One of the things I didn’t expect about writing a book was the long-lasting nature of it. I guess, technically, it’s an asset now. I thought we’d sell a few copies right off the bat and that would be that. But it’s neat to come in every day and see that some new person somewhere in the world downloaded it. I wonder how long that will keep happening?
I guess as long as we have a Draco Shop and I’m willing to make shameless plugs!
Seriously, though. I know I’m never going to make any real money off this thing. It’s just satisfying knowing that these ideas are circulating out there in the world. I’m a big believer in Seth Godin’s mantra that “ideas that spread, win.” I hope these ideas spread because I honestly think they are good ones that real people can benefit from.
Which reminds me, three more things:
- If you downloaded the book, send it to a friend. Or share our newsletter with them. I published it under a Creative Commons license for this exact reason. The primary goal is to share ideas, not to make money. I encourage you to pirate it!
- If you enjoyed the book or enjoy our weekly musings, then write a quick Amazon review or at least leave a rating. Pretty please with whipped cream and a cherry on top. I really do appreciate it. User reviews are one of the reasons why people shop at Amazon. I always read the reviews of everything that I buy. Heck, even if you hated the book, go ahead and leave us a 1-star review!
- If you want some more specific information on some of the investment ideas I sketched in the book, I’ve been doing a series of focused articles over at Seeking Alpha. The first part was on Energy vs. Financials, which received their special “Editor’s Choice” designation and was near the top of the site in “recommends.” The second part is on Consumer Staples vs. Discretionary which just hit the site.
Thank you!
Market Recap
Volatility continues to be the word on the street.
The good news is that the VIX hasn’t violated its high of 48 from August 8th. That was the day the Dow was down 654 points. Every stock in the S&P was down. I heard Bob Prechter mention on Bloomberg that the advance/decline line and market internals were the ugliest they’d been since the 1920′s. I wonder if everybody out there truly appreciates what a historic event this August has been.
When the VIX is above 30, swings of several hundred points in the Dow ain’t no thing. If you’re wondering when we’ll stop seeing days where the market opens up 180 points and closes down 250 points or up 400 points, we’ll stop seeing them when the VIX drops back into its normal range.
I’ve been writing about the troublesome economic backdrop for quite some time. I feel like I have a reasonable idea about what it means for the long term — slow growth, general market volatility, and disappointing returns across nearly all asset classes. But I haven’t a clue about what it means for the short run.
Right now I’m watching volatility. If it stays high, I’ll stay cautious for the short run. If it comes back down, I’d expect a long, slow rally or stabilization. The fundamentals are disappointing but not disastrous.
I’m also watching my wonkish credit spreads. LIBOR-OIS has broken out to a new high for the last year. That’s bad. This is basically an indicator of how much banks trust each other.
I don’t like watching this go up. But it’s important to provide a little context.
Here’s a 5-year chart of LIBOR-OIS.
It’s certainly higher than a historically healthy baseline. But banks and the credit markets simply are not freaking out the way they were back in 2008. What happened in 2008 was long-lasting and fundamental. This latest correction certainly could be the beginning of a cyclical bear market. I just don’t think it’s another financial apocalypse.
The TED Spread is rising too but it’s still reasonably tight. Junk bond spreads have risen somewhat but haven’t blown out the way they did in early ’08. EURIBOR is getting up there, but you guys are all strictly avoiding Europe anyway, right?
The media has tried to link this latest market decline to concern about a slow U.S. economy or a possible sovereign credit meltdown in Europe. Well, guess what. This is the exact same economic backdrop that existed three months ago when the market was making new highs. Nothing has changed in the last three months. The U.S. economy was looking at slow growth prospects back in May and it’s looking at the same slow growth prospects today. Greece wasn’t any less likely to default on its debt back in May than it is today.
If you think this whole mess is news driven, sorry to burst your bubble. It’s not.
What really moves the market
Look: the market does what the market wants to do.
The best way to think about the market over the short-term or medium-term is as one big barometer for how willing people are to take risk. When the market goes up in a week or a month, it means investors feel good and feel good about taking risk. When it goes down, it means investors are a little more careful or fearful.
Over the long run, the market goes up by roughly GDP + Dividends + Inflation. We’ve talked about this equation before. It’s actually more of law. U.S. stocks in aggregate can’t grow their earnings at a rate greater than GDP because, well, the act of growing their earnings contributes directly to GDP. The relationship between earnings growth and GDP is not just correlative, it’s causative.
Obviously, the market doesn’t go up by that equation every year. It almost never does. That equation is a long term average. So the noise you see within any given year is almost entirely a reflection of mood.
You might ask — why did the market average 15%/year between 1982 and 2000? That was way higher than GDP + Dividends + Inflation. The answer is that stocks started at levels that were very cheap, cheap in the sense that investors were extremely reluctant to take risk. At the very bottom, investors were only willing to pay about 8x one dollar of earnings in the stock market.
But over the years that psychology changed. We had some economic success in the 80′s and 90′s and everybody gradually felt better about taking risk.
It peaked during the dot-com bubble. That’s when we were all day-trading our 401(k)s in companies that had no earnings and no business model. In 1999 the market was worth 30x one dollar of earnings.
Pretty amazing, huh? We went from completely avoiding risk to being desperate to take it.
Here’s a variant of Price/Earnings ratio that I track. It normalizes the ratio by using 10-years of averaged earnings as the denominator. It’s what Robert Shiller uses and it’s one of my favorite charts.
If you haven’t already guessed, we’re now on the path the other direction. Over the last decade investors have slowly started to feel less comfortable about taking risk. You can see how that ebbs and flows through short-term cycles, but you can also see long-term trends at work.
