torsdag 16 oktober 2014

Yes, I think the stock market will crash

This is now a bear market. The reasons are:
  1. Momentum has turned. So far the market has been saved over and over again by its own momentum, but the last week momentum has turned and now selling begets selling instead of the opposite.
  2. Everything is built on printed money and debt, which is just another way of saying it's all smoke and mirrors, an indian rope trick if you will
  3. Once interest rates normalize the game is over; it's only a matter of time (first, however, flight to safety will cause interest rates to fall)
  4. I think so
That's the short and the long of it. However, most people want more. Just note, that anything said about the stock market is just beliefs, never really truths. Anyway, here goes:

  • The economy is built on debt:
    • Governments are more in debt than ever
    • Deficits are large despite 6 years of recovery - imagine what will happen with debts an deficits in a recession. Sooner or later taxs must increase to close the gap. That will hurt growth and profits. Considering the size of the debt burden, the breaking point is rather sooner than later
  • Valuations are built on debt
    • Investors buy stocks since nothing else has a return due to money printing, pushing up valuations
    • Companies borrow and buy their own stock to manipulate earnings per share and compensate for stock options. These buybacks push up bothe EPS and stock prices, while lining companies with debt
    • Investors' margin debt at the NYSE is at record levels - these will be called and thus create forced selling at a certain point
  • Profits are misleadingly high
    • Government deficits and transfers, food coupons etc mean people can keep consuming more than otherwise, despite low or no wages
    • Low savings rate means companies can pay less wages while still selling more, thus earning more than they normally would. The savings rate is low, since people are used to financing their consumption with loans due to low interest rates (consumer loans, house loans, car loans, student loans). Neither individuals, nor the state will be able to afford paying for retirement without higher savings or higher taxes.
    • Profits are artidicially high, since they don't account for true personnel cost (they are paid with stock options instead of cash)
    • Profits are phony, since the large debts hardly affect profits, as long as interes rates are near zero
  • The benign feedback loop now reverses
    • Falling asset prices weakens confidence and leads to more selling
    • Less collateral for loans mean less room for spending
    • Companies will raise prices on what they can; necessities; leading to even less room for spending
    • Less room for spending means lower profits, but also demands for higher wages and pensions,leading to even less profits and more public budget tightening
    • Higher wages, pensions, taxes and higher prices means inflation and sooner or later higher interest rates
    • Higher interest rates means less lending as well as higher loan service costs. This leads to lower house prices, lower stock prices, even less confidence etc...
Hence, in my mind it is only a matter of time before the economy, profits and valuations of these profits will join with reality again, With lower growth, lower profit margins and lower valuations of these lower profits, stocks should be worth at most half of what they are today.

Now, should and will are two different things, in particular when it comes to stocks. On the other hand, the stock market moves in cycles, just as most things do and when the market pendulum has reached its max and its momentum fades, the pendulum inevitably turns.

Momentum dies when a small correction feels big. After 6 years of relentlessly rising stock prices and ever smaller corrections, it takes "a lot" to shake investors' confidence and create sellers of buy-the dippers. On the other hand, the more debt is piled upon debt the less it takes to feel like "a lot". The current little correction of 10 per cent usually occurs at least once every year and should be nothing. Now however, many are panicking already.

Consequently, I think we are right on the edge of whether the big downturn has started or not. Just as Bob Janjuah said in his market call update today (Bob's World), if we close at the current levels for two weeks in a row (tomorrow and next Friday), confidence will be broken (confidence in the market, in the economy, in central banks, in politicians), selling will beget selling and the downturn will be confirmed.

There will be many, many bounces; dead cat bounces. Don't let them fool you. Sure, try to trade them if you feel like it. The market seldom drops more than 20 per cent in a straight line and seldom for more than a quarter, so try to buy some after similar plunges. Sell once it has bounced 10-15 per cent; don't go for more or you risk being locked out of the market fall. During the downturns of 2000-2003 and 2007-2009 there were tens of such bounces.

