Wednesday, July 12, 2017

The Economy: “The Tripwire on the Next ‘Black Monday’”

“The Tripwire on the Next ‘Black Monday’”
by Brian Maher

"The Dow plunged 508 points that hell-mouth day - an unthinkable 22%. A similar stock market event today would spell a 4,724-point cataclysm. We liken that October day in 1987 to the ancient Battle of Cannae, when invincible Rome lost as many as 70,000 legionnaires to Hannibal’s armies - in a single day. Or July 1, 1916, the first day of the Battle of the Somme, when nearly 20,000 British soldiers fell before the German guns, and never got up.

What could lead today’s market to its own Cannae, its own Somme, another Black Monday? Today we set aside our renowned optimism, enter into the spirit of doom, and consider one possibility.

Harley Bassman is a world-class expert in derivatives - what Warren Buffett has termed “weapons of mass destruction.” Bassman’s taken the current market and put it under his microscope. He specifically wanted to answer: "The only question one cares about, identifying the tripwire that would tip our system into disequilibrium. That is, what could turn a bad day on Wall Street into another Black Monday-level event? And is there a specific point when the the dominoes could start going over?"

Turns out there might be. But before revealing that (black) magic number, let us identify the villain of this fellow’s tale, a possible trigger for the next event. It’s a suspect we’ve also recently identified: record-low market volatility. A typical portfolio might normally contain 60% stocks and 40% bonds. Bonds are generally considered safer than stocks.

But market volatility has been so low lately, many stocks seem as low-risk as a three-month Treasury. This despite a softening economy, rising interest rates, rising geopolitical tensions, etc. Note the diverging paths between global economic uncertainty and market volatility in this chart:
This record-low volatility has led investment funds to overshift their holdings away from bonds, and toward stocks. All is well as long as peace is abroad and rainbows appear in the skies over Wall Street. But if volatility spikes, if a storm whips up, all those funds that fattened on stocks will drop them quick as a wink. Then the selling could feed and feed and feed upon itself, until there’s nothing left to eat.

That’s what led to Black Monday in 1987. It began as just another down day. But once the market dropped below a critical threshold that October day, the computers caught a collective fever and unloaded everything in sight at the speed of electrons - hence the single-day 22% plummet.

As this Bassman fellow explains the dynamic: "Once a destabilizing event occurs it leads to a feedback loop where asset selling begets more selling. This exacerbated (but did not start) the 1987 crash."

Or as Jim Rickards describes: "In a bull market, the effect is to amplify the upside as indexers pile into hot stocks like Google and Apple. But a small sell-off can turn into a stampede as passive investors head for the exits all at once without regard to the fundamentals of a particular stock."

In nuce: Record-low volatility has thrown a mask over rising risk. Investment funds are flush with stocks they’ll all try to drop at once when a destabilizing event breaks. And that selling could possibly spiral once a critical threshold is crossed.

Ah, yes, but what is that threshold? At what point does that down day on Wall Street turn into a Cannae, a Somme, another Black Monday? Bassman’s investigations have yielded an answer: A 4% single-day drop: "It seems possible that as little as a 4% decline in a single day could be enough to create critical mass."

From today’s stratospheric Dow reading of 21,527 (at writing) a 4% single-day swoon translates to an 861-point loss. A thumping drop, yes, but not beyond imagining. A canvass of the past decade reveals 15 single-day drops of at least 469 points. The largest being 777 points on Sept. 29 2008, when the heavens nearly fell.

Could the next black day exceed even that figure? The answer lies outside our slender grasp. But consider... the Dow was around 11,100 on Sept. 29, 2008. And that 777-point cataclysm represented a 7% single-day plunge. But the Dow is now above 21,500. And if Bassman is right, a mere 4% single-day drop could be enough to unleash the hounds.

So in that sense today’s market could be even more precarious than 2008’s? Let us hope these dogs don’t slip the leash anytime soon… or ever.

Jim Rickards believes the signs of a worldwide financial meltdown are unmistakable, and shows you how the current market bubble “could break the world.” What could cause it to burst? Read on.”
“The Bubble That Could Break the World”
by Jim Rickards

"The key to bubble analysis is to look at what’s causing the bubble. If you get the hidden dynamics right, your ability to collect huge profits or avoid losses is greatly improved. Based on data going back to the 1929 crash, this current bubble looks like a particular kind that can produce large, sudden losses for investors. The market right now is especially susceptible to a sharp correction, or worse.

Before diving into the best way to play the current bubble dynamics to your advantage, let’s look at the evidence for whether a bubble exists in the first place.  My preferred metric is the Shiller Cyclically Adjusted PE Ratio or CAPE. This particular PE ratio was invented by Nobel Prize-winning economist Robert Shiller of Yale University. CAPE has several design features that set it apart from the PE ratios touted on Wall Street. The first is that it uses a rolling ten-year earnings period. This smooths out fluctuations based on temporary psychological, geopolitical, and commodity-linked factors that should not bear on fundamental valuation.

The second feature is that it is backward-looking only. This eliminates the rosy scenario forward-looking earnings projections favored by Wall Street.

The third feature is that that relevant data is available back to 1870, which allows for robust historical comparisons.

The chart below shows the CAPE from 1870 to 2017. Two conclusions emerge immediately. The CAPE today is around the same level as in 1929 just before the crash that started the Great Depression. The second is that the CAPE is higher today than it was just before the Panic of 2008.