Right now in the market it’s pretty tough to decipher. On a one year trailing basis, PE ratios are as low as they’ve been since March of 2009. But when you look at the bigger picture for earnings, you can argue that the market is still expensive.
This might be the worst that it gets. This might be the point at which savvy investors say, “yeah, it’s time to load up on stocks again.”
But I don’t think so. I think that bottom is still lurking out in the future. Don’t you? Probably not this year, and hopefully not next. But I feel pretty good about forecasting that event at some point in the next 3-7 years.
That’ll be the generational opportunity in the stock market. That’ll be my cohorts’ version of 1982. And the great irony is that when that day day does finally arrive, nobody will want to take any risk. Very few will actually have enough assets left to do it.
Where will you be?
What will that world look like?
OK, smart guy. What makes the market go back up again?
Back to the present…
You might be wondering where stocks are headed for the next couple of months. I have no idea. But the market isn’t going to snap right back to where it was. Sorry. It doesn’t work that way. The first rule of market action is that these things go down a lot faster than they go up. It’s pretty much the opposite of gas prices.
The second rule of market action is that they don’t go in the same direction forever. At some point stocks will put together a significant rally. Who knows how big a rally it’ll be and who knows how long it’ll last. It will happen though.
And let me tell you why: stocks are the only game in town.
Seriously. I wrote about this a while back. Remember Risk-or-Die?
This is a negative real rate environment that we’re living in.
Yes, Neo. Negative real interest rates means if you have idle cash sitting around, you’re slowly losing money to inflation. If you invest in near term Treasuries, you’re slowly losing money. If you buy TIPS or longer-dated Treasuries, you’re pretty much treading water. If you buy high-yielding corporate debt, you’re taking a lot of risk and if you don’t want to take a lot of risk, well, now you’re squeaking out maybe a percent or two above the inflation rate. Same deal with Munis. Commodities — gold included — represent crazy risk, so you can’t have too much of your portfolio there. Real Estate is a morass and it’s a very difficult asset class for normal people to make money in. Hedge funds may offer opportunity, but those have all sorts of weird net worth requirements.
What’s an investor to do? What’s a retiree to do? What’s a state pension fund manager who needs to make 7% do?
The answer is that these guys buy stocks. They have to. Stocks are the only game in town.
At some point, we get tired of panicking. Our fear subsides. Volatility retreats. We realize that the world isn’t actually going to fall apart, and stocks start slowly going back up again. They climb that wall of worry.
The Fed knows this. And they know what a disastrous effect it would have on the market if short rates were allowed to float up towards the inflation rate. Higher interest rates would likely have an ugly impact the real economy as well. This environment has been explicitly engineered and it’s been engineered for a reason.
Investors have to take risk in stocks else they die in cash or other low yielding assets. It’s a perverse, masochistic game that we’re all playing. I’m of the belief that the only way you can win is if you re-program your psychology. You’ve gotta learn to be happy with 4% yields on semi-risky assets. You have to look at things that others find distasteful or boring. You have to be careful and prudent.
Basically, you have to forget a lot of what it means to be an American.
The Only Game in Town
It’s hard to speak about the future and it’s folly to try and predict it.
But in some sense, I feel like it’s really easy to see what we’re in for. This bizarre psychology — the chronic need to make money and the occasional panic of risk-avoidance — is the dynamic that will drive market action for the coming decade. This will be the dominant pattern of market behavior. I am confident of this. And I cannot overemphasize how important it is for every investor of every discipline to understand.
For long term investors, it’s a reminder that you have to do your buying when stocks are cheap. You do it during environments like this current one when PEs are at cyclically low levels. It’s also a reminder that these environments happen. If you’ve got a portfolio of stocks and you’re truly committed to a 10-20 year horizon and you can psychologically withstand losing half of your money over the course of an 18-24 month span, then you have to remember that corrections will just happen.
If you’re a trader with a shorter-term investment horizon, you have to remember this asymmetry. You have to have risk models in place that are prepared to handle large drops that come seemingly out of nowhere. And you have to be patient with your gains. You have to understand that it takes longer for that greed/need to settle back in than it does for fear to swirl through the marketplace.
If you hate stocks with a passion and are skeptical of the markets, you’ve got to be aware that if you don’t relax that mindset in the coming decade you’re going to miss the opportunity when it arrives. I know a lot of people in my generation completely distrust the stock market. I can’t blame them after the decade we’ve lived through. Many of us would rather go to the casinos than play in the market because at least in the casinos you understand the rules and the probabilities.
And if you’re one of those Boomers who fell head-over-heels in love with the equity markets in the good ol’ days, you have to understand that this thing can cause pain that’s equal to — actually, greater than — all of the joy you experienced watching stocks go up 15% every year. The good news is that we’re already a decade into this mess but the bad news is that there’s probably another decade of it still to come and none of you have saved enough.
The psychology of today’s markets means different things to different investors. But the point is that this dynamic won’t change until the negative real interest rate phenomenon goes away. Until investors truly have a choice, and truly have an option to make a little bit of money while avoiding the risk associated with the stocks, the market is going to take it’s sweet time getting to where the fundamentals suggest it should be.
It’s going to rally long and slow and then collapse out of nowhere.
- The market is going to have crazy swings every day as long as the VIX is high. Keep your eye on volatility and credit spreads for indication on when it’s safe to wade back in.
- Over the long-run, fundamentals are what matter most to the market. But over shorter periods of time the stock market acts as a barometer for how comfortable investors feel taking risk.
- The most important phenomenon in the markets right now is this environment of negative real interest rates. It creates a massive incentive for investors to take risk, something they don’t really want to do, but have to because there’s no other way to make money. Then one day panic sets in and the market drops 15% in two weeks.
All of us are familiar with Frankenstein.