Maybe a bounce is already due; maybe we will fall another ten per cent first. In any case, I would use the bounces for selling, not the falls for buying. The market is now a bear market where you sell the bounces, not buy the dips.

Cheer up! If the market falls by half, you'll get the opportunity to invest at reasonable valuation levels. Good for you. The market has already fallen by 50 per cent two times since the peak in 2000; a third time won't break the global system or cause wars. Just be sure to keep some money at the ready, to be able to invest if the current rout does indeed turn out to be the beginning of the real downturn.

15 kommentarer:

  1. If anything, remember my 'claim to fame' is making most of my money from SHORTING stocks during the downturns of 2000-2003 and 2007-2009, while still making decent returns in the bull years of 1994-2000, 2003-2007 and 2009-2011.


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  2. ZeroHedge has quoted most of Bob's letter here:

  3. The real question is when will the big correction occur? Confidence is dwindling by the second and a market correction will be made surely soon.

    It would also be very insightful if you could possibly do a quick article on one of your winning short trades from the 2000's and tell us what indicators you used and why you took that position against others without giving proprietary information away from Futuris.

    Furthermore, I am having trouble finding the right expiration date to place my put option contracts. You were recommending on taking 10 positions and roll them over against each other in accordance to 1 week intervals due to lower premiums on theta? I understand that your opinions may or may not play out.

    Thank you Karl

    1. Hi

      I think the correction has started. Remember that even the crashes of the 30s, the 70s as well as 2000 and 2007 played out during several years. I don't think it is productive to bet on a large air pocket like the one in 1987 (on the other hand, I woldn't bet against it either)

    2. Regarding particular piositions and reasoning from 14-15 years ago... I'm sorry but that is all but forgotten and lost in history. We didn't do anything fancy. During 1998-1999 it was just a "gut feeling" building up due to more and more companies without profits, without real business models that got ridiculous valuations.

      The fund made a lot of money during the final run-up in the fall of 1999 (the fund grossed 60% in the fourth quarter of 1999, net to clients 51%).

      When the market took its first dive in the first half of 2000 we were understandably slightly wrongfooted, but managed to keep performance around zero for the first half; so no real losses.

      That initial plunge of H1 2000 sparked ideas about what kind of short positions could work. Then the market came roaring back, despite weakening fundamentals (Days sales outstanding in IT companies e.g.).

      We then concluded that the IT rally was most likely over. Valuations were even more crazy than today, biz models were worse and more entangled (the co:s did barter trades at phony prices with each other, stock option compensation was even more pronounced than today, all IPO money was spent on buying ads at other .com companies. They bough ads from each other with IPO money...!)

      Thus we started to carefully short specific stocks with extremely high valuations and questionable fundamentals, typically "internet consultancies" that basically were just consultancy firms with 10x the valuation. We shorted stocks like Red Hat and Enea, Framfab, Ericsson. We shorted just about anything that was associated with internet, wireless communication, advertising, networks etc. At the same time we kept a net neutral position in the fund by buying "old economy" stocks with low valuations (forestry, construction, concrete...). The latter part of the strategy is impossible these days since utilities, consumer etc are expensive today (du to ZIRP -sero interest rate policies)

      The general strategy from then on, after the initial downturn i Mach 2000 (i.e., from September 2000) became a sort of guerilla warfare against IT companies in various regions: 1) we shorted ahead of earnings reports and 2) we shorted stocks in Germany and France that were similar to stocks that had already crashed in the US or Sweden

      nothing fancy, no complicated strategies, just plain old fundamental sound reasoning and analysis. The timing was decided by that first warning shot in H1 2000. I think there is an analogy to now; October 2014 is the warning shot and you should sell expensive and unsustainable stuff on bounces.

    3. Regarding put options: All I'm saying is "don't put all your eggs in the same basket".

      If you have 100 'currency' to place in the market, do not plan to use more than 10 on options. Those 10 should be 'invested' 1 at at a time, e.g., buy a put option with expiry 15-45 days from now around 5% out of the money (S&P 500 at 1770).

