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 Tips for Surviving the Next Two Months, Market’s Most Volati

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Registration date : 2007-07-01

PostSubject: Tips for Surviving the Next Two Months, Market’s Most Volati   Mon Sep 03, 2007 10:02 pm

Tips for Surviving the Next Two Months, Market’s Most Volatile Time

Posted by Dan Denning on Sep 3rd, 2007

a threatening month September is shaping up to be. Masked protestors
threaten violence this week up in Sydney. Meanwhile, candid central
bankers are calling the credit crunch a new kind of bank run. Rumours
abound of 9/11-style options trades on the S&P. And investors are
being “urged to ride out market volatility”, according to Karlis Salna
in today’s Australian.
Would you ride out a cyclone? A tsunami? A tornado? How about the
next two months in the market - traditionally two of the most volatile
and worst-performing? Being a “long term” investor has worked since
1982. Stocks have gone up. But now credit is in a bear market. How will
stocks continue to rise, or corporate earnings grow, with a bear market
in credit?
Andrew Pease, the chief investment strategist at the Russell
Investment Group, says that valuations are reasonable and the outlook
for corporate profits is good. “The Australian share market is now on a
forward PE ratio (ratio of share prices to 12 month ahead consensus
earnings forecasts) of 14.4 times and the MSCI developed world index is
on a forward PE ratio of just 13.6 times,” Pease said.
“For Australia,” Pease ads, “EPS forecasts have lifted from 8.3 per
cent to 9.8 per cent. June quarter earnings results were broadly better
than expected in the US, Europe and Asia, and the current Australian
reporting season is shaping up well.”
We’ve pointed out before that PE ratios are often low at the top of
a stock market cycle because earnings have grown so fast. Our simple
question is this: With a housing-led recession in America and rising
interest rates in Australia, what will drive corporate earnings growth
for the next two years? Now that we’re in a bear market for credit,
we’d expect much slower profit growth and a recession in America’s real
It’s not like we haven’t seen what happens at the top before. It’s
just that we’re choosing not to believe the end of the credit bubble
will result in falling stock prices. But why shouldn’t it? As the
Nasdaq declined to 4,900, 4,800, 4,500 there were plenty of dip buyers.
What a bunch of dipsticks.
Once the tech bubble burst, there was no going back. The Nasdaq fell
77% from its March 09, 2000 closing high of 5,041 to 1,114 on October
9th of 2002. Yes, it’s up 128% since then. But its Friday close at
2,542 is still 50% below the 2000 high. Asset classes that lead one
bull market up rarely lead the next one up. Instead, they go into a
generational bear market, like real estate in Japan. It takes a long
time to wash the taste of a crash out of your mouth.
How is today so different that a genuine bear market in credit does
not mean much lower stock prices? You could argue that there is real
economic growth to this boom, and that this boom is global. That would
give you some justification for buying stocks. But which stocks? And
more importantly, should you be buying any stocks at all right now,
when the bear market in credit appears to be getting ready for
something spectacular, vicious, and completely unplanned?
“The current turmoil in the financial markets has all the
characteristics of a classic banking crisis, but one that is taking
place outside the traditional banking sector, Axel Weber, president of
the Bundesbank, said at the weekend,” according to Krishna Guha in
today’s Financial Times.
“What we are seeing is basically what we see underlying all banking
crises,” Mr. Weber said. “Some Federal Reserve policymakers also
privately see comparisons between the current distress in credit
markets and the bank runs of the 19th century, in which savers lost
confidence in banks and demanded their money back, creating a
spiralling liquidity crisis for institutions that had invested this
money in longer-term assets,” Krishna added.
You can take off your tinfoil hat now. A “bank run” outside the
official banking sector is a real possibility in the next two months.
“James Hamilton, a professor at the University of California, warned
that – as in old-fashioned bank runs – sudden demand for liquidity can
lead to a fire sale of assets that depresses their price, making
otherwise solvent institutions insolvent.”
You need three things to profit from a fire sale. First, you have to
be outside the warehouse when it burns down. Second, your assets need
to be in your pocket in the form of cash rather than in the warehouse
in the form of ash. And third, you need an idea of what’s worth owning
at much lower prices, even if it’s damaged goods.
You can probably see where we’re going with this. Liquidating any
shares that are dependent on the US consumer is no longer an
interesting hypothetical. It’s probably a good time to do it. It may
even be the last window you get to do it while stock prices still
reflect the illusion that everything is fine.