Whether it was Mel Brooks’ campy classic or Mary Shelley’s groundbreaking work, we’ve each heard the story somewhere along the line. There’s something about it that speaks to us. God creates man in his image. Man grows bold, starts playing God, and creates new life in his image. But Man is not God and when he starts messing around with forces he shouldn’t, things get… out of control.
The story ends badly.
It’s timeless. It’s the basic Prometheus myth. These are concepts that man has been toying with for thousands of years. Deep inside of us is the desire to push the boundaries of creation.
What happened in the crash
My guess is that this latest crash will be forgotten as quickly as it happened. That’s usually how these things go. An 18% drop isn’t the end of the world. Nobody got killed and nobody jumped out any windows. But the Dow is down another 500 points this morning, so we’ll see. In a few weeks investors will get their August statements.
Since the Flash Crash of last year I’ve been reading a lot about high frequency trading and the ways in which it has been distorting the markets. HFT is a dirty word in certain pockets of the industry, but it’s largely unknown in the general public. Not all high frequency trading is bad. Some HFT is rather vanilla and non-destructive. But some HFT is extremely destructive.
When talking about high frequency trading, it gets really technical and complicated in a hurry. The long and short of it is that there are certain algorithms that really mess with the structure of the market. And by doing so, they give other normal market participants a huge incentive to not provide too much liquidity. Liquidity, of course, is really important during market dislocations. If you want to sell, it’s important that there’s someone out there willing to buy. If not, the price of your asset drops until it finds a willing buyer. So long as the market doesn’t appear completely chaotic, the asset price usually doesn’t have to drop very far before finding a willing buyer. After all, these markets are pretty efficient.
But high frequency trading distorts that. Consider the strange case of the S&P 500 e-mini contract, one of the largest and deepest futures trading contracts in the world. The order book is normally about 20,000 contracts deep, which means you can sell a little over $1 billion dollars (notional value) of these things without distorting the market price too much. According to a study from Nanex, the size of that book dropped to around 1/10th of the size during the crash. What that means is that relatively small sell orders were distorting the market price dramatically and that’s why the markets were jumping around in hundred point intervals.
Check it out:
I know that chart is tough to read, but each colorful line represents a different day. The purple & blue end of the spectrum are dates from June. The green & yellow are dates from mid-late July. The orange and red dates are from August. It’s scary to think about, but somebody out there probably saw this coming.
As volatility increased, liquidity decreased. Dramatically. The more quickly sell orders came through, the more quickly they sliced through the resting bids in the book and the sharper the price drops were. That just created fear and more sell orders, exacerbating the problem through a vicious feedback loop.
One of the root causes of this lack of liquidity is a specific HFT algorithm. It periodically disrupts the markets, screwing arbitrageurs who have positions in linked securities. Now these guys have just stopped posting their bids. The humans are afraid to get eaten by the machines and have altered their behavior in a way that winds up hurting society.
Here’s a great little video about high frequency trading:
High-frequency trading from Marketplace on Vimeo.
There’s another algorithm out there that bombards an exchange server with over a million bids in less than one second, rescinding the orders instantaneously. That overwhelms the server and slows it down. As the HFT algorithm gathers information about resting orders, it places a simultaneous trade in a linked security. It knows that the security will tick up or down because of the information it’s gathered, and it knows it before the exchange server is able to speed back up again and update properly.
Tell me that doesn’t sound like cheating.
Many of these HFT firms co-locate their servers next door to the exchanges so they can trade in and out faster than it takes light to travel from one side of the country to the other. Read that again. Wait — I’ll just re-write it: these firms are trading in and out faster than it takes LIGHT to travel from one side of the country to the other.
Remember that the fastest that data can travel is at the speed of light through a fiber optic cable. It’s pretty fast but it’s not instantaneous. There is an actual quantum speed limit. But on Wall Street, we’re bumping up against that limit. Firms out there are using that cosmic speed barrier to their advantage.
Who woulda thunk?
Here’s an analogy that you younger readers will understand, as will my Gen X peers who grew up playing video games. Imagine if, while playing multiplayer Halo or Quake or shooter of your choice, you had a magic button that you could press that would instantly slow down all your opponents’ connections. Imagine if you could make their avatar freeze up helplessly with lag, giving you an extra moment or two to aim your railgun for a perfect headshot.
They do this in the world of high-frequency trading. It’s called “latency arbitrage.” Why it isn’t illegal is beyond me. But then again, the words “latency” and “arbitrage” are both probably beyond those who write the rules.
The profits on these trades might only amount to one penny a share, but if you do it a few million times per day it adds up to real money. Themis Trading estimates that this generates $6-12 million per day for HFT firms, a total of around $3 billion per year for the industry. That figure is actually lower than what I’ve seen elsewhere. I’ve heard that HFT is more like a $6 billion industry and just a few years ago was a $13 billion industry.
The reason why you should care about these big numbers is because it’s all coming at the expense of other investors. The people that lose out are the institutional investor and the retail investor.
That’s you.
OK, I get it. It sounds pretty bad.
You may wonder how this is all allowed to go unchecked, but HFT is a multi-billion dollar niche and these firms have a powerful lobby that aligns themselves more generally with the Wall Street lobby. On top of that, these exchanges — which are now for-profit enterprises! — collect juicy fees on all this trading. Depending on who you listen to, HFT accounts for at least 60% and as much as 90% of the entire volume in a given day.
Why? Why do we permit this?
When you marry those ridiculously mis-aligned incentives with the highly technical nature of the problem, it’s no surprise that no one is doing anything about this. The regulators either don’t care, don’t understand the dynamics, or willingly look the other way, convincing themselves that the activity isn’t actually harmful. And the public pretty much says, “Blargh. Looks like Greek to me.”
