relationship between printing money and rising stock markets (or profits for that matter). Stocks are up because stocks are up. More money in deposits does not necessarily mean higher prices or profits. Sure, lower interest rates lead to more debt than otherwise, more created money to buy houses and also leaking into the stock market as a carry trade. That works as long as there is confidence in the system, but now the cracks are showing: unemployment may be down, but job market participation too and food stamp use has skyrocketed. Also see point nr 1; it has been easy to sell the narrative that money printing "works" and back it with manipulated markets where robots rule but the robots don't care which way they make money once the trend changes. And now the so called market internals (Dr Hussman's notion) have cracked.

3 Debt is all around. When houses stopped working as ATMs, car and student loans took over. Also, corporates have been borrowing (partly because they could, because rates were so low and (junk) paper demand so high, partly because they needed to buy back their own shares to support earnings per share and compensate for stock option dilution). And governments have not held back, gladly accepting 5-10 per cent deficits per year. All that debt will have to be paid back eventually, or defaulted upon. Zero sum game? No, not so much, since the other man's wealth that was founded on being paid back will disappear and with that both his and the borrower's wealth and demand evaporate. In addition margin debt on the NYSE is higher than ever. Yes, ever. Yes, compared to the market cap.

4 The bull is very long in the tooth. The bull market has outrun itself. For one, it has gone on for very long and the upturn has been historic (+200% on the S&P in 5.5 years). Second, every lever has been cranked to maximum for decades. All variables that formed the base for the rally since [take your pick: 1945, 1982, 2009] have gone from supportive to being liabilities: population growth, productivity, leverage (debt), global growth, environmentalism, government deficits, individual savings ratio and more. The market is at least due for an ordinary correction of 10-20%. Those usually come along once a year and now it's been years since the last one. And when that happens, trend followers may get signals to sell, pushing markets down another 10%. And by then value players in the form of hibernated bears may bet on market levers to normalize, thus looking for another 10% down, which in turn leads to stop losses, margin calls and redemptions (remember the margin debt on NYSE that is used to buy shares by leveraging your existing holdings), forcing some planned long-only accounts to sell - and there you have another ten per cent down. By then, the downturn takes on a life of its own, making everything undershoot at the same time, just as has happened so many times before; the more euphoric the peak, the more dystopian the trough. Imagine simultenous generational lows in debt, profits, valuation multiples, turnover etc,

Me, partying like it's 1999 (which it was)

5 Valuations are at their highest ever - this variable should be nr 1 on the list, given how extreme it is. However, valuations usually work as a stopped clock, or like the sun to a comet. Follow the trend as long as it is stable, but when the comet starts to turn (market internals weaken), remember it won't just slow down, it's coming all the way back to the sun... and then some. Valuations tend to be reasonable for a very short time around 2-3 times per full cycle, as the market swoops by at high speed between its extreme highs and lows. They can however guide you to when you can start buying during the downturn - even if prices probably will fall much further, giving you plenty of opportunities to average down a couple of times (often more times than you would like)

Easy to get euphoric at the peak
(me in my underwear at 7km; 23 000 feet)

it is due because the trend is broken

In summary, the most important reason this rout may last, and may rival the downtuns of 2002 and 2008, is simply that it is overdue. It is overdue for a lot of reasons: Time, Increase, Debt, Valuations, but most of all it is due because the trend is broken.

the dynamic has changed

That means the dynamic has changed from one where central banks and robot traders are perceived to be in control, and where buyers are buying because others are buying, because that is what you are supposed to do (think all the newbies in the market, that have only seen markets trending upward; the buy the dip newbies), to a situation where confidence in the system, in central banks and in the buying of others is eroding.

Stopping the bull (again)

12 kommentarer:

  1. Interesting read.

    "the pendulum swings back when momentum fades"

    --This is the main thing I'm taking away from the article.

    Btw, what is your general opinion of ZeroHedge? Do you read it a lot?

  2. Zerohedge runs a dangerous site. It is dangerous because it is so good, so up to date, so frequent and so to the point on many issues - albeit still extremely negatively biased and conspirational.

    If you read ZH with the right knowledge it works very well as a financial news site - they comment on just about everything and present the relevant charts and links as well.

    I've been immersed in a flow of financial information for 20 years, listening to CNBC (the opposite of ZH), reading Bloomberg news (as well as several other real time news sources), reading company and economy research from 20 different broker firms and research boutiques, frequently talking to macro economists and strategists, reading daily newspapers locally and globally, reading monthly financial magazines (such as The Economist) etc etc. And on top of it all I've read Zerohedge and other financial blogs.

    I think I can say I have a good grasp of what news sources there are and how well they cover the real world. A quick ranking would look like this: Financial Times is the least biased and still comprehensive news source. Bloomberg news is the best realtime one. The Economist is not really a news source but is good for keeping up to date with thebig picture. CNBC is the absolute worst of all news sources in all respects but one - when news break they WILL tell you, will SCREAM it out loud.