Neither data point is definitive proof of a bubble. CAPE was much higher in 2000 when the dot.com  bubble burst. Neither data point means that the market will crash tomorrow. But today’s CAPE ratio is on the order of 180% of the median ratio of the past 137 years.

Given the mean-reverting nature of stock prices, the ratio is sending up storm warnings even if we cannot be sure exactly where and when the hurricane will come ashore.
This chart shows the Shiller Cyclically Adjusted PE Ratio (CAPE) from 1880-2017. Over this 137-year period, the mean ratio is 16.75, media ratio is 16.12, low is 4.78 (Dec 1920) and high is 44.19 (Dec 1999). Right now the 29.91 ratio is above the level of the Panic of 2008, and about equal to the level of the market crash that started the Great Depression.

With the likelihood of a bubble clear, we can now turn to bubble dynamics. The analysis begins with the fact that there are two distinct types of bubbles. Some bubbles are driven by narrative, and others by cheap credit. Narrative bubbles and credit bubbles burst for different reasons at different times. The difference is critical in knowing what to look for when you time bubbles, and for understanding who gets hurt when they burst.

A narrative-driven bubble is based on a story, or new paradigm, that justifies abandoning traditional valuation metrics. The most famous case of a narrative bubble is the late 1960s, early 1970s “Nifty Fifty” list of fifty stocks that were considered high growth with nowhere to go but up. The Nifty Fifty were often referred to as “one decision” stocks because you would just buy them and never sell. No further thought was required. Of course, the Nifty Fifty crashed with the overall market in 1974 and remained in an eight-year bear market until a new bull market began in 1982.

The dot.com  bubble of the late 1990s is another famous example of a narrative bubble. Investors bid up stock prices without regard to earnings, PE ratios, profits, discounted cash flow or healthy balance sheets. All that mattered were “eyeballs,” “clicks,” and other superficial internet metrics. The dot.com  bubble crashed and burned in 2000. The NASDAQ fell from over 5,000 to around 2,000, then took sixteen years to regain that lost ground before recently making new highs. Of course, many dot.com  companies did not recover and were never heard from again.

The credit-driven bubble has a different dynamic than a narrative-bubble. If professional investors and brokers can borrow money at 3%, invest in stocks earning 5%, and leverage 3-to-1, they can earn 6% returns on equity plus healthy capital gains that can boost the total return to 10% or higher. Even greater returns are possible using off-balance sheet derivatives. Credit bubbles don’t need a narrative or a good story. They just need easy money.

A narrative bubble bursts when the story changes. It’s exactly like The Emperor’s New Clothes where loyal subjects go along with the pretense that the emperor is finely dressed until a little boy shouts out that the emperor is actually naked. Psychology and behavior change in an instant. When investors realized in 2000 that Pets.com was not the next Amazon but just a sock-puppet mascot with negative cash flow, the stock crashed 98% in 9 months from IPO to bankruptcy. The sock-puppet had no clothes.

A credit bubble bursts when the credit dries up. The Fed isn’t raising interest rates just to pop a bubble - they would rather clean up the mess afterwards that try to guess when a bubble exists in the first place. But the Fed raising rates for other reasons, including the illusory Phillips Curve that assumes a tradeoff between low unemployment and high inflation, currency wars, inflation or to move away from the zero bound before the next recession. It doesn’t matter. Higher rates are a case of “taking away the punch bowl” and can cause a credit bubble to burst.

The other leading cause of bursting credit bubbles is rising credit losses. Higher credit losses can emerge in junk bonds (1989), emerging markets (1998), or commercial real estate (2008). Credit crack-ups in one sector lead to tightening credit conditions in all sectors and lead in turn to recessions and stock market corrections.

What type of bubble are we in now? What signs should investors look for to gauge when this bubble will burst? My starting hypothesis is that we are in a credit bubble, not a narrative bubble. There is no dominant story similar to the Nifty Fifty or dot.com days. Investors do look at traditional valuation metrics rather than invented substitutes contained in corporate press releases and Wall Street research. But even traditional valuation metrics can turn on a dime when the credit spigot is turned off.

Milton Friedman famously said the monetary policy acts with a lag. The Fed has force-fed the economy easy money with zero rates from 2008 to 2015 and abnormally low rates ever since. Now the effects have emerged.

On top of zero or low rates, the Fed printed almost $4 trillion of new money under its QE programs. Inflation has not appeared in consumer prices, but it has appeared in asset prices. Stocks, bonds, commodities and real estate are all levitating above an ocean of margin loans, student loans, auto loans, credit cards, mortgages, and their derivatives.

Now the Fed is throwing the gears in reverse. They are taking away the punchbowl. The Fed has raised rates four times in the past eighteen months and is on track for more. In addition, the Fed is preparing to do QE in reverse by reducing its balance sheet and contracting the base money supply. This is called quantitative tightening or QT, which I’ve discussed quite a bit recently.

Credit conditions are already starting to affect the real economy. Student loan losses are skyrocketing, which stands in the way of household formation and geographic mobility for recent graduates. Losses are also soaring on subprime auto loans, which has put a lid on new car sales. As these losses ripple through the economy, mortgages and credit cards will be the next to feel the pinch.

A recession will follow soon. The stock market is going to correct in the face of rising credit losses and tightening credit conditions. No one knows exactly when it’ll happen, but the time to prepare is now. Once the market corrects, it’ll be too late to act.”

No comments:

Post a Comment