I’m as big a fan of technological innovation as anyone. I want to see Man expand the boundaries of science. But right now we are having a hard time taming a monster of our own making. Frankenstein’s beast is on the loose and while it’s too late to un-make our creation, we should probably do something before somebody really gets hurt.
It should explain why we’ve never seen market behavior quite like this and the Flash Crash in all of human history — with the exception of 1987, an event now commonly accepted to have been driven in large part by computerized program trading. That crash was exacerbated, of course, by the fear that the volatility spike created.
This is the world you live in as an investor. The average guy on the street has been skeptical of Wall Street since the dawn of the localized exchange. The only thing that’s changed over time are the reasons why he feels skeptical.
It’s them versus you. The stakes are high and they don’t like losing.
So what?
I bring all of this up not to sound like a conspiracy theorist or some ideologically-driven crusader. I simply want to let you know what’s what.
I watch the markets all day long every day. My guess is that you don’t do that. My guess is that you don’t spend ten hours a day engrossed in market data, news, spreadsheets, research, interviews, investment commentary, and continual strategizing. My guess is that you don’t check the futures on Sunday night to see how the week will open.
My recommendation — actually — is that you don’t do all of that. Not unless you love it for its own sake. Don’t be like me. Go play golf. Go do something that makes you happy or less stressed out.
But I am a financial professional and my fiduciary duty is to safeguard client assets. And part of that is staying plugged in. I happen to have a platform of readers and I know that the couple thousand of you that stop by every week aren’t doing it for my movie reviews. You’re reading because you want to know what’s what. There is no shortage of opinions and perspectives in this business (and self-interests, too).
Why me? Why listen to me? Way back on Day One of this po-dunk little newsletter I realized that if I was going to have any chance at all, I’d have to differentiate myself. Being honest was part of that.
So there you have it: the markets are broken. It isn’t that they are rigged or that the Men in Grey Flannel Suits are all out to get you. The dynamics that facilitate the daily operation of buying and selling simply have a few fundamental problems. Most of the time they work just fine but every once in a while completely abnormal things happen. It’s unnecessary, too.
The real problem is that these events are socially unproductive and have real world consequences. Did you happen to see the U. Mich. Consumer Sentiment reading that came out right at the bottom of the crash? 30. Year. Low. This crash is the kind of event that could singlehandedly tip an economy that’s just growing slowly into outright contraction. Again: unnecessarily.
Think of these broken markets like driving around on a tire with low air pressure. Nine days out of ten you don’t notice a thing. But then one day you get on the freeway and get a blowout. Hopefully you don’t suffer a serious accident. Hopefully you’re OK. But why take the risk? You could have just kept the tire inflated.
For some reason, we are all psychologically wired to ignore the low air pressure and delude ourselves into thinking that the probabilities of a blowout are lower than reality would imply. I don’t know why this is. I don’t understand why we can’t be honest about the low pressure and pump the stupid thing up with air.
Maybe it’s not the broken dynamics that I should be worried about. Maybe it’s our broken psychology.
I feel like we can do something about broken markets. Reinstate the uptick rule. Ban flash orders once and for all. Make all offers good for at least a half-second. Don’t let private firms house their trading machines in the same building where the exchange’s servers live. Think about taking away the profit motive for the major exchanges. Make order stuffing illegal.
All of that is rather easy to do.
But I’m powerless about fixing our psychological deficiencies. Within those are the true seeds of our own destruction.
How can that not make me feel depressed?
Chill out
I apologize for the somber mood. I’m travelling down in Los Angeles this week. I lived here for six years and every time I come back it dredges up complicated emotions. I grew up in a relatively small town and moved here during a period of my life when I was particularly vulnerable to outside influence. It had a permanent effect. The City ripped out and devoured my credibility as a humble, small town boy. It injected me with a metropolitan ethos, reconfiguring my personality though never accepting me as one of its own. I became the bat of Native American mythology — he that fit into neither the mammalian or avian kingdom.
This is truly the City of Mixed Emotions. So much here to love. So much here to hate.
While I write this here on the pier in Redondo Beach, I feel like I can see things a little more clearly. A change of venue usually does that. So will good coffee and a pleasant morning. But I sense a little more cynicism than normal seeping in. I wouldn’t worry about it if I wasn’t so introspective or wasn’t discussing matters of actual importance with the public.
Nobody cares about my own battles of internal philosophy and personality. So let me tell you why the general case matters.
Victor Frankenstein is why this matters. What makes us great is our desire to learn, to push boundaries, and to grow. This is the dominant theme of all of human history. But this poses tangible risks in the world of finance. Everybody remember the term “financial innovation?” It was only a few years ago when we thought we had conquered the world of risk thanks to fancy statistical models. We built fabulously complex securities on these principals. CDOs. Credit Default Swaps. Securitized bundles of subprime residential mortgages. These were awesome because these were profitable. Frankenstein rejoiced!
But they came with costs that we ignored at the time of their construction. We know that now and we know that it pays to be introspective about the technology we develop. It pays to ask deep, difficult, open-ended questions along the way. But that payout happens over the long-run. In our short-term psychology, all we see is cost. The guy at the Wall Street bank that asked, “uhh, what happens if a higher percentage of these mortgages default than we’re currently modeling?” got fired. Answering that question would have cost his bank money that quarter.
“Screw that guy,” said the shareholders.
Victor Frankenstein didn’t ask these questions either. We sympathize with him today and have been doing so for ages.
We sympathize because we know we’ll be repeating his mistakes a thousand years from now.
I knew there was a problem in the markets when I came home on Sunday and saw my wife watching Inside Edition. They were talking about stocks. Sandwiched between updates on the Kardashians and some guy whose car was attacked by a giant snake on the highway, they were talking about the crash in the market.
