Short Now

Going out to dinner... brief thought:

1000 point jump in 2 days? With a plethora of bad economic news still on the way? Give me a break. Now is the time to short the market. My instincts tell me it's going down.

Oil at $40?

Yet another predictive story by the FT . National oil companies expect oil to fall to $40/barrel. Personally I don't think they will go that low, although it's certainly a possibility. This prediction reminds me of the summer, when Goldman Sachs predicted $200/barrel oil and OPEC gave even higher forecasts.

Deflation and Stock Market Valuation

Here's an interesting article about the spectre of deflation which bond markets are anticipating (inflation-indexed bonds are priced with the assumption that there will be deflation over the next 5 years).

In 2003, as the article points out, there was a deflation scare which caused the Fed to cut interest rates down to 1% and helped fuel the housing bubble. To paraphrase one banker who posted on an investing forum, "Under normal conditions, you go to work at 9 am and cautiously lend money until 5 pm. In 2003, all the 'good' loans for the day were made by 12 pm. This left everyone 5 hours to have a party and make crappy loans (and huge profits) with really cheap money."

30-year treasuries are now yielding a mere 4.4%. Short sale opportunity anyone? The only problem is proper timing. I KNOW they are overvalued, perhaps drastically so because most investors are afraid. This is irrationality in action. The only question is, WHEN will confidence return to the bond markets (so that yields can rise again and you can make money on a short sale)? And will the return of confidence be gradual or sudden?

Also, I am grappling with the question of whether the stock market is currently 'undervalued' or whether it is now finally returning to fair value after a decade of decadent capital gains. I have seen blog posts and heard people say both. I suppose it depends on the way you compute P/E. This article answers the question rather nicely. As does the graph below, showing cyclical P/E ratios just returning to average after years of overvaluation. Cyclical P/E ratios are computed using the price of the stock over the average of the earnings over the last 10 years.


As the article says however, "The news has to come with the caveat that markets are prone to overshoot and become too cheap after prolonged periods when they have been too expensive. Hence, both these measures are consistent with stocks falling much lower before they find a bottom, even though they are currently fairly priced."

Will the market fall ever further after the recent boom period? If one believes that economies which experience a tremendous amount of unsustainable activity must compensate by enduring periods of slowdown below potential growth to compensate and that these economic booms and busts are reflected in stock prices (translated in technical terms as the negative serial correlation of real stock market returns) , then it looks like we may still have a long way to fall.

Here is a prescient report by Andrew Smithers written in February 2007. His thinking on economics, finance and market valuation is quite pragmatic and many of his predictions have already come true. He writes:

"The average return over the past 10 to 30 years has been over 8%, compared with 6.9% over the past 135 years. Investors in the US stock market must expect very poor returns over the medium-term, such as the next 5 to 10 years."

Check THIS one out:

"The gap between the valuations given by CAPE and q indicate, at first sight, that financials are much more overvalued than nonfinancials. We check, by an alternative approach to cyclical adjustment, the overvaluation indicated by CAPE. This confirms the estimate of overvaluation. On the other hand, our look at the details of net worth data for non-financials leads us to suspect that these have become increasingly overstated in recent years."

He concludes:

"The US stock market is probably overvalued by around 77%, as indicated by CAPE, and thus needs to fall to around 800 on the S&P 500 index to reach fair value."

Keep in mind, this was written BEFORE THE FINANCIAL CRISIS. The S&P 500 as of today is at 873. Which means there is still quite a way down to go, especially if you take overshooting into account.

A Goodwill Bubble

I have always been wary of extreme emotion on a group level. It can be fun and exciting in a harmless context like a sports game, but in the arena of national politics it can be deadly, especially without strong institutions.

(I wonder if leaders who enjoy extremely strong support can more easily be hated, and if leaders who merely experience moderate support equivalently experience moderate dislike, in the same way that a high technology stock will gain or lose 40% in a week and a utility company might only fluctuate by 5%.)

I believe that we are currently experiencing a 'bubble' of political goodwill with the election of Obama. Surely he might turn out to be a good (or even great) president, but it is rare that such enthusiasm and adoration from the crowd persists over a long stretch of time. At some point, even the most beloved politicians make one misstep too many and lose their political base. And even if the politican is able to inspire the country (a la FDR) his actual policies may do more harm than good as in FDR's case who attempted to pump-prime the economy in classical Keynesian style by paying men to bury money and then paying them once again to dig it up. As I understand it, unproductive procyclical fiscal policy and a lack of business confidence were two major reasons for the perpetuation of the Great Depression. Undoubtedly fiscal policy only works well when it is conducted productively.

(Note to self: investigate this question some more. What are the quantitative differences between productive and unproductive fiscal policy? What specific policies count as productive or unproductive? Did it really perpetuate the Great Depression? Learn more about the Great Depression's causes. There is so much to learn!)

I digress. I tentatively predict that Obama will enter the White House with a large amount of support, but at some point will slip up and experience a temporary or more likely, permanent decrease in goodwill. Barring assassination, this seems to be the life cycle of most politicians. The less history a politician has, the fewer hard binary choices he's made, the fewer groups he's pissed off, the more people like him. Obama seems to be intelligent and practical; I doubt he would make the recession worse in 2009 by instituting contractionary fiscal policy in the form of much higher taxes or trade restrictions. But if he does, the economic effects could be devastating and his political life cycle would be that much shorter.

Annoying Cliches

I see these all too often when I read business/political news. They are especially prevalent in online forum discussions and political speeches. They betray a lack of rhetorical skill that may also imply a broader lack of creativity and intellect.

"Shore up the economy"

"Quick study"

"Chickens come home to roost."

"Boots on the ground" - in reference to Iraq/Afghanistan usually

"That's an X, if I've ever seen one."

More to be added.