The nature of crashes is they are often seen in the rear-view mirror. Only in retrospect does it become clear they have happened. Except for 1987, they haven’t been short blips.
It took the summer of 1932 for the 1929 Great Depression to bottom out at 90% retreat. Every time the market turned upward a few days, hopes were lifted that the pain was over, the bottom in place and the market in recovery mode. The same applied in 2001 and 2007.
The next downturn won’t be seen, and it will take its good old time.
January 2007, banking stocks slowly crumbled as they were weighed down by “non-performing loans”. The markets as a whole continued to rise. It wasn’t until fall 2007 that the rest of the market started to comprehend the depth and scope of the issue.
A market crash is like missing the forest for the trees. We are 10 years into a bull market and the cracks are starting to appear, slowly but surely.
A bull market is a market where share prices are rising, encouraging buying
From start-ups rushing to the market with all time high total market capitalizations anticipating slowly earnings growth. Chinese downturn and weak European data. Significant deficits in the US, which could well be exacerbated by a recession, hampering the Fed response to stimulate the economy. Share buybacks have been propping up earnings. Trade tariffs have cost consumers over 20 billion dollars in 2018 alone, and are set to worsen as companies are forced to relocate, switch out banned or expensive technologies and cut back operations. The yield curve briefly inverted which has occurred pre to the last 7 recessions. Trump tax cuts are accelerating US deficits. The housing market is cooling, and with it the wealth effect and consumer confidence, feeding into a diminishing Purchasing Manager’s Index (PMI). While these factors do not entail a recession in and of themselves, the market reacts to a confluence of news. These can worsen or abate depending on new economic and geopolitical inputs as and when they arise.
No one can predict the future with any degree of certainty. Anyone who knows a crash is imminent will have magically gained an insight no other has. If you find them, let me know and I’ll leverage every piece of property to my name, mortgage my home and convert all to cash and short using the most leveraged instrument like index futures with a strike far out of the money.
Sarcasm aside, what makes investors good returns is not timing the market but time in the market.
Monthly contributions over many years will average out these dips and troughs in widely diversified plays. But there is something to be said for placement and rebalancing. It is starting to look like the bull market has run its course, bar the US election year looming.
The problem for investors isn’t just falling prices but the risks built into the financial system, the most potent of which in recent memory was the 2008 market collapse, acutely felt in properties and stocks.
Alternatives to Decouple From Risk
The problem with asset-based financial instruments is their interconnectedness. The ease with which new products can be built from existing instruments already accepted as having value has spawned a financial system with two critical flaws. One being every aspect of the system is connected to every other aspect of the system meaning that the failure of one institution can precipitate catastrophic failure in the system itself. Secondly, the extent of the risk of this interdependent system cannot be quantified, i.e. the risk is unknown.
This can be illustrated by the total value of 2014 broad money at $80.9 trillion. All derivative contracts came in at $1.2 quadrillion. No one really knows the size of the market.
The 2007 subprime mortgage bailouts with the collapse of Lehman Brothers on September 15, 2008 led to a full-blown international banking crisis. Excessive risk-taking helped to magnify the financial impact globally. Massive bail-outs and palliative monetary and fiscal policies were employed to prevent the world financial system’s collapse.
Steve Eisman, perhaps know best as played by Steve Carell in “The Big Short”, happened to see this coming. He described the situation like so:
“There’s no limit to the risk in the market. A bank with a market capitalization of one billion dollars might have one trillion dollars’ worth of credit default swaps outstanding. No one knows how many there are! The failure of, say, Citigroup might be economically tolerable. It would trigger losses to Citigroup’s shareholders, bondholders, and employees – but the sums involved were known to all. Citigroup’s failure, however, would also trigger the payoff of a massive bet of unknown dimensions from people who had sold credit default swaps on Citigroup to those who had bought them.”
The “unknown dimensions” quoted by Eisman are the dependencies of other institutions on, in this case, Citigroup. That is to say, the value of financial institutions – banks, insurers, brokerages, clearing houses – all depends on others in the chain. This mutual dependence is the result of asset-based instruments, and the scope of its risk lies in the inability to assess the exposure. Combined, these represent systemic institutional failure.
Belief-based instruments like gold or oil are unlikely to carry the same systemic failure risk, because their value does not depend on another asset by necessity. Bitcoin and oil may well carry value even in the event of worldwide financial system collapse. A good analogy would be comparing them to the internet, one asset fails and another can take its place.
Failing development of belief-based instruments like Tether coin pegged on parity with the US dollar, redeemable for fiat-currency at any time. Media in 2018 stated it was not backed by US dollars. This would mean that the parity is established as a function of expectations. Therefore, it demonstrates belief-based instruments can track specific stated value, e.g. tokens track spot price of gold without the risks of exposure to the asset-based instruments and the token value would be outside legislative security requirements.
A point of failure is isolated, quantifiable and limited to the sum invested. Any repercussions are thereby limited. It would open possibilities of saving as a form of investment, currently made not possible because of the inflationary nature of fiat currencies.
This paves the way for investment products that deviate from the unquantifiable, systemic risks of institutional failure arising from asset-based instruments (hedge funds, derivatives).
A decoupling would preserve value should globally interconnected markets and their institutions fall.
Failing faith in cryptographic tokens, what are the alternatives?
Short term fixed deposits earning higher interest as the Fed raises interest rates to cool the overheating economy. Other Central Banks tend to follow suit. Current stock valuations at all-time highs, so when the dip comes, you may want to wait it out for confirmatory trend reversal. In 2000, it took 3 years to reach the bottom. Valuations are not far off 2000, meaning this crash may last longer than expected. Shorting the S&P E-Mini Future Contract with leverage and liquidity, and sans the premium decay of options.
Experts tell us to sit tight and wade it out. Experts are generally the same. For those of a nervous disposition, seeing half your net worth evaporate before your eyes, being told to pucker up and sit put isn’t a whole lot of comfort as they watch their hard-earned savings sink. Instinct tells us to sell out before it gets worse.
Stock market crash vs stock market correction
The occasional crash is the price paid by investors for the higher returns available from stock markets. Otherwise, investing would be easy. The trouble is, people tend to over-react to volatility, often selling out just as markets are about to recover. In fact, what may seem like a crash is actually a correction, defined as 10% fall as opposed to a 20% fall. Corrections are natural parts of the cycle and occur annually according to Deutsche Bank.
Investors should bear in mind: the strongest gains often come after the biggest falls.
So Should I Sell?
The US research group Dalbar runs a study on investor behaviour each year.
It has found investors have lost an average of 8% per year over the last 30 years, as a result of buying at the wrong time and selling at the wrong time. As such, it’s crucial to stay invested, no matter how uncomfortable it feels.
There is one exception to the rule: Japan 1989 December 29th. The Nikkei reached 38,916 all-time high. The asset bubble had surged upwards with property prices leading the way. What goes up must come down as they say. After 30 years, the Nikkei sat at 21,269.
So, although patience tends to pay, don’t put all your eggs in one basket.