It’s always a bad sign when they’re talking about stocks on Inside Edition.
WTF is going on?
This is why you probably tuned in today. You’re looking for guidance on what to make of all this madness.
Buckle up. Here we go:
Three weeks ago the market started going down. The moves were normal and based on fundamental concerns about Europe and a U.S. economy growing at a lackluster pace — the kind of thing I’ve been writing about for the last year or two. There was a little bit of worry about the debt-ceiling but everybody knew they’d get a deal done.
Two weeks ago the selling accelerated. Some technical factors started to kick in as traders began to hit important thresholds that forced them to sell. High frequency trading exacerbated the problem, raising volatility and pushing the intra-day trends way out into either direction. The machines and the hedge funds took hold of the market.
One week ago the U.S. lost its AAA rating and the world really started to panic. That’s when the psychology of fear erupted and every investor on the planet immediately went into “de-risking” mode, scrambling out of every trade at whatever the cost. Institutional investors hit their pain thresholds and pulled the plug. The volatility index spiked to the highest level since the financial crisis.
Here’s where we’re at right now:
That, my friends, is a chart for the ages. It was a drop of 18%. Doug Kass basically called it 1987 spread over two weeks. Around the office we’ve been referring to it as a “slow motion Flash Crash.”
What’s an investor supposed to do?
Weeks like this certainly put the old adage, “buy when others are fearful” to the test. After all, that’s what you’re supposed to do, right? Step up and buy when it looks really, really scary out there and everyone is panicking?
Well, allow me to share some key insight: OTHERS ARE FEARFUL.
It’s tough, though, isn’t it? It’s a lot easier to sit around while the market is going up and hope for a nice little 15% pullback so you can buy some of these companies you’ve had your eye on at a discount. Then the correction actually comes. You freeze up. You say, “uhh, maybe I should stay in cash for a little while and see how this all shakes out.”
For long term investors, there’s probably opportunity out there. I saw that the S&P was trading at the lowest PE multiple since March of 2009. I know that’s based on record earnings, but if your time horizon is sufficiently long and you know how to pick out the companies with resilient cash flows, you can probably find value in some good assets that have been thrown out alongside the bad.
During times like this it pays to:
Whether you’re bullish and think the economy is going to hang in there or if you’re bearish and think that we’re on the brink of recession, the best thing you can do is keep a cool head and stay rational.
In the words of Douglas Adams, “don’t panic!”
Here are some of the most important items of the week.
The Downgrade
Unless you were living under a rock or have been on safari in the Kalahari Desert, you saw that S&P downgraded the United States’ debt. I have a few thoughts on this:
- In the grand scheme of things, this is fundamentally meaningless. It’s not going to affect the U.S.’s borrowing costs and it’s not going to influence global demand for our bonds. U.S. Treasuries have the lowest probability of default of any security in the world.
- S&P doesn’t exactly have a lot of credibility. Remember that this was the firm that rated Enron as AAA and also handed out AAA ratings to AIG and all those funky CDO’s. They have a lot of egg on their face after the whole subprime thing. They gotta get their reputation back somehow and making bold moves like this must be part of their strategy.
- It was probably the right call. The U.S. default risk may be zero but that doesn’t mean the U.S. balance sheet is attractive and worthy of the highest rating.
- However meaningless, investors freaked out about it. But that panic was just a catalyst for more important issues.
Banks Under Pressure
This is what really worries me. I don’t like seeing banks down 20% in a single day. That’s what happened to Societe Generale yesterday. They’re one of Europe’s biggest banks. Banks throughout Euroland are getting shellacked right now. In my opinion, a full-blown European crisis is the single biggest risk that the markets face right now.
I’m hearing all sorts of rumors — from stories of a major French money center bank dumping prodigious amounts of gold onto the market to whispers that a run may be beginning at SocGen. I don’t like hearing rumors like this and neither do the markets. Whether they are true or not, they stoke fear and fear, as we all know, is the path to the dark side.
And there’s concern in the U.S. too. Bank of America dropped 35% this month. Thirty-five percent! They’re now trading at like 1/3 of book value. Apparently the markets think B of A’s accountants have made a mistake. Citigroup and Wells Fargo aren’t as bad but they’re in the same boat.
Continue to watch these financials. They’re going to lead the market and indicate whether it’s safe or dangerous to wade in.
As critical as I am of the European Union and their central bank, I do think they learned a lesson from the U.S. financial crisis and are willing to do the distasteful things that are necessary to prevent the situation from completely melting down. But that doesn’t mean that the market can’t or won’t freak out about it.
The consumer isn’t dead
I know that precisely zero people in the world are interested in this right now, but check out what’s going on in the Consumer Metrics Institute’s Daily Growth Index. This is another one of those obscure leading economic indicators that I follow and you can read more about it here. It’s pretty cool; they track major discretionary purchases and they do it in real time.
This is actually a more complicated chart to read than it seems. The blue line is the economic contraction that began in 2010. It’s been going on for 566 days. Instead of measuring the absolute magnitude of the contraction, it measures the rate of change. So that recent spike up means that their metrics show that the contraction has pretty much stopped.
No longer getting worse probably qualifies as great news in this environment, and it’s interesting to see it happen against this stock market backdrop that seems to imply that the world is falling apart.
This is a data point that clearly shows that the world — or at least the U.S. consumer, who, arguably drives the world economy — is not disintegrating It’s stabilizing and may even be starting to improve a little bit.
But remember that these guys are ahead of the curve. Don’t get too excited about it. Their data points are very far upstream in the production chain and the economy is still feeling a lot of the pain that their indicators were measuring earlier in the year.
We looked at a bunch of data last week that told a similar story: slow growth, but growth. U.S. companies just posted record profitability last quarter.