      One week or a couple of weeks later buy another put for 1 'currency' with the same characteristics, i.e. 15-45 days to expiry and about 5% out of the money. Keep repeating until your 10 'currencies' have been spent. Maybe it will take 6 months to invest it all. If you make money on some of them, and feel there is more downside left, just keep repeating. I think this downturn might last 12-24 months.

      It's really not a system, just a way of making room for errors in timing and actual outcome.

      Again, nothing fancy and I'm sure you can improve on the "system" yourself.

      (please disregard spelling errors - bad keyboard and little time, in particular the comment above, I noticed afterward)

  4. Fast moving markets... European stocks have already bounced 5.5% since the bottom yesterday at noon. The dead cat bounce may be over sooner than you think. HFT's might mean this downturn will be played out in fastr forward mode.

  5. Your advice has been much appreciated. It's crazy how the markets move today in respect to their historical volatility. Most trades are electronically automated, and fundamental input is regarded less than quantitative input.

    The edge in knowing fundamental financial theory is having a good idea where the overall economy or particular stock is going before earnings, government reports or other news come out. I presume that you are less dependent on technical/quantitative indicators and have excellent intuition in the workings of financial markets. Robert Greene, author of Mastery, said intuition or having a subconscious ability to understand one's subject is the greatest form of mastery.

    A successful real estate investor running the largest franchisee empire in the United States told me his greatest piece of advice in earning a fortune is to understand timing. He further said timing will save your ass after making a bad investment decision. Overall, I enjoy investing because you're rewarded when you're patient, thereby it frees up my time into focusing on other endeavors.

  6. The discussion under this post is really valuable for me. I have two questions in my mind, and would really appreciate, if you could answer them.

    1)What do you mean by fundamental input?

    2)What is fundamental financial theory?

    Can you recommend anything to understand it?

    Thank you very much,


  7. Fundamental = that which is real and relevant

    In stock market analysis fundamentals means the true, objective inputs that decide how much a company and its shares are worth. The most fundamental, relevant and important of all variables is CASH FLOW, i.e. how much cash the company generates. Cash is what is left of sales after costs and taxes are deducted and cash use for growth or replacement investments have been considered.

    So, the most fundamental variable when buying a share in a company is how much cash it will give you back - not when you sell the share, but if you keep it forever.

    Other fundamentals are those that affect cash generation. These can be the company's technology, sales force, customers, competitors, general economy and almost anything that affects sales volumes, prices, cost of production, wages etc.

    Then it's time for financial theory to step in and actually VALUE the cash flow. How much is a certain pattern of cash flow worth? That depends on when you get it and what you could have done instead with your money in the meantime. Hence, timing and alternative investment returns are important

    A quick and dirty way to handle this is simply to say that if I get 11 dollars a year from now, that is worth 10 dollars today, i.e. you are prepared to pay 10 usd today to get 11 dollars next year; equivalent of 10% annual interest rate. Financial theory teaches how to come up with "the right interest rate" or "alternative cost" or "risk adjusted discount rate".

    Unfortunately I don't have a ready recommendation for you where to learn this stuff, but I'll think about. If something comes to mind I'll tell you.

  8. Thanks a lot :)

    It reminisced me about the finance rule " the dollar today is worth more than a dollar tommorow ".

    I read your answer couple times, and what is coming to my mind is that :

    Let's say, that we have a company X, and this company has a certain monthly cashflow from their sales. So when they have their earnings after all direct and indirect costs, they have to use financial theory to decide further.

    What is the cost of keeping profits in the bank, when it remains idle?

    With such and such a sales should we invest in new better technology, to increase our future cashflows?

    What opportunities we have, to invest somewhere our profits, that the cash will not be idle?

    Am I thinking right?

  9. Hi,

    It looks right. When looking at the stocks of Allianz, BMW or ADIDAS at the german DAX, the recent falls seem more serious for the whole 3 year period.