    Zerohedge is almost as quick as CNBC and Bloomberg, almost as all-encompassing as FT, at least as deep and analytical as broker firm research, is FREE in all respects (no agenda, no cost, no affiliations, not selling anything), and it is a good source to OTHER sources of financial analyses and articles.

    However, ZH is biased so be sure to pay attention to how ZH's editors choose their time intervals and chart scaling; An overlay chart of two variables does NOT constitute an acceptable or even relevant statisical analysis of correlation - and definitely not of causation.

    And yes, I read ZH a lot. It is the best financial news source there is to have for free, as long as you know your statistics and can look through biased research. But do, look elsewhere too, perhaps to positively biased sources in order to inoculate yourself to ZH's dystopian (albeit to large degrees correct) narrative.

  3. Agree 100%. When I read that UK retail investors had put more money into tracker funds in July than in any other month since records began, I knew the bull run was over. How would you trade this? Buy puts? Will you trade this?

    1. Hi

      I am already more than prudently net short the market. I wrote a post about my investments about a month ago. That still stands. Short stocks, long gold, long USD vs SEK. Looking for opportunities to buy interesting micro cap stories if they get severely punished early; otherwise I will wait a year or two for large cap opportunities.

    2. August 7

    3. Thanks, I'll check it out.

  4. Alright. Thanks for the overview!

    I used to read ZH frequently a few years ago (2010-2011) when I was into precious metals. I never read any of the other news sources much at all. At the time, ZH was incredibly bearish and biased. They were all about gold and silver (which I was speculating in at the time). Lots of people in precious metals industry (and other industries), who CLEARLY had incentives and agendas of their own, did guest posts at ZH at the time.

    I have not read ZH much over the last 2 years.

  5. Youre a real wealth of information thanks for keeping it real!

  6. My brother is going to love this article. He's heavily into finance and trading, So I'll make sure I show him this!

  7. What positions do you recommend to get into for short exposure during this market downturn? Currently I am trading a considerable position in a leveraged short ETF fund (SRTY), but I want more leverage and less trouble with daily/monthly leveraged resets, so possibly getting into put options? In the option field, what should I look at?

    1. Hi Kyle and thanks for reading and taking the time to comment and ask a question. It's great to know I'm not just shouting in a vacuum.

      At least three things stop me from making worthwhile recommendations on this topic.

      1) I really shouldn't officially recommend anything at all, for fear of the SEC
      2) Shorting is dangerous over time, due to among other things: growth and money printing
      3) Instruments are market dependent (US, Sweden...).

      However, I guess your SRTY works similarly to other ETFs with neg market exopo; i.e. it consists of sold futures that are rolled every month or two causing a performance leakage and a repositioning tracking error. In addition, you say the leverage is too low. Just note that my short ETF "only" has 1.5x leverage and considering how "dangerous" shorting is that should be enough for anybody.

      If you STILL want a comment on put options and more shorting leverage, here goes:

      Buying put options yourself instead of letting some ETF handle it is definitely 1) more efficient (almost no performane leakage ) 2) opens up to way more leverage and risk than the typical ETF.

      If you understand puts and think you can handle the risk, I would point you to ordinary, listed puts on the S&P 500 index. Those are extremely liquid.

      However, please note (perhaps another reader than you thinking about this) that buying a put option 10% out of the money with a delta of around 10-20% (I haven't checked the actual prices) means that if the market doesn't fall at least 10% you will lose the entire invested amount.

      Also, please note this too, you will still have to go through the hassle of rolling (selling the current expiry and buyingthe next) your puts yourself every month or other month, since long term puts are more expensive than they should be. That costs commission and opens up for tracking error if not performed carefully - or if the market suddenly moves just as you are rolling your puts.

      Final word, plase do the math properly before going short at all and in particular before buying put options. Make sure from the beginning that you have enough money and is prepared to make at least 10 similar bets (size, degree of OOTM, expiry etc) since you can easily, and often do (that's how options are priced and why the "smart" money usually sells options rather than buy them) LOSE ALL OF YOUR MONEY, until one of your calls cach a fat tail and you make it all back and hopefully more so.

    2. Index put options are simple and efficient but still almost as financially dangerous as a Las Vegas Roulette wheel. But if you want still more risk, why not go for individual put options on certain stocks in certain industries you assess being particularly weak?

      There certainly are a lot of crazy valuations around in both technology stocks and so called defensive stocks (consumer, food, energy, utilities). Not least internet, gaming, "cloud" plays, software, and just new companies like GoPro with ridiculous valuations. They will come crashing back to earth, it's just that they might increase another 100% first, wiping you out.