What I’m trying to say
The point is that the world is not falling apart.
You might think that the apocalypse is nigh given the fact that the stock market cratered this month and was apparently worth talking about on Inside Edition. The economy is certainly weak and probably slowing, but I don’t think this is the brink of total disaster.
Sure, there’s a lot of fear out there. This is the biggest rally in the VIX (the volatility index aka “the fear gauge”) in three years. And there are definitely risks ahead. I’ve written repeatedly through the last several years that the decade in front of us is going to be a difficult one. We are in the era of sacrifice, and in the era of sacrifice, investing is an extremely challenging proposition. The market isn’t going to do what it did during the days of the Long Boom. The market is going to go up and down and up and down and at the end of the decade, investors are going to wonder if it was all worth the heartburn.
But just because there are risks ahead doesn’t mean it’s a repeat of 2008. It’ll be a tough road — a bumpy road — but this road won’t go off a cliff the way it did in the wake of the housing bubble and in the heart of the crisis.
I understand that my perspective might frustrate you guys. Some of you are probably saying, “Come on! Are you bullish or bearish?!”
The answer is that I’m neither. When I vainly attempt to peer out into the future, I see an economy that’s pretty much flat and a market that trades in a broad range. We’ll get big rallies and sharp selloffs. We’ll get modest recessions and long periods of sub-par growth. We’re dealing with major structural problems in this country and they’re going to take a while to fix.
In that world, I’m focused on two things: specific opportunity and broad diversification.
In the equity space I’m looking for companies that are robust, with defensible business models and a global footprint, clean balance sheets and good cash flow, and a strong dividend with a history of raising it.
In the bond space, I’m not chasing yield. I’m not getting greedy. I’m focused on higher quality debt and balancing my risk and return. I’m happy with 3-4% percent if I know my odds of getting paid back are a virtual certainty.
I’m looking at alternative strategies, hedge funds that know how to trade markets that move both up and down.
I’m looking at real estate because the world hates it and for the first time in my adult life, you can actually make investment properties pencil out again.
I’m dabbling with commodities because inflation is always something investors need to stay on top of. But I’m not getting crazy about it because I don’t buy the hyper-inflationary doomsday scenario.
Periodic bouts of deflation concern me more, and that’s why I’m keeping a much bigger pile of cash on hand than normal. Cash is nice to have in spells of deflation because it’s relative value goes up as the price of the things it can buy goes down.
So I guess you could say I’m rather agnostic when it comes to the markets. I’m just looking for value wherever I can find it. I’m being cautious and I’m diversifying as broadly as I can. I don’t like volatility.
I actually wrote about a bunch of this stuff in my book, The Trade of the Decade.
Even in times of chaos like this month, those long-run strategies are relevant.
(The book is also available as a PDF and published under a Creative Commons license which means you can buy it and share it with your friends.)
At the Mountains of Madness
Have you ever read any H.P. Lovecraft? I know that all you true horror aficionados already have. But if you haven’t, you really should. I guarantee that it’ll be unlike anything you’ve ever read.
The reason why I enjoy Lovecraft is that his style of horror is completely original. We even have an adjective now, “Lovecraftian,” to describe a very specific type of horror.
Lovecraftian horror is a bizarre, existential horror. It isn’t about psycho killers or ghosts or zombies and other things that pop out of dark corners and eat human flesh. Lovecraft’s horror is about things the that man cannot comprehend. It’s about beings and forces that are so much older and so much more powerful than man that they are beyond our capacity for control or even understanding.
At the Mountains of Madness is a perfect example of this. It’s about a geologist who, on a voyage to Antarctica, discovers the remnants of a previous expedition. All the men and dogs were slaughtered and alien objects litter the ruins of the campsite. Deeper inside the mountains he discovers strange beings, immensely powerful beings who are up to God-knows-what. There’s even evidence that these Elder creatures are battling forces that they themselves don’t really understand. None of it is ever resolved and none of it is ever fully explained.
And that’s what makes it scary.
I’m a hyper-rational individual, so psycho killers, ghosts, and zombies don’t do anything for me. My brain doesn’t understand why people are afraid of these things. Or maybe it understands why, but it just feels nothing. When I go see a scary movie with Mrs. Draconian, honestly, I’m more afraid of whether she’s going to claw my arm if a monster jumps out than the actual jumping out of the monster onscreen.
But Lovecraftian horror — that existential horror that reminds us of our trivial existence here on this planet — absolutely horrifies me. I find the notion that there is a gigantic realm of phenomena that we do not understand very unnerving. And the fact that so many of these things are impossible for us to understand — simply beyond the powers of our capacity for comprehension — makes it even worse.
For me, it’s a dark, lurking terror. It’s always there, buried in the dusty crypt of my subconscious. Waiting. Patiently. My deepest fear is that one day I visit that crypt and find it empty, beast on the loose. Because that is the day I descend into madness.
This is what scares me about the stock market.
It’s impossible to understand. Though that doesn’t keep us all from trying. We derive theories. We conduct studies. We tell stories. And we convince ourselves that, yeah, this stuff makes perfect sense. Or enough sense to shoehorn into some quantitative VaR parameters. Our confidence grows and we act on our knowledge. We put our money at stake! We profit.
Then one day we discover that everything we know is wrong. And we are reminded for a brief instant that we never really will know. We are dealing with forces that are bigger than us. They are more complex than our puny human minds can grasp.
This Lovecraftian market is a monster. You cannot master it. Don’t even try.
The best you can do is what the geologist in the book does. He narrowly escapes and tries to warn the rest of the world. His story is a cautionary tale, a reminder to be careful when messing around with things that we don’t understand.