Everything is not fine. But there are ways out of the US dollar. The
key is to unhitch your portfolio from the performance of the US
economy. You could also make a list of outstanding US firms worth
buying after a steep fall in the markets. But for the next twenty
years, the big driver of global growth is the East, not the West.
Follow the money.
“Growth, especially of private consumption in the United States,
will suffer because of the housing crisis and that can naturally not go
without negatively affecting the world economy overall,” wrote Deutsche
Bank CEO Josef Ackerman in a column published this weekend. He sees a
coming dislocation in the global economy as the US loses its place at
the top of the heap.
We agree. We’d only add that the short-term focus should be avoiding
the loss of your capital during the dislocation…so that you can use
that capital to scoop up assets after the worst is over. As for
timing…this is always the tough part. However, right now we’d say
there’s more to be lost by staying fully invested in stocks than there
is to be gained.
There is also some unusual activity in the options market to
consider. You may recall that prior to the 9/11 attacks in the US,
someone bought a lot of puts on US airline stocks. Those puts soared in
value when airline stocks tanked in the following weeks.
The Internet was abuzz with rumours last week of similar, seemingly
inexplicable activity in the S&P options market. Specifically,
someone seems to have sold around 65,000 deep in-the-money calls on the
S&P. The strike price on the calls is 700. The S&P currently
trades at 1,473. Who would write a call so deep in the money? And more
importantly, who would buy a call like that? The right, but not the
obligation, to buy the S&P at more than half its current level is
rather expensive.
There are also a few sizable bets on puts as well. Either way you
look at it, it would suggest someone is expecting a big move in the
S&P before September 21 (options expire on the third Friday of the
month). Not to worry, say Steven Smith and Aaron Task at the The unusual activity is part of a “box spread trade”.
“Simply put,” they write, “two parties agree to trade the box at a
price that essentially splits the difference between current rates. For
example, the rough numbers would be that given the September 700/1700
box must settle at a value of 1,000 - it is currently trading around
997 - that translates into a 5% interest rate. For the seller it is a
way to borrow money at a slight discount to the prevailing rate, and
for the buyer, it is a way to lend money at a low rate of return, but
it’s better than nothing at a time when others are scared and have
painted themselves into a box (ha ha) because they have run out
available funds.”
The technicalities baffle us. But the idea that a distressed hedge
fund facing redemption requests and not able to borrow money from a
bank can raise money by selling deep in-the-money-calls…that makes
sense to us, although it’s unusual. Then again, we live in unusual
times. And if you have to raise cash by selling options, well you do
what you gotta do, don’t you?
“Reptitio est mater doctrinae” we read this weekend. Repetition is
the mother of learning, to translate from the Latin. We point this out
not because we are trying to fake a knowledge of Latin, or any kind of
knowledge at all for that matter. Nope, we have a practical reason.
“The repetition of events, sometimes in precise detail, teaches us
that when similar forces converge, similar results emerge,” writes Sean
Carroll in The Making of the Fittest. Carroll was writing about how
evolution has often produced the same mutation in different species, in
different places, at different times in history. Natural selection
“selects” what’s needed when it’s needed.
But you can also apply this saying to the markets. All credit
bubbles are the products of the same basic ingredients…too much
money…too little discipline…too much greed and credulity on the part of
investors. The South Sea Bubble, John Law’s Mississippi Scheme, the
Dutch Tulip Mania, the tech bubble…they all were variations on the same
theme. Yet the DNA of credit bubbles is always the same.
Credit bubbles are also “fit for a purpose” in the popular sense.
They make people feel richer, for a while. They become “unfit” when the
misallocations of capital…the money wasted on wars, bogus financial
instruments, and plasma screen TVs must be reckoned up. The results are
sharply falling asset values in the stock market. And as Bill Bonner
and Lila Rajiva show in their new book, “Mobs, Messiahs, and Markets,”
the political and sociological results are often more shocking and
disruptive than the merely economic results.
Either way, here’s something to think about for the day. If the
biggest, baddest, most global credit bubble in all of human history is
popping - starting with the subprime mess in August, but ending God
knows where or when - are there any safe stocks to own in the market at
all? Or is it better to be in cash and well away from the coming
firestorm? Send us your thoughts at or leave a comment at the end of this post.
Dan Denning

The Daily Reckoning Australia
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