I guess that’s part of what I try to do around here. I discuss events, occasionally I talk about strategy & tactics, and I encourage you all to invest around something that you can understand, which is yourself.
Ultimately it comes down to the fact that nobody knows which way the market is going to go. And we don’t always know why it does the things that it does on a given day. The best you can do is figure out something that works for you, something that doesn’t cause you to lose any sleep. It might be diversification, it might be computerized trading systems, it might be a portfolio of straight Treasuries. Do what feels natural and what you’re good at.
Be careful. Respect the unknown. Stay rational.
That’s the only bit of advice that you’ll ever get from me that’s worth a damn.
It’s been a crazy two weeks. Let’s get straight to it.
Market Recap
The market sold off dramatically last week. It was the worst single week for stocks in quite a while. Selling pressure continued into this week, carving out an -8% drawdown. Yesterday, had the Dow closed lower, it would have been the first time since 1978 to have nine consecutive down days. Today it’s down again.
When I step back and look at the bigger picture, my thought is that this reminds me of what we wrote about back in early May. It was called “What Happens When QE2 Ends.” At the time, I said it was our most important newsletter of the year and I wasn’t joking around.
In that newsletter we looked at a few examples of quantitative easing through history and tried to see if they were relevant for the present. It turned out that they were and so we used them as a baseline for historical precedent.
I came to three conclusions, two of which wound up being right and one that was dead wrong.
The first risk that I saw was that the end of QE2 would mean the end of the bull run in stocks. The stock market had been partying pretty hard since the previous August and back in May I thought it was “last call.” This was not a popular view at the time.
But the party in stocks did end. And I doubt there are many on Wall Street that think that the cessation of QE2 had nothing to do with it. QE2 had a lot to do with it, but when you take a step back, what we have now is a market that has spent most of 2011 discounting an economy of slower-than-normal growth.
Check this chart of the S&P out:
Flat economy ahead? Flat market.
Apparently, the market has been discounting this all year. This is why you listen to the markets and ignore the headlines. The news back in May was rosy. The news today is dire. But the discounted future stream of cash flows that the United States stock market is set to provide has changed very little in the last six months.
The second risk that I saw was that commodities could really get spanked. This was the one I was most worried about but least confident of. It was the one that was by far the most contrarian and the one that got the most push back from our readers. It was also the one materialized the quickest and most dramatically.
Here’s a chart of the Reuters/Jefferies CRB Index since then:
It was like the commodity markets realized all at once that prices were too high from the artificial stimulus and corrected 10% before anybody could really blink.
Again, this was highly contrarian view earlier in the year. I’d probably be engaged in a round of extreme back-patting right now were it not for…
Interest rates
Wow! Was I spectacularly wrong about interest rates. I thought it’d be a no-brainer that rates would rise into and through the conclusion of QE2. After all, without The Fed buying ridiculous quantities of bonds, who would step in and fill gap? A 10-year yield under 3% isn’t exactly what most investors would call compelling.
But here’s a chart of that benchmark rate:
Amazing. Rates kept falling and falling and spiked right at the end of June — in perfect accordance with the script. But then that move reversed as quickly as it began and rates plunged further.
And the funniest thing about it? This was the consensus view! Most people back in April thought that stocks and commodities would be fine through the end of QE2 and that rates would rise into the Treasury bond vacuum once occupied by Captain Ben and the Federal Reserve.
Serves me right for running with the mainstream on that one. I got the most support on the interest rate view and it was the one that wound up being fantastically wrong.
Somewhere in all of that I’m sure there’s a lesson.
Right now I think the bond market is working on muscle memory. Bonds have moved in only one direction for so, sooo long that the world isn’t really accustomed to anything different. I know I write all the time about how yields on U.S. bonds are a frustrating proposition, but that’s just me being a rational investor. The fact is that there are a lot of people around the world that control gigantic pools of money that have no choice but to buy Treasuries. They are forced to by mandate.
So we’ll see how long these buyers can keep bonds afloat and we’ll see how low they’re willing to drive down yields. The Japanese 10-year bond yields a sliver over 1%. There are a boatload of ways in which the U.S. resembles Japan (and a few in which we don’t), so something in the 1% range might be as good a bogey as any.
A 1.5% yield on the 10-year Treasury note would surprise probably everyone in the world except Gary Shilling. Let’s all hope we don’t get there.
Listen to the Market
I think there’s something else that the bond market is telling us that’s worth listening to. It’s concerned about slowing economic growth.
Last week the headlines had it wrong. The story last week was about a nation freaking out over dysfunctional politicians and the chance that the world’s largest economy may default on its debt. That was all a smokescreen.
This week the headlines have it right. The story this week is about a growth slowdown and risk of higher unemployment. That’s a legitimate concern.
Regular readers around these parts know that we’ve held a very contrarian, very conservative outlook on economic growth for quite some time now. In fact, one of our predictions for 2011 was below-consensus GDP growth. So this isn’t a new concern for a certain swath of cautious investors. Now the rest of the world seems to be catching on and the markets have reacted all at once.
When it comes to getting a read on what’s in store for the economy, there are a few places I go.
The first stop is Lakshman Achuthan of the Economic Cycle Research Institute. I’ve been listening to him talk about his leading economic indicators for a while. So far, he hasn’t come out to explicitly forecast a recession. His signals have been flashing warning signs all year about a slowdown in the business cycle but still positive growth.
Guys like me get really hung up on the long-term fundamentals. And we forget that there’s a shorter-term, cyclical component to the economy. That’s Mr. Achuthan’s gig. The cycle naturally swells and shrinks and right now it’s shrinking.
After that I visit my “Three Amigos”
The Amigos seem to be telling the same story. No recession yet but buckle up for possibly disappointing growth.
The ISM Purchasing Managers Index indicates expansion with a value above 50 and contraction when it’s below 50. July’s reading was 50.9. A reading under 50 doesn’t necessarily indicate recession, but you can’t have a recession without a lousy PMI. Those of you who took Intro to Philosophy back in college will recognize that as a condition that is necessary but not sufficient.
Capacity Utilization will let you know when the recession has officially begun. Capacity utilization always plunges during recessions. Businesses that make stuff make less of it when the economy contracts and buying demand for their product dries up. (Hence, the unused capacity.) It could be either teetering on the brink right now or it could just be taking a breather.
Junk Bond Yields are still like, “whatever.” The planet is historically desperate for yield right now, so my guess is that if we’re going to have a recession, yields may be one of the last things to move and when they do it they’ll do it all at once.
Where I don’t go is the White House or the Fed for a read on the economy. It happens that they don’t see a recession coming. But we all know about their track record as forecasters.
Anyway, there are a lot of leading indicators that are flashing yellow. They’re not flashing red, which is why I continue to say that we’re not going to get a recession in 2011. But 2012 is a totally different story.
As a long-term investor, I’m concerned about that. A recession in 2012 would almost certainly mean that the stock market will enter a decisive bear market trend at some point between now and the end of this year. That could get ugly, too, with this new backdrop of fiscal austerity. There is no political will for additional stimulus so the “recovery” will be on its own.
The tide is receding around the U.S. economy and we’re about to discover whether or not it’s wearing a bathing suit.
Get defensive
The market crossed under the 200-day moving average on Tuesday. If you’re a long-term investor, it means you need to think twice before initiating new positions. If your horizon is a couple of years or so, you might also think about going to cash. And if you play in the alternative space, make sure you’ve got your bear-market/defensive strategies switched on.
My long-term outlook has now moved from “cautious” to “defensive.”
That being said, I think there may be opportunity if you’re a short-term trader and you know what you’re doing. The market is incredibly over sold right now on a technical basis.
I highlighted all the times in the last 2 years that the market has been this oversold. It doesn’t happen very often, but when it does, you can see that it’s a fairly powerful indicator. Even after the Flash Crash last May, stocks rallied back something fierce in the subsequent days, clearing the oversold condition only to establish another one a few weeks later. For this study I used a simple relative strength index, but there are many different oscillators that you can use.
Barton Biggs and Laszlo Brinyi — highly respected voices in this industry — have both come out and said that stocks should be purchased aggressively right here.
Now, that’s obviously going to depend on your risk tolerance. This is not a trade for everybody. But if I am a believer in one thing when it comes to the markets, it is the phenomenon of reversion to mean. Despite what you hear at euphoric bull market peaks or panicked bear market bottoms, markets only go so far in one direction before snapping back the other way.
What lies beneath
Suddenly, everything that we’ve been writing about in the last year or so seems incredibly relevant.
Remember all that talk about how it’s a new world, a world of slower, lumpier economic growth than we all got used to during the heyday of the Long Boom? A more volatile world with a new set of risks that we haven’t had to worry about for a long time?
This is the era of sacrifice, an environment of higher taxes and lower spending, an economy that can no longer depend on ever-increasing leverage and easy credit to keep it afloat.
I talked about some of these things in the book that I just published, The Trade of the Decade.
These trends are all unwinding and its going to take a while for the foundation of the next Super Bull Market to be poured. It’s going to be a turbulent decade. In the book I outlined some broad strategies to cope with all of this. I think may help lower your risk and help you returns.
The book is for sale now, too! Just in case you thought I was above a shameless plug.
Click here to get it for Kindle and click here to get it in PDF.
I published it under a Creative Commons license, which means it’s totally legal to pirate this thing. Buy a copy and send it to your colleagues. Go ahead and reprint an entire chapter on your website so long as you properly attribute yours truly and don’t use it for commercial purposes.
I worked hard on it and I hope you enjoy it. If the spirit catches you and you’ve found some of the things we’ve had to say around here of value, leave us a nice review over at Amazon.
Thanks for being such great readers.
And finally, something useful.
Here’s a question for you: have you lost any sleep in the last week because of what’s been going on in the markets?
If the answer is “yes,” then you’ve got too much risk on.
I’m serious. You need to re-balance your portfolio. Your subconscious is telling you something and my entire theory on investment philosophy is that there are a ton of strategies that work, but only a handful that will work for you. Find something that fits your personality.
If you’re nervous, cut your volatile positions and get some exposure to assets that don’t fluctuate so much. The sooner you do it, the better. Right now, my favorite place to get that kind of stuff is near the front of the yield curve in the corporate bond market. It’s not sexy, but it won’t give you bad dreams. There are a lot of mutual funds out there and even some ETFs that offer exposure to high-quality short-term corporate debt.
If you’re too good for boring ol’ corporate bonds and want to stay and play in the equity space, approach it with a similar philosophy. Re-balance your equity portfolio into high quality stocks, those that trade at sensible valuations and pay good dividends.
In the past, I’ve written about Intel, which has become one of the most boring companies on the planet. Their stock is trading at about 9x this year’s earnings. Over the next decade, their earnings won’t grow the way they did in their early days, but they will grow and probably do so at a rate greater than GDP. Intel also pays a 3.8% dividend and they’ve become one of those companies that raise it consistently. To top it off, they have no debt on their balance sheet.
I’m not endorsing Intel, and I don’t own it personally, but it’s a good example of the type of value that can be found out there in the market. There are a lot of companies out there with a similar profile and I think that businesses like that are going to make it through this tricky decade in great shape.
And if you enjoy the volatility and you like to trade the swings, knock yourself out. Everybody’s different. This is why I encourage you all to work with a financial professional who’s willing to go the extra mile to get a sense of who you are